25th annual health sciences tax conference - ey · partnerships and joint ventures (jvs): ......

25th Annual Health Sciences Tax ConferencePartnerships and joint ventures (JVs): Mergers and acquisitions (M&A), current developments, and JVs with exempt organizationsDecember 9, 2015

Partnerships and joint ventures (JVs): mergers and acquisitions (M&A), current developments, and JVs with exempt organizations

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► This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer’s facts and circumstances.

► These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice.


Presenters

► Dan Jensen HCANashville, TN

► Dave Courtney Ardent Health ServicesNashville, TN

► David MillerErnst & Young LLPDallas, [email protected]+1 214 969 0636

► Eric J. Matuszak Ernst & Young LLPLos Angeles, [email protected]+1 213 240 7075


Agenda

► M&A topics► Mixing bowl trap► Disregarded entities – disappearing liability trap► Preferred returns and guaranteed payments► Unlocking value – Up-C structure► Unlocking real estate value – real estate investment trust (REIT)

conversions

► Current developments► Notice 2015-54► New partnership audit and adjustment rules

► JVs with exempt organizations


M&A topics


Mixing bowl trap


Mixing bowl rules

► General rule► The “mixing bowl rules” generally require a partner that contributes built-in gain

property to a partnership to recognize gain if, within seven years of the contribution, either:► Section 704(c)(1)(B) – the contributed property is distributed to another partner,

Or ► Section 737 – other property is distributed to the contributing partner

► Amount of gain► Section 704(c)(1)(B) – the remaining unrecognized Section 704(c) gain in the

contributed property – i.e., gain that would have been allocated to the contributor pursuant to Section 704(c) if the contributed property had been sold for its fair market value as of the time of the distribution

► Section 737 – the lesser of (1) the remaining unrecognized Section 704(c) gain in the contributed property or (2) the excess of the fair market value of the distributed property over the adjusted basis of the contributing partner’s partnership interest

► In both cases, the gain recognized “burns off” over time in the case of depreciable Section 704(c) property (as the Section 704(c) gain burns off)


Mixing bowl transactions

Section 737

TP Partner

LLC

Section 704(c)(1)(B)

Partner

LLC

TP


Mixing bowl exceptions

Section 704(c)(1)(B) exceptions► Certain liquidations

► Section 704(c) property is distributed to the non-contributor in liquidation of the partnership and (1) in the liquidation, the contributing partner receives an interest in the contributed Section 704(c) property and no other property; and (2) the built-in gain or loss in the property after the distribution is at least equal to the built-in gain or loss that would have been allocated to the contributing partner on a sale of the property immediately before the distribution



Section 737 exception► Certain divisions

► Transfer by a partnership (transferor partnership) of all of the contributing partner’s Section 704(c) property to a second partnership (transferee partnership) in a Section 721 transaction, followed by a distribution of an interest in the transferee partnership (and no other property) in complete liquidation of the interest of the contributing partner

► Previously contributed property► Property distributed to the contributing partner consists of previously

contributed property► Certain exceptions to the exception for distributions of interests in previously

contributed entities



Dual exceptions► Technical terminations► Complete transfers to another partnership

► A transfer by a partnership (transferor partnership) of all of its assets and liabilities to a second partnership (transferee partnership) in an exchange described in Section 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership as part of the same plan or arrangement

► Incorporation of a partnership► Like-kind property► Undivided interest

► A distribution of an undivided interest in property that does not exceed the undivided interest contributed by the distributee partner


Mixing bowl trap example 1

TP Partner

LLC

Operating assets

Operatingassets

► Taxpayer (TP) and Partner each contributed an operating business to LLC on Day 1

► The venture has not worked out well and TP and Partner would like to liquidate LLC (with each taking back the business it contributed)

► Do any of the mixing bowl exceptions apply?

► What if LLC has new furniture, fixtures and equipment (FF&E), other purchased assets, etc.?

► Are the existing intangibles associated with the businesses the same intangibles each partner originally contributed?



► TP contributes Asset 1 (land) and Partner contributes cash to LLC on Day 1

► The plan to develop the land falls apart, and TP and Partner would like to unwind LLC

► LLC is liquidated; TP receives an undivided interest in the land it contributed, and Partner receives an undivided interest in the land plus all other assets of LLC

► Do any mixing bowl exceptions apply to the distribution of an undivided interest in the land to Partner?

TP Partner

LLC

Asset 1 $



► TP and Partner each contribute units in existing partnership (PS) to LLC on Day 1

► The partners disagree as to whether to later sell the interests in PS

► Can the partners agree to have LLC sell PS units on behalf of one partner and allocate the gain solely to that partner?

► If not, can LLC distribute PS units back to the partners without triggering gain under the mixing bowl rules? Is whether LLC made subsequent contributions to PS relevant?PS

Third Party

PSunits

TP Partner

LLC

Asset 1 $


Disregarded entities – disappearing liability trap


Disappearing liability trap

Deemed liquidation of a partnership► TP has an outstanding loan to LLC and

purchases Investor’s interests in LLC for cash

► Under Rev. Rul. 99-6, LLC is deemed to liquidate with TP deemed to receive a portion of LLC’s assets in a liquidating distribution

► Even though the loan remains in existence for state law purposes, it “disappears” for federal tax purposes when the borrower (LLC) becomes a disregarded entity of the lender (TP)

► Is LLC deemed to distribute a portion of its assets in satisfaction of the loan in a taxable transaction? If so, what if some assets trigger gains and others trigger losses?

► Is the loan deemed discharged in a manner that triggers cancellation of debt income (CODI)?

► Is the loan deemed discharged without any tax consequences?

Assets

Loan by TP to LLC = $40

TP Investor$

LLC

LLC units


Preferred returns and guaranteed payments


Overview

► In a typical fund structure (real estate, private equity, etc.) investors contribute capital in exchange for an interest that entitles such investor to both a common and a preferred return.

► In a given year, the character of the preferred return income can vary depending on whether the payment is considered to be a distributive share of partnership income or a guaranteed payment under Section 707(c).


Section 707(c)

► Section 707(c) states: ► To the extent determined without regard to the income of the

partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for purposes of Section 61(a) (relating to gross income) and, subject to Section 263, for purposes of Section 162(a) (relating to trade or business expenses).


Section 707(c) regulation example

► Under an existing regulation example, a partner entitled to receive the greater of a percentage of partnership income or a specified amount is treated as receiving a guaranteed payment only to the extent the allocated share is less than the minimum amount.

► For example, if a partner is to receive the greater of $10,000 or 20% of partnership income (determined without regard to the payment) and the partnership reports $20,000 of income for the year, the partner would be entitled to $10,000. Under the existing regulations, $4,000 of the payment (20% of $20,000) would be characterized as an allocable share of income and $6,000 would be treated as a guaranteed payment under Section 707(c).


Section 707(c) regulation example

► A proposed regulation package would modify the current regulation example to state that the entire minimum amount ($10,000) is to be treated as a guaranteed payment in light of the fact that the minimum amount is not subject to significant entrepreneurial risk.


Example

► A contributes $20 of cash in exchange for a 20% common interest and B contributes $80 of cash in exchange for a 10% preferred return and an 80% common interest

► Is any of B’s $8 preferred return a guaranteed payment if PRS:► Earns $0 of net and gross income in

Year 1 (i.e., PRS owns as its sole asset stock of a subsidiary corporation that doesn’t pay a dividend)?

► Loses $100 of net income in Year 1 (made up of $100 of gross income and $200 of expenses)?► If not, must PRS allocate $100 of

gross income to B under Section 704(b)?

B

PRS

$80$20

A

20% 80%


Unlocking value – Up-C structure


Representative traditional IPO transaction steps

► Step 1: Legacy Owners contribute property to newly formed C corporation (PubCo)

► Step 2: PubCo issues common stock to the Public in an initial public offering (IPO) for cash

► Result: PubCo takes a carryover basis in the assets contributed by the Legacy Owners

PubCo

LegacyOwners Public


Representative formation transaction steps

► Step 1: Legacy Owners acquire high vote stock (golden shares) in a newly formed C corporation (PubCo)

► Step 2: PubCo issues regular common stock to the Public in an IPO for cash

► Step 3: Legacy Owners contribute Business and PubCo contributes cash to partnership (OpCo) ► PubCo holds the managing interest in

OpCo► Legacy Owners’ units in OpCo are

exchangeable for stock in PubCo on a one-for-one basis

► PubCo will take a fair market value basisin those units upon a later exchange resulting in a step-up in tax basis

PubCo

OpCo

Business

LP GP

Class B Class A

LegacyOwners Public


Benefits of the Up-C structure

► Raise equity capital through a well-accepted public vehicle

► Take advantage of public multiples► Preserves single level of tax for legacy owners► Potential for tax-efficient monetization for legacy owners► Exchange rights provide liquidity to legacy owners► Creates two types of acquisition currency► Tax-efficient management incentives through profits

interests► Tax receivable agreement (TRA) increases return to

legacy owners as compared to traditional IPO structures


Tax receivable agreement

► Up-C structure provides PubCo with a step-up in the tax basis of its share of the partnership’s assets upon legacy owners’ exchange of units (in contrast to a traditional IPO)

► PubCo and legacy owners share the benefit of the step-up (generally 85% to the legacy owners and 15% to PubCo)

► TRA payments typically made in cash and are treated as additional purchase price paid by PubCo for units in OpCo (and interest)

► TRA provides legacy owners with additional cash payments as compared to a traditional IPO

► Market does not appear to view presence of the TRA negatively

► Different types of basis adjustments may or may not be covered under the TRA

► Anti-churning considerations


TRA – simple example

► Assumptions► Step-up delivered to PubCo:

$100► PubCo effective tax rate: 40%► TRA payment ratio: 85% to

legacy owners► Discount rate for net present

value: 8%► Step-up allocated entirely to

intangible assets amortizable over 15 years

► PubCo has sufficient taxable income to utilize amortization as generated

► Iterative effect of TRA payments on basis step-up and interest payments are ignored for this calculation

YearPubCo

amortizationPubCo

cash taxsavings

TRA paymentto legacyowners

Net cashsavings to

PubCo

1 $ 6.67 $ 2.67 $ 2.27 $ 0.40 2 6.67 2.67 2.27 0.40 3 6.67 2.67 2.27 0.40 4 6.67 2.67 2.27 0.40 5 6.67 2.67 2.27 0.40 6 6.67 2.67 2.27 0.40 7 6.67 2.67 2.27 0.40 8 6.67 2.67 2.27 0.40 9 6.67 2.67 2.27 0.40

10 6.67 2.67 2.27 0.40 11 6.67 2.67 2.27 0.40 12 6.67 2.67 2.27 0.40 13 6.67 2.67 2.27 0.40 14 6.67 2.67 2.27 0.40 15 6.67 2.67 2.27 0.40

Total $ 100.00 $ 40.00 $ 34.00 $ 6.00

Nominal value to legacy owners $34.00 Net present value to legacy owners $19.40


Unlocking real estate value – REIT conversions


REIT introduction

► REITs generally provide greater access to capital for real estate oriented businesses than other structures.► The listed REIT sector is well established.

► REITs (particularly umbrella partnership real estate investment trusts (UPREITs)) have significant advantages in structuring future property acquisitions because they generally can offer a mix of consideration (i.e., cash, REIT stock and/or operating partnership (OP) units) tailored to each particular seller’s business needs.

► REITs minimize their corporate tax expense (relative to a C corporation) via dividends paid deductions (DPDs).

► To qualify for REIT tax treatment, among other requirements, the REIT’s assets must primarily consist of real estate and its income must primarily consist of rents or interest on loans secured by real estate.


OpCo-PropCo REIT conversions

► A handful of high-profile businesses in a variety of industries have recently separated or announced plans to separate their real estate assets into a REIT that leases (or will lease) the real estate to the operating business.► Penn National Gaming (Gaming and Leisure Properties, Inc.)► Windstream (Communications Sales & Leasing, Inc.)► Ensign Group (CareTrust)► Darden (Four Corners Property Trust)► Energy Future Holdings

► Many of these transactions were structured as tax-free spin-offs under Section 355 and were completed after receiving a private letter ruling from the Internal Revenue Service (IRS).► The IRS has recently announced that it generally will no longer entertain private

letter ruling requests involving spin-off transactions in which the distributing or controlled corporation elects to be a REIT.


Activity in the health care space

► The long-term trend of separating health care real estate (e.g., medical office, lab space, senior housing, skilled nursing) is broadening to the hospital sector – examples include Medical Properties Trust/Capella Healthcare and Ventas/Ardent Health Services.

► Although the capital advantages of major players (e.g., Ventas, HCP, Welltower, Omega) have moderated in recent months, we continue to see significant appetite among the listed REITs and private equity players for health care assets.

► Notwithstanding the activity in the area, many providers in the hospital sector are concerned about the impact of a transaction with a REIT on their ability to control the real estate.


UPREIT IPO alternative to Section 355 spin-off

Public

Realestate

► Instead of spinning off its real estate into a REIT in a Section 355 transaction, OpCo transfers its real estate using a partnership structure:► Step (1): Newly formed REIT issues stock

in an IPO► Step (2A): REIT contributes its IPO

proceeds to OP, a partnership, in exchange for OP units

► Step (2B): OpCo contributes its real estate to OP in exchange for OP units► OP units are generally exchangeable

for REIT stock► OpCo’s contribution can be combined

with certain disguised sale planning techniques – e.g., assumption of OpCo liabilities, reimbursement of capital expenditures

► Step (3): OP leases real estate to OpCo► See, for example, MGM and CyrusOne

Realestate

Operating assets

$

Lease

$

1

2A2B

3

REIT

OP

OpCo


UPREIT IPO alternative to Section 355 spin-off

OpCo

Public

OP

REIT

Realestate

Operating assets Lease


Current developments


Notice 2015-54


Notice 2015-54 – overview

► Treasury and the IRS announced the intent to issue regulations under:► Section 721(c) providing that Section 721(a) will not apply when a US transferor

contributes “Section 721(c) Property” to a “Section 721(c) Partnership,” unless the “Gain Deferral Method” is applied with respect to such Section 721(c) Property

► Sections 482 and 6662 are applicable to controlled transactions involving partnerships to ensure the appropriate valuation of such transactions

► Regulations under Section 721(c) will apply to transfers occurring on or after August 6, 2015

► Section 721(c) Property► Built-in gain (BIG) property, subject to certain exclusions

► Section 721(c) Partnership► Domestic or foreign partnership if: (1) one or more foreign persons related to the

US transferor is a direct or indirect partner in the partnership; and (2) the US transferor and related persons own more than 50% of the interests in partnership capital, profits, deductions or losses


Notice 2015-54 – Gain Deferral Method

► Remedial allocation method – Partnership adopts the remedial allocation method with respect to all Section 721(c) Property contributed by US transferors

► Proportionate allocation – In each taxable year in which there is remaining BIG on the Section 721(c) Property, all items of Section 704(b) income, gain, loss and deduction with respect to such property are allocated in the same proportion

► Reporting requirements – The reporting requirements under Sections 6038, 6038B and 6046A are satisfied


Notice 2015-54 – Gain Deferral Method

► Acceleration event – US transferor recognizes BIG with respect to any item of Section 721(c) Property upon an “Acceleration Event”► An Acceleration Event is any transaction that either would reduce the

amount of remaining BIG that a US transferor would recognize under the Gain Deferral Method, or could defer the recognition of BIG.

► Subsequent contributions – The Gain Deferral Method is applied to all subsequent contributions until the earlier of: (i) when no BIG remains on any Section 721(c) Property to which the Gain Deferral Method first applied; or (ii) 60 months after the initial contribution to which the Gain Deferral Method applied


New partnership audit and adjustment rules


► As part of the Bipartisan Budget Act of 2015, Congress made significant changes to the partnership audit and adjustment rules.

► The legislation replaces the Tax Equity and Fiscal Responsibility Act of 1982 partnership audit rules (Sections 6221 through 6234).

► The legislation repeals the special rules for electing large partnerships (Sections 771 through 777 and Sections 6240 through 6255).

► The new rules are designed to collect adjustments from the partnership rather than from the partners.

► The new rules would apply to partnership returns filed for tax years beginning after December 31, 2017.

Bipartisan Budget Act of 2015


► New Section 6221 provides that: ► Any adjustment to items of income, gain, loss, deduction or credit

of a partnership for a partnership taxable year (and any partner’s distributive share thereof) shall be determined, any tax attributable thereto shall be assessed and collected, and the applicability of any penalty, addition to tax or additional amount that relates to an adjustment to any such item or share shall be determined at the partnership level.

► Certain partnerships with 100 or fewer partners can elect out of new Section 6621.

New Section 6221


► Underpayments collected from partnerships:► For adjustments that result in tax underpayments, new Section

6225 allows the IRS to collect the additional tax directly from the partnership in the year of an adjustment.

► The tax can be collected at the highest individual tax rate.

► If the partnership elects, any imputed underpayment of tax by the partnership can be taken into account and paid by the partners if certain conditions and procedures are satisfied.

Other changes


► Partnership representative► New Section 6223 requires partnerships to designate a

partnership representative “who shall have the sole authority to act on behalf of the partnership in this subchapter.”

► The partnerships and all partners will be bound by the actions of the partnership and by any final decision in a proceeding with respect to the partnership.

Other changes


JVs with exempt organizations


Impact on exempt organization – status

► Participation in a JV may cause an exempt organization to lose its exempt status.► See Redlands Surgical Services v. Comm’r, 113 T.C. 47 (1999)

► Exempt organizations may participate in a JV without losing their exempt status in certain situations.► Rev. Rul. 98-15 – An exempt organization may form and

participate in a partnership or LLC provided: 1. The participation furthers a charitable purpose.2. The arrangement permits the exempt organization to act exclusively in

furtherance of its exempt purpose and only incidentally for the benefit of the for-profit partners or LLC members.

3. If a management contract is entered into, the exempt organization retains “ultimate authority” over the assets and activities being managed and the terms and conditions of the contract are “reasonable.”


Impact on exempt organization – unrelated business taxable income (UBTI)

► When an exempt organization is a partner in a JV, that exempt partner may recognize and pay tax on UBTI.

► UBTI may result from many sources, including:► Dealer sales by the JV (e.g., home or condo sales)

► Active business income of the JV (e.g., service income)

► Acquisition indebtedness► However, Section 514(c)(9) provides limited exceptions for “qualified

organizations” provided that the “fractions rule” is met.


Impacts on JV and other taxable partners

► A partner’s tax exempt status impacts the JV, including: ► Whether allocations have substantial economic effect

► Effective savings clause that ensures proper capital accounts at liquidation is generally required

► The application of the Section 704(c) anti-abuse rule► Absent the anti-abuse rule, the traditional method may shift income to

a tax-exempt partner in certain instances► The application of Section 706► Recovery period and method of depreciable property

► See Section 168(h)(6)► The application of Section 163(j)’s interest stripping rules

► Applicable when “blocker” corporation is used and is capitalized with debt


Questions?

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