partnership preferred returns: identifying capital shifts and...

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Partnership Preferred Returns: Identifying

Capital Shifts and Recharacterization Risks

TUESDAY, DECEMBER 6, 2016, 1:00-2:50 pm Eastern

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Dec. 6, 2016

Partnership Preferred Returns Net Income

James R. Browne, Partner

Barnes & Thornburg, Dallas

[email protected]

Joseph C. Mandarino, Partner

Smith Gambrell & Russell, Atlanta

[email protected]



Disclaimer

This document is not intended to provide advice on any specific legal

matter or factual situation, and should not be relied upon without

consultation with qualified professional advisors.

Any tax advice contained in this document and any attachments was

not intended or written to be used, and cannot be used, for the

purpose of (i) avoiding penalties that may be imposed under

applicable tax laws, or (ii) promoting, marketing, or recommending

to another party any transaction or tax-related matter.

Partnership Preferred Returns: Identifying Capital Shifts and

Recharacterization Risks

James R. Browne Barnes & Thornburg LLP

2100 McKinney, Suite 1250 Dallas, Texas 75201 Tel: 214.258.4133

Email: [email protected]

December 6, 2016

Part I – Target Allocations and Preferred Returns

6

Two Types of Agreements

• Allocation-based agreements ‒Allocation provisions control economics ‒First allocate income and loss to the capital

accounts according to detailed allocation rules ‒Then liquidate according to capital accounts • Operating cash flow distributions are often made according to

specified percentage interests, but liquidating distributions are always made in proportion to capital account balances

• Distribution-based agreements ‒Distribution provisions control economics ‒Distribute cash according to specified sharing rules, and

allocate income or loss to track the distributions

7 December 6, 2016

Two Types of Allocations

• Layered allocations ‒ Compute each partner’s share of profit and loss

directly based on detailed allocation rules ‒ Generally results in “layers” of allocations

• Target allocations ‒ Compute each partner’s share of profit and loss

indirectly based on the partner’s distributive share of total partnership capital (target capital account)

‒ Each partner’s profit or loss is the amount needed to cause the partner’s ending capital to equal the target capital account (net of minimum gain; i.e., deductions and loss funded by debt)

• Hybrid ‒ Layered allocations for operating profit/loss and target

allocations for profit/loss on liquidation 8 December 6, 2016

Layered vs. Target Allocations

Layered Allocation

Solve for ending capital using allocated income/loss: Beginning capital

+ Contributions

– Distributions

+/– Allocated income / loss

= Ending capital

Target Allocation

Solve for allocated income/loss using targeted ending capital: Targeted ending capital*

– Contributions

+ Distributions

– Beginning capital

= Allocated income / loss * minus minimum gain related to nonrecourse debt

9 December 6, 2016

Evolution of Agreements

• Early practice ‒ Initially, allocation-based agreements were

the norm • Allocation-based agreements always use layered allocations

‒ As economic deals got more complex (carried interests, preferred returns, etc.), allocation-based agreements created problems • Errors in drafting complex layered allocation provisions could lead to

unintended economic results • Even if the drafting was correct, accounting errors could produce

untended economic results • Other disparities between cash distributed and capital accounts • Special allocations increase complexity and opportunities for errors

10 December 6, 2016

Evolution of Agreements

• Modern practice ‒ Partners and lawyers responded by

moving to distribution-based agreements ‒ Initially, distribution-based agreements used layered

allocations that traced the expected cash distributions • Same economics/allocations disparity risks, but it was an accounting

problem not a deal economics problem

‒ Target allocations were invented to eliminate the need to draft complex layered allocation provisions • The accountants just “plug” to the economics as necessary

‒Distribution-based agreements with target allocations are now the norm in complex deals

11 December 6, 2016

Ex. 1 - Allocation-Based Agreement

• Facts ‒ M contributes $1MM cash, and S contributes $0, to Newco ‒ Newco buys $1MM assets for a widget manufacturing business to

be managed by S ‒ No debt

• Economic deal ‒ First, 10% preferred return to M ‒ Next, return of M’s capital ‒ Next $1MM, 80% to M and 20% to S ‒ Residual, 50% to M and 50% to S

12 December 6, 2016


• Distributions ‒Operating cash is distributed according to the economic deal ‒ Liquidating distributions are distributed according to the

partners’ positive capital accounts (maintained according to the Section 704(b) capital account maintenance rules) • Note that capital accounts control final distributions,

making this an allocation-based agreement ‒ The operating agreement contains a qualified income offset

in lieu of a deficit restoration obligation (DRO)

13 December 6, 2016


• Allocations (layered allocation provision) ‒ a. Profits:

• (i) Excess Loss Recapture: First, to partners in proportion to and to the extent of the excess of (1) the cumulative losses allocated under Section b(v) over (2) the cumulative profits previously allocated under this Section a(i)

• (ii) Capital Loss Recapture: Next, to partners in proportion to and to the extent of the excess of (1) the cumulative losses allocated under Section b(iv) over (2) the cumulative profits previously allocated under this Section a(iii)

• (iii) Preferred Return: Next, to partners in proportion to excess of (1) the sum of (A) cumulative losses under Section b(iii) plus (B) Preferred Return over (2) the cumulative profits previously allocated under this Section a(ii)

• (iv) 80/20 Allocation: Next, 80% to M and 20% to S to the extent the cumulative profits allocated under this Section a(iv) is less than $1MM minus the cumulative losses allocated under Section b(ii),

• (v) 50/50 Allocation: Thereafter, 50% to M and 20% to S

14 December 6, 2016


• Allocations (layered allocation provision) ‒ b. Losses:

• (i) 50/50 Profit Chargeback: First, to partners in proportion to and to the extent of the excess of (1) the cumulative profits allocated under Section a(v) over (2) the cumulative losses allocated under this Section b(i)

• (ii) 80/20 Profit Chargeback: Next, to partners in proportion to and to the extent of the excess of (1) the cumulative profits allocated under Section a(iv) over (2) the cumulative losses allocated under this Section b(ii)

• (iii) Preferred Return Profit Chargeback: Next, to partners in proportion to and to the extent of the excess of (1) the cumulative profits allocated under Section a(iii) over (2) the cumulative losses allocated under this Section b(iii)

• (iv) Capital Loss: Next, to partners in proportion to and to the extent of their unreturned capital contributions

• (v) Excess Loss: Thereafter, 50% to M and 50% to S (subject to regulatory prohibition on adjusted capital account deficits)

15 December 6, 2016

Ex. 2 - Distribution-Based Agreement

• Same facts and deal terms as Example 1 • Distributions ‒ All distributions are made according to the economic deal (i.e., not

according to capital account balances)

• Allocations (target allocation provision) ‒ Net profit or loss is allocated to the members as

necessary to cause each member’s capital account to equal, as nearly as possible, (i) the amount the member would receive if all Newco assets at the end of the allocation period were sold for cash at their [book values], all Newco liabilities were satisfied according to their terms, and any remaining cash was distributed to the members according to the distribution waterfall, minus (ii) [minimum gain].

16 December 6, 2016

Defining the Preferred Return

• Fertile ground for disputes! ‒ The definition of preferred return in the

operating agreement is often poorly drafted, setting up potential future disputes regarding the preferred equity holder’s economic rights

‒ A related area of concern is determining whether the preferred return and return of capital thresholds in the distribution waterfall have been satisfied such that distributions are made according to the residual sharing provisions

December 6, 2016 17


• Example Distributable Cash will be distributed in the following order of priority:

(a) First, to the Members until each Member has received a 6% preferred return on Invested Capital.

(b) Second, to the Members until each Member’s Adjusted Capital Contribution has been reduced to zero.

(c) Finally, to the Members in proportion to their Percentage Interests.

• Issues ‒ Allocation among Members within tiers 1 and 2 ‒ Definitions of Invested Capital and Adjusted Capital Contribution ‒ One-time or repeated application of preferred return (“until” issue) ‒ Preferred return compounding and compounding period; measurement

period; conventions (e.g., 360/365 day year); proration within periods

December 6, 2016 18


• Planning ‒ Pay special attention to the definition of preferred return and

to the operation of the distribution waterfall to make sure they work as intended

‒ Avoid complex financial concepts (such as internal rate of return) and Excel® formulas; those provisions often create unrecognized problems

‒ Prepare a financial model for forecasted operations; it can identify gaps and ambiguities in the definitions and distribution mechanics and thereby minimize the risk of future disputes

December 6, 2016 19

Preferred Return Example (Simple)

• Facts ‒Distribution waterfall (same as prior examples) • First, 10% preferred return to M • Next, return of M’s capital • Next $1MM, 80% to M and 20% to S • Residual, 50% to M and 50% to S

‒Operating Results • Year 1: $120,000 book/tax profit and cash distribution • Year 2: $150,000 book/tax profit and cash distribution • Year 3: Sale of property for $2,400,000

December 6, 2016 20


• Year 1 and 2 capital accounts (layered allocations)

21

01/01/Y1 Capital Contribution 1,000,000 1,000,000 - 1,000,000 600,000

12/31/Y1 Year 1 Profit Allocation 120,000

a(iii) Preferred Return 100,000

a(iv) 80/20 split 16,000 4,000 (20,000)

12/31/Y1 Year 1 Distributions (120,000)

1. Preferred Return (100,000)

2. Return of Capital (20,000) (20,000) -

12/31/Y1 Year 1 Ending Capital 1,000,000 996,000 4,000 980,000 580,000

01/01/Y2 Year 2 Beginning Capital 1,000,000 996,000 4,000 980,000 580,000

12/31/Y2 Year 2 Profit Allocation 150,000


a(iv) 80/20 split 41,600 10,400 (52,000)



2. Return of Capital (52,000) (52,000)


Date DescriptionUnreturned

Capital80/20 SplitTotal M S

December 6, 2016


• Year 3 capital accounts (layered allocations)

22

01/01/Y3 Year 3 Beginning Capital 1,000,000 985,600 14,400 928,000 528,000

01/01/Y3 Year 3 Gain on Sale 1,400,000


a(iv) 80/20 split 422,400 105,600 (528,000)

a(v) 50/50 split 389,600 389,600

01/01/Y3 Year 3 Adjusted Capital Accounts 2,400,000 1,890,400 509,600 928,000

01/01/Y3 Year 3 Distributions (2,400,000) (1,890,400) (509,600) (928,000)

01/01/Y3 Year 3 Ending Capital - - - - -

Check 1. Preferred Return (92,800) (92,800)

2. Return of Capital (928,000) (928,000)

3. 80/20 split (600,000) (480,000) (120,000)

4. 50/50 split (779,200) (389,600) (389,600)

(2,400,000) (1,890,400) (509,600)

Unreturned

Capital80/20 SplitDate Description Total M S

December 6, 2016


• Year 1 capital accounts (target allocations)

23

01/01/Y1 Capital Contribution 1,000,000 1,000,000 - 1,000,000 600,000



2. Return of Capital (20,000) (20,000) -

12/31/Y1 Year 1 Profit Allocation (plug) 120,000 116,000 4,000 (20,000)


check Total Capital to Be Distributed 1,000,000

1. Preferred Return -

2. Return of Capital 980,000 980,000

3. 80/20 split 20,000 16,000 4,000

4. 50/50 split

Target Capital Accounts 1,000,000 996,000 4,000

Unreturned

Capital80/20 SplitDate Description Total M S

December 6, 2016

Part I Summary

• Two types of agreements: ‒ Allocation-based: the allocation provisions control the

economics (distributions are determined by capital accounts) ‒Distribution-based: the distribution provisions control the

economics (capital accounts are not controlling)

• Two types of allocations: ‒ Layered: profit/loss is allocated to the partners based on

specified shares and layers ‒ Target: profit/loss is allocated based on targeted capital

account balances

December 6, 2016 24

Part I Summary (con’t)

• For “straight up” deals where each partner shares according to contributed cash, an allocation-based agreement with layered allocations is workable

• For more complex deals (including deals with preferred returns), current practice prefers a distribution-based agreement using target allocations

• In either case, pay careful attention to definitions and to deal specific issues (such as tax distributions, special allocations, debt-funded expenses, character issues, etc.)

‒ Target allocations are not a cure-all!

25 December 6, 2016

December 6, 2016

Joseph C. Mandarino Smith, Gambrell & Russell, LLP

Promenade II, Suite 3100

1230 Peachtree Street Atlanta, Georgia 30309

www.sgrlaw.com

Partnership Preferred Returns: Identifying Capital Shifts and

Recharacterization Risks

http://www.balch.com/

http://www.seblaw.com/

http://www.seblaw.com/

Overview

• Preferred Returns and Guaranteed Payment Issues

• Preferred Returns and Capital Shift Issues

• Preferred Returns and Disguised Sale Issues

• Mitigating Risks

28

Preferred Returns and Guaranteed Payment Issues

29


• In general, an allocation or payment to partner that is made without regard to partnership income is treated as a guaranteed payment.

• The guaranteed payment rules were originally devised to handle compensatory payments by a partnership to a partner.

• Example 1: Newco’s operating agreement provides that Jones, the managing member, receives $1,000 each week.

• Generally, this would be viewed as a guaranteed payment because it is not dependent on the income of Newco.

30


• Example 2: Newco’s operating agreement provides that Jones, the managing member, receives the first $1,000 of Newco’s income each week.

• Generally, this would be not be viewed as a guaranteed payment because it is dependent on the income of Newco – if there is no income, then Jones is not paid anything.

31


• A preferred return arrangement could be treated as a guaranteed payment.

• As noted, in many instances, the arrangement will be drafted so that a return is accrued or earned or credited to a partner regardless of whether the partnership actually has any income.

• Here we have to separate preferred return arrangements that are more in the nature of preferred distributions and those arrangements that provide (directly or indirectly) for allocations of income.

32


• Assuming that a preferred return arrangement is subject to the guaranteed payment rules, then what are the consequences?

• This, unfortunately, is unclear. There are two main views here:

• treat the income as interest income to the partner and create an offsetting interest for the rest of the partnership

• treat the income as “distributive share” income – it has the same items and attributes as any allocation of income.

33


• If income allocations under a preferred return arrangement can be treated as allocations of interest, it may open up several planning opportunities.

• For example, an tax-exempt partner may prefer this treatment because interest income is generally not included in UBTI.

• Assuming a partnership earns income from the active conduct of a trade or business. If a pension fund investors receives a distributive share of such income, the fund may have to include the income in UBTI and pay tax on it.

34


• If, instead, the pension fund is allocated income under a preferred return arrangement and that income is treated as interest, then it may be excluded from UBTI and the fund would avoid having to pay tax.

• Similarly, a foreign investor may also prefer that the income from a preferred return arrangement be treated as interest.

• For example, if a foreign person becomes a partner in a partnership that conducts a U.S. trade or business then the foreign person will generally be subject to U.S. income tax on his or her distributive share of partnership income.

35


• Moreover, such an arrangement would also subject the foreign person to a U.S. tax filing obligation.

• If, instead, the foreign person is allocated income under a preferred return arrangement and that income is treated as interest, and if such interest comes within the portfolio debt exclusion, then the foreign person may be able to avoid U.S. tax on the income and avoid filing a U.S. tax return.

• Even if the requirements of the portfolio debt exclusion are not met, the interest income may be subject to a reduced rate of withholding under a U.S. tax treaty (or even a zero rate).

36


• However, in some instances a partner may not want interest treatment and may prefer distributive share treatment.

• For example, assume that a partnership sells capital assets at a gain. A distributive share of the partnership income in that year could include a significant amount of capital gain income.

• An individual partner might prefer to be allocated a distributive share of such income, rather than received interest income.

37


• Unfortunately, a very old regulation suggests that guaranteed payments are always ordinary income.

• Treas. Reg. §1.707-1(c):

• Guaranteed payments do not constitute an interest in partnership profits for purposes of sections 706(b)(3), 707(b), and 708(b). For the purposes of other provisions of the internal revenue laws, guaranteed payments are regarded as a partner's distributive share of ordinary income.

• This suggests that, with certain exceptions, guaranteed payments, even under the distributive share view, cannot include capital gain income.

38


• While this regulation appears to preclude interest-treatment, it appears to be contradicted by a more recent regulation – Treas. Reg. §1.704-1(b)(2)(iv)(o) – which can be read to suggest that interest treatment is the appropriate view.

• Even under Treas. Reg. §1.707-1(c), the apparent all-ordinary-income approach that is advocated breaks down if the partnership has no actual income in the year of allocation.

39


• For feign and exempt investors, the characterization can be critical – treatment as interest may permit a direct investment and result in a higher after-tax yield.

• Conversely, the distributive share approach could force such investors to use corporate blockers and/or could reduce the after-tax yield.

40

Preferred Returns and Capital Shift Issues

41


• Capital shift issues can also be triggered by preferred return arrangements.

• Example

• X and Y form Newco with $500 cash each. Newco buys real estate (Redacre) for $1,000 and plans to hold it for five years and then sell it. X is more risk-averse than Y. The partnership agreement provides that if Redacre is sold, the first $1,000 of proceeds will be distributed $750 to X and $250 to Y, and thereafter, 25% to X and 75% to Y.

• Thus, X is trading off future profit for a greater immediate share of proceeds.

42


• This arrangement creates a hypothetical capital shift.

• If Redacre is sold the day after it is purchased, and assuming no increase in the value of Redacre, then X is entitled to $750, while Y is entitled to only $250.

• If this occurred, then X has a $250 gain and Y has a $250 loss.

• Practitioners will say that $250 of Y’s capital has shifted to X.

43


• Is this capital shift a taxable event?

• It is not clear under the capital account rules that Newco would be required to adjust the capital accounts of X and Y for a hypothetical event.

• The IRS might argue that in order to come within the 704(b) safe harbor, Newco must maintain capital accounts and liquidate in accordance with capital account balances.

• Thus, the IRS would argue that in order to so liquidate, it is necessary to adjust the capital accounts of X and Y today.

44


• And, to adjust the capital accounts appropriately, it is necessary to allocate $250 of income to X and allocate a loss or expense of $250 to Y.

• Then, in subsequent periods, it would be necessary to adjust Y’s capital account further based on changes in the value of Redacre.

• Thus, if Redacre increased in value by $100, Y would be allocated $100 of income so that Y’s capital account reflected an increase of $100.

45


• Assume that Newco does sell in year 5, but has no income or loss until then.

• Nonetheless, under this view, Newco is required to book annual income and/or loss amounts based on the sharing waterfall and changes in the value of Redacre.

• Thus, Newco is required, effectively, to report Redacre on a mark-to-market basis.

• There is no specific authority for this.

• There is analogous authority in the compensatory equity area.

46


• Assume instead that the Newco operating arrangement provides for a return of capital plus a 10% preferred annual return to X, then a return of capital to Y, and then all income is split 25/75 between X and Y.

• Again, the IRS could argue that if Redacre is sold the next day, then X would be entitled to a distribution of $550 (i.e., a return of capital of $500, plus a 10% preferred return of $50).

• If Newco has no actual income, do we force through a phantom income amount of $50 to X and a phantom loss or expense amount of $50 to Y?

47


• In year 2, assuming there is still no income at the Newco level, do we nonetheless make another $50 phantom income allocation to X and a $50 phantom loss or expense allocation to Y?

• Here we have reduced the first year phantom income hit, and instead we make smaller allocations each year equal to the preferred return amount.

• Note that under this approach the phantom allocations are driven by the preferred return rate and not by the value of Redacre.

48


• In fact, the value of Redacre should be taken into account to determine the necessary capital account balances.

• For example, if Redacre increased in value by $50 at the end of year 1, then the phantom loss allocation to Y is unnecessary.

• If Redacre increased in value by $150 by the end of year 1, then there would still be a phantom income allocation of $50 to X to reflect the preferred return, and the balance of $100 would be split 25/75, for a total allocation of $75 to X and a $75 to Y.

49


• However, again, Newco has no actual income.

• And it is extremely odd that changes in the value of a partnership’s assets should drive changes in capital account balances.

• Indeed, the general approach in the Code is to wait for a disposition event before a change in the value of an asset triggers taxable income or loss.

• Thus, absent some other provision of the operating agreement, Newco might take the position that no capital account adjustments (and therefore no phantom income or loss allocations) are necessary until there is a disposition event.

51


• Now let us assume that X is very risk averse. Instead of a preferred return or preferred distribution, X wants its capital account to increase in real time so that, if Newco is liquidated, X will have a strong argument for a preference in that liquidation.

• Thus, the preferred return arrangement is drafted so that X’s capital account is increase annually by a 10% return on equity.

• In this instance, it would appear that an income allocation is needed to change X’s capital account balance. Moreover, if Newco has no income, then this must be a phantom allocation.

52


• And, if Newco has no income and if X is allocated phantom income, then it would follow that Y must be allocated a phantom loss.

• Assuming this is done, what is the nature of the income or loss?

• If Newco merely holds a capital asset for investment purposes, there is an argument under Arrowsmith that the income and loss items should be of the same character as the event that they relate to – i.e., the eventual sale of Redacre.

• Thus, the allocations should be of capital gain and capital loss.

53


• If Newco was engaged in a trade or business, then it would follow that the phantom allocations should be of ordinary income or loss.

• What if, due to other activities that Newco engages in after the year 1 allocation, Redacre ceases to be a capital asset and its disposition triggers ordinary income or loss.

• Arguably, the year 1 allocations as capital gain and loss could be defended on the basis that Redacre was still a capital asset.

• This lesson here is the complexity of engaging in phantom allocations.

54


• Assume now that X’s 10% return is treated as a guaranteed payment. This will not run through X’s capital account. Instead, Newco’s accounting method will come into play.

• For example, if Newco is an accrual basis taxpayer, then the accrual of X’s 10% preferred return would be the key event: at that time, X would have $50 of income, Y would have a $50 loss or expense item, and Y’s capital account would be reduced by $50. Note that because the preferred return qualifies as a guaranteed payment, it does not add to or run through X’s capital account.

55


• If Newco were a cash basis taxpayer, then the payment of X’s 10% preferred return would be the key event: at that time, X would have $50 of income, Y would have a $50 loss or expense item, and Y’s capital account would be reduced by $50. Again, because the preferred return qualifies as a guaranteed payment, it does not add to or run through X’s capital account.

• Note that during the period between the accrual of X’s preferred return and its actual payment, there are no consequences to X or Y or their capital accounts. Thus, if Newco is a cash basis taxpayer, the use of preferred return arrangements that are guaranteed payments may permit some planning.

56

Preferred Returns and Disguised Sale Issues

57


• The disguised sale rules of the Code can convert a transaction or series of transactions that the parties assumed would not be taxable into one or more taxable events.

• There are several “disguised sale” rules within the Code, but our focus here is on IRC 707(b).

58


• In order to come within IRC 707(b), three elements must be present:

• there is a direct or indirect transfer of money or other property by a partner to a partnership,

• there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and

• these transfers, when viewed together, are properly characterized as a sale or exchange of property.

59


• The most difficult element in many cases is proving that the transfers are related.

• The regulations provide a presumption that if the transfers occur within 2 years of each other, they are related.

• Conversely, if the transfers occur more than 2 years apart, they are not related.

60


• In the case of a preferred return, it would appear that there is a transfer to the partnership (a capital contribution), followed by a transfer by the partnership to the same partner (the preferred return).

• Thus, practitioners have generally been concerned that many common preferred return provisions would trigger the disguised sale rules.

• The relevant regulations provide an important safe-harbor that overrules the 2-year presumption.

61


• Generally, a preferred return will not trigger disguised sale treatment if it is reasonable.

• Regardless of the labels used by the parties, such payments must actually be for the use of capital.

• The key is that such payments must be to provide the partner with a return on investment in the partnership.

62


• The §1.707-4 regulations set up the safe harbor noted above that overrides the 2-year presumption in the §1.707-3 regulations.

• Safe Harbor:

• The partnership agreement must provide for a preferred return in writing for the use of capitol.

• The rate must not exceed 150% of the highest AFR for the unreturned capital balance.

63


• The December/2016 long-term AFR is 2.26%.

• Under -4 regulations, then, a preferred return in excess of 3.39% would be outside of the safe harbor. Such a preferred return would be subject to the 2-year presumption of the -3 regulations.

• As a practical matter, most preferred returns will exceed the safe harbor.

• What happens?

64


• Cash Contributions

• Non-Cash Contributions

65


• Assume a partner makes a cash contribution on which the partnership pays a preferred return.

• If the transactions are treated as triggering the disguised sale rules, the original contribution can be treated as a taxable event, rather than a tax-free contribution to capital.

• But, if the contribution was all-cash, the partner would not recognize any gain or loss, because cash has a basis equal to FMV.

• Thus, re-casting such a contribution as a taxable sale generally would not have any tax consequences.

66


• Assume a partner makes a non-cash contribution on which the partnership pays a preferred return. Furthermore, assume the contributed property has a significant amount of built-in gain.

• In that case, the application of the disguised sale rules could trigger the built-in gain.

• However, the type of preferred return will be important.

• For example, if the partnership agreement allocates income to the partner, then the effect of the disguised sale rules may be mitigated.

67

Mitigating Risk

68

Mitigating Risk – Guaranteed Payment Issues

• determine whether you want guaranteed payment treatment

• draft arrangement so that it provides for preferred distributions rather than income allocations

• link guarantee payment to partnership income

• re-structure as a loan for overt interest treatment

69

Mitigating Risk -- Capital Shift Issues

• avoid use of targeted capital account allocations

• rely on compensatory capital shift regulations

• partner’s interest in the partnership/non-safe harbor approach

• preferred returns that are not tied to adjustments to capital account balances

• open transaction approach

• income allocation approach – nature of income and loss

• guaranteed payments – cash vs. accrual basis timing

70

Mitigating Risk -- Disguised Sale Issues

• safe-harbor (150% of AFR)

• link preferred return to income (entrepreneurial risk doctrine)

• effect of disguised sale on cash contribution

• effect of disguised sale on non-cash contribution

71

partnership preferred returns: identifying capital shifts and...

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