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Recent developments in corporate and partnership planning
Domestic Tax Conference
May 14, 2013
Eighth Annual Domestic Tax Conference2
Disclaimer
► Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited located in the US.
► This presentation is ©2013 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young and its member firms expressly disclaim any liability in connection with use of this presentation or its contents by any third party.
► The views expressed by panelists in this webcast are not necessarily those of Ernst & Young LLP.
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Circular 230 disclaimer
► Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.
► These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice.
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Today's presenters
► Robert Crnkovich► Todd Golub► Steve Flanagan► Michael Kaibni► Mark Lowry
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Topics
► Section 355 Monetization Strategies & New No-rule Policy► Section 355 & REIT Election► Partnership IPO Structures► Virtual Incorporations► Gone & Back Strategy► Chairman Camp’s Small Business Tax Reform Draft
Proposal
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Section 355 Monetization Strategies & New IRS No-rule Positions
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Background
► A frequent objective in Section 355 transactions is to optimize the capital structures of the businesses of the distributing corporation (“D”) and the controlled corporation (“C”), providing each business with a capital structure tailored to how it operates.
► Another frequent objective is for a corporate group to divest itself of one or more lines of business in order to focus on a core business (or business). However, D may want or need to receive compensation for the divestiture but, for a variety of reasons, a sale of the unwanted business may not be possible or practical.
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General Methods
► Generally, there are six methods by which the value can be extracted from a non-core business in connection with the tax-free separation of core and non-core operations. ► Controlled Assumption of Liabilities: assumption of liabilities of the
distributing corporation (D) by the controlled corporation (C);► Controlled Cash Distribution: distribution of C’s cash in exchange for
assets transferred by D;► Controlled Cash Purchase: C’s purchase of D’s assets for cash;► Controlled Securities Exchange: exchange of C securities (long-term
debt) for D debt;► Controlled Stock Exchange: exchange of a portion of C stock for D debt;
and ► Reverse Direction Spin-off: leverage the non-core business and spin the
core business (together with the proceeds of leveraging)
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Controlled Assumption of Liabilities and Distribution of Cash: Mechanics & Limitations
Mechanics► D transfers Business 2 to newly formed C in exchange
for C stock, cash (debt funded), and C’s assumption of some of D’s outstanding liabilities and D distributes the stock of C to its shareholders.
Business 2
C stock, cash, & assumption of D
liabilities
Limitations► Basis Limitation: Assumed liabilities and distributed cash are cumulatively limited to the
basis of the assets transferred by D to C.► To the extent that the liabilities assumed by C and cash distributed to D exceed the basis in the
transferred assets, D will recognize gain.► Contingent liabilities generally excluded.
► Use of Cash: Cash must be used by D (i) to repay its debt* OR ii) for distribution to its shareholders (i.e., dividends or redemptions).
D
C
D S/Hs
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Controlled Securities & Stock Exchange Prior to No-Rule: Mechanics
Mechanics
► D issues $600M principal amount short-term debt (ST debt) to a financial institution (FI), which holds the debt for its own account, in exchange for cash.
► D transfers Business 2 to a newly formed C in exchange for ► $300M of C securities (long term debt), and ► Two classes of C common stock – Class A high vote
(80% vote & 60% value) and Class B low vote (20% vote & 40% value).
► D transfers the C securities (300M), and Class B low vote shares to FI in exchange for the $600M ST debt and distributes the C Class A stock to D’s shareholders in a distribution intended to qualify under Sections 355 and 368(a)(1)(D).
► FI sells the C securities & Class B shares for cash in a public offering.
D
D S/Hs
Bus 2
D
D S/Hs
C
Bus 2
C stock
FI
$600MST debt
$600M cash
FI
$300M C securities & C
Class B shares
$600M D Debt
Bus 2
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Controlled Securities & Stock Exchange Prior to No-Rule: Mechanics (continued)
► D now has $600M of cash with no restrictions on what the cash can be used for.
► Receipt of Controlled Stock and Controlled Securities is currently NOT basis limited (compare distribution of cash or assumption of a liability).
► Key to tax free treatment of Securities Exchange & Stock Exchange is that the Securities & Stock were used to retire D “Debt”.
D
D S/Hs
C
Bus 2
$600M Cash
80% Vote/60% Value
New S/Hs20% Vote/40% Value
SecurityHolders
FI
$ Fees
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Revenue Procedure 2013-3, Section 5, No-Rule, Areas Under Study► New Debt Issuance: Whether either sections 355 or 361 applies to a distributing
corporation's distribution of stock or securities of a controlled corporation in exchange for, and in retirement of, debt issued in anticipation of the distribution.
► Control: Whether a corporation is a "controlled corporation" within the meaning of section 355(a)(1)(A) if, in anticipation of a distribution, control was acquired as the result of a recapitalization, or if, in anticipation of a distribution such corporation issues stock to another person having different voting power per share than the stock held by the distributing corporation.
► North-South: Whether transfers of property by a person to a corporation and transfers of property by that corporation to that person in what are ostensibly two separate transactions (so-called "north-south" transactions), at least one of which is a distribution with respect to the corporation's stock, a contribution to capital, or an acquisition of stock, are respected as separate transactions for Federal income tax purposes.
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North-South Example
Parent
D
C
Cash Controlled Stock
► For business reasons, D would like to distribute the stock of C to Parent.► However, Distributing is subject to certain debt
covenants and Parent needs to contribute cash or other assets to D in order to compensate for the loss of C.
► Alternatively, in a recent but unrelated transaction, Parent contributed business assets to D.
► Under the current no-rule position, the Service will not rule on this transaction.► Potential 20% exception► Note: the North-South no-rule applies to Section
355 distributions as well as to other movements of property outside of the Section 355 context.
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Section 355 & REIT Election
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Spin-off and related “Propco” REIT conversion
Parent
Propco
Propertyassets and
entities
Propcoshares
Step 1: The dropdown Step 2: The spin-off
Shareholders
Parent(Opco)
Propcoshares
Propco
Shareholders
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Summary illustration of Opco/Propco spin-off (cont.)
Step 3: Post-spin-off
Shareholders
PropcoOpco(former Parent)
100% 100%
LeaseAgreement*
* Alternatively, Opco could enter into a management agreement with Propco or a subsidiary of Propco.
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Partnership IPO Structures
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Partnership IPO StructuresOverview
► Publicly Traded Partnership (PTP) / Master Limited Partnership (MLP)► Limited availability► Limited investor base► Complex reporting
► Up-C Structure► Possible application where:
► PTP is not available or desirable► Issuer cannot consolidate with Sponsor
► Tax Receivable Agreement
► Full-on Incorporation / Traditional IPO
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Partnership IPO StructuresPTP/MLP vs. Up-C vs. Traditional
PublicSponsor
PTP/MLP
PTP/MLP
PublicSponsor
OpCo
Up-C
NonqualifyingIncome
QualifyingIncome
PubCo
High-Vote Shares
Qualifying & Nonqualifying
Income
PublicSponsor
IPO Co.
Qualifying & Nonqualifying
Income
Traditional IPO
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Partnership IPO StructuresComparison of IPO Structures
PTP / MLP► Double tax only on
nonqualifying (blocked) income
► Asset basis step up on sales of equity, except for blocked assets
UP-C► Double tax on Public’s
share► Asset basis step up on
sales of Sponsor equity
Traditional IPO► Double tax on everything
unless Sponsor can consolidate
► No asset basis step up on sales of equity
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Partnership IPO StructuresUp-C Structure Benefits and Considerations
► Benefits► Tax receivable agreements
► Cash benefit to Founders► PubCo agrees to pay the Founders a percentage (commonly 85%) of the
cash tax benefit it receives from a positive Section 743(b) adjustment (and other attributes) in OpCo’s assets
► Founders are still subject to a single level of tax► Provides multiple currencies (OpCo interests and PubCo stock) for
future acquisitions and/or executive compensation arrangements
► Considerations► Anti-churning rules (if PubCo is related to Founders)► Introduces greater complexity from several perspectives (e.g.,
governance, operating, capital markets, accounting, tax)
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Checkable Arrangements (a.k.a. Virtual Incorporations)
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Virtual incorporations
► USP operates division X (“Division X”). ► USP also owns 100% of the stock of
Oldco.► USP wants to incorporate Division X for tax
reasons, but, due to non-tax reasons (e.g., non-transferrable assets, transfer taxes, regulatory, etc.), USP cannot transfer the assets of Division X to another legal entity.
► Reg. §301.7701-3(a) provides that a “business entity” that is not classified as a corporation (i.e., an “eligible entity”) can elect to its classification for US federal tax purposes. Division X is not an “entity” for purposes of the check-the-box regulations.
Beginning structure
USP
OldcoDivisionX
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Virtual incorporations (cont’d)
► In order to obtain the benefits of “incorporating” Division X, the following steps are taken:1. USP and Oldco enter into a contractual
arrangement, under which Oldco will share in the economics of Division X.► See Reg. §301.7701-1(a)(2) (“A joint
venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.”)
2. Division X elects to be treated as a corporation for US federal tax purposes.
► Same result if Division X is a branch.
► See, e.g., PLR 201305006.► “Entity” status considerations – how
significant?
Contract execution
USP
Oldco
profits interest in Branch
Check-the-box election
DivisionX
profits interest
DivisionX
USP
Oldco
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Gone and back in 120 seconds – Taxable Distributions and Upstream Reorganizations
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Gone and back in 120 seconds
► Parent is a holding company.
► Sub 1 has two lines of business (X and Y).
► Sub 2 has one line of business (X only).
► For valid non-tax business reasons, Parent wants only Sub 2 to operate business line X.
Parent
Sub 2Sub 1X & Y X
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Sub 1
Gone and back in 120 seconds (cont’d)
► Step 1: At 11:57 p.m. on Day 1, Sub 1 converts to an SMLLC pursuant to applicable state elective conversion statutes.
Parent
Sub 2X & Y X
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Parent
Sub 2S1Sub 1 LLC
X
► Step 2: At 11:58 p.m. on Day 1, Sub 1 LLC transfers business line X directly to Sub 2 in exchange for no consideration.
Gone and back in 120 seconds (cont’d)
XX & Y
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Parent
Sub 2S1
► Step 3: At 11:59 p.m. on Day 1, Sub 1 LLC converts back to a corporation pursuant to applicable state elective conversion statutes.
Gone and back in 120 seconds (cont’d)
Sub 1 LLCXY
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Parent
Sub 2Sub 1
► Section 311(b) distribution?
► Section 332 liquidation followed by Section 351 transfer?
► Sideways reorganization with boot?
► Upstream reorganization?
► See, e.g., PLR 201201012; PLR 201127004.► New “technology?”
► PLR vs. opinion letter.
► State tax consequences.
► Impact of minority shareholder ownership of Sub 1?
Gone and back in 120 seconds (cont’d)
Parent
Sub 2Sub 1
11:56 p.m.
11:59 p.m.
X
XY
X & Y
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Chairman Camp’s Small Business Tax Reform Draft Proposal
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Camp Draft ProposalOverview
► On March 12, 2013, House Ways and Means Committee Chairman Dave Camp (R-MI) released a discussion draft for reforming the tax rules affecting small businesses.
► The draft is intended to solicit feedback from a broad range of stakeholders, practitioners, economists, and members of the general public on how to improve on the proposal.
► The draft presents two options for the reform of pass-through entities► Option 1 – Retains Subchapter K and Subchapter S as separate.
► Option 2 – Unified rules for partnerships and S corporations.
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Camp Draft ProposalOption 1 – Revisions to Subchapters K and S
► Subchapter K revisions:► Repeal guaranteed payment rules.► Require basis adjustments upon partnership distributions of property or transfers of
interests in a partnership.► Adjust the limitation on a partner’s share of losses to take into account the partner’s
share of the partnership’s charitable contributions and foreign taxes.► Apply Section 751(b) to all inventory items, not just substantially appreciated
inventory items.► Eliminate the current seven-year limitation on the recognition of pre-contribution
gains or losses on distributions of property.
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Camp Draft ProposalOption 1 – Revisions to Subchapters K and S
► Subchapter S revisions:► A permanent reduction in the recognition period for the built-in gains tax under
Section 1374 from 10 years to 5 years. Correspondingly, the draft would make permanent the rule that installment sales are governed by the provision that was applicable when the sale occurred.
► Increase to 60 percent (from 25 percent) the amount of gross receipts that an S corporation with Subchapter C earnings and profits may have before being subject to the tax on excess passive investment income.
► Permit nonresident aliens to be potential current beneficiaries of electing small business trusts (ESBTs).
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Camp Draft ProposalOption 2 – Unified Rules for Passthroughs
► This option repeals Subchapter K and Subchapter S and replaces them with a uniform set of rules that apply to non-publicly traded businesses for Federal tax purposes regardless of how the business is organized for state law purposes. ► Would the rules apply to any non-public entity?► Would publicly traded partnerships be eligible for flow-through treatment?► Transition rules?
► The new rules would:► Allow contributions of property and money on a tax-free basis.► Maintain the passthrough nature of an entity’s items (and preserve the character of
those items).► Permit special allocations of only net ordinary income or loss, net capital gain or
loss, and tax credits (and prohibit special allocations of individual items within each of those three categories).
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Camp Draft ProposalOption 2 – Unified Rules for Passthroughs
► The new rules would (continued):► Require basis adjustments upon a distribution of property by the passthrough entity
or a transfer of an interest in a passthrough entity.► Require entity-level withholding on the passthrough entity’s income and gain with a
corresponding credit for the owner’s tax reporting.► Limit deductions for losses to an owner’s basis in his passthrough interest, but
allow excess losses to be carried forward indefinitely.► Limit tax-free distributions (of money and property) to an owner’s basis in his
passthrough interest. ► Require passthrough entities to recognize gain on all distributions of appreciated
property and require owners to take a carryover basis in the distributed property (to preserve losses in distributed property).
► Allow owners to include entity-level debt (both recourse and non-recourse) in their basis in their passthrough interest.
► Allow owners to be treated as employees of the business.
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Questions and answers
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Thanks for participating