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Advanced Tax Strategies for LLC and Partnership Transactions

Author/Moderator: Robert Ricketts, CPA and Larry Tunnell, CPAtts, CPA
Publisher: AICPA
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Description

Plan now to protect your LLC and partnership clients from potential tax traps. Study the complex issues necessary to ensure that the LLC, partnership and its owners attain the maximum benefits. Focus on a broad range of distribution issues including disproportionate distributions of "hot" assets and structuring distributions to retiring partners in order to maximize tax benefits for both the retiring partner and the partnership. Apply complex rules of Subchapter K to related “groups” of partnerships or LLCs and understand tax consequences of partnership/LLC acquisitions and divisions, technical terminations, etc.

Objectives:
  • Analyze partnership or LLC balance sheets to recognize potential tax traps associated with distributions and other transfers between a partnership/LLC and its partner/members
  • Recognize opportunities to make tax-free exchanges of like-kind properties through the partnership or LLC
  • Structure "retirement" distributions to maximize after-tax benefits to the distributee-partner or LLC member and minimize after-tax costs to the partnership or LLC
  • Understand the tax consequences associated with transferring equity interests to partners or LLC members that are not commensurate with their capital contributions
  • Determine the tax consequences associated with the merger of two or more partnerships/LLCs or the division of a single entity into two or more entities

Prerequisite: Completion of LLC and Partnership Taxation: Beyond the Basics or equivalent knowledge and experience.

Accepted for CFP® credit.

Table of Contents


  • Chapter 1 - Partnership Tax Update
    • Learning Objectives
    • Allocation of Recourse Liabilities to LLC Member May Not Create At-Risk Basis
      • Final Regs. ~§~1.752-2(b)(1) (October 2006) Regarding Treatment of Recourse Liabilities by Singlemember
        LLC or Other Disregarded Entity
      • Hubert Enterprises, TC Memo. 2008-46, February 28, 2008 - Deficit Restoration Obligation Does
      • Not Increase Owner's At-Risk Amount with Respect to the Entity's Recourse Liabilities
    • New Proposed Regs Address Application of ~§~~§~704(c) and 737 Following "Assets-Over" Partnership Merger
      • Regulations ~§~1.704-3(a)(9), Issued August 22, 2007, Corrected November 6, 2007
      • "Old" vs. "New" ~§~704(c) Gain
      • Exception Where Ownership of Transferee and Surviving Partnerships Is Identical
    • Revenue Procedure 2007-59 (2/6/2007) Illustrates Application of "Reverse ~§~704(c) Allocations" by Securities Partnerships Following Asset Revaluations
      • Reverse ~§~704(c) Allocations in General
      • Revenue Procedure 2007-59 - Application of ~§~704(c) to Securities Partnerships
      • Qualified Partnership
      • Qualified Financial Assets
      • Requirements Once a Partnership Opts to Aggregate its Financial Assets
    • Final Regs on Rollover of Gain from Qualified Small Business Stock Make Favorable Modifications for Partnerships - T.D. 9353, 8/14/2007
      • Overview - Section 1045
      • Partnership Sale of QSB Stock
      • Reinvestment through Another Partnership
      • Limitation on Deferral Amount under ~§~1045
      • Distribution of QSB Stock to a Partner
    • Dispute between Partners Regarding Division of Partnership Income Does Not Prohibit IRS from Assessing Tax on Income Reported to Partner on Schedule K-1
      • T.J. Burke, 2007-1 USTC ~¶~50,497 (CA-1 May 4, 2007)
    • Interest Expense Allocated to Limited Partner in Trading Partnership is Subject to Investment Interest Expense Limitation
      • Rev. Rul. 2008-12
    • Final Regs Clarify Application of Code ~§~199 by Partners, Partnerships and Other Pass-through Entities - T.D. 9381 (5/17/2007)
      • Overview - Section 199
      • Application of ~§~199 by Partnerships
      • Expanded Affiliated Groups
    • Revenue Procedure Allows Partnerships Option to Compute Domestic Production Activities Deduction
      • Rev. Proc. 2007-34
    • Regulations ~§~1.752-6 can be Applied Retroactively
      • Cemco Investors, 2008-1 USTC ~¶~50,178 (CA-7, 2/7/2008)
    • Statute of Limitations - Regs. ~§~1.752-6 and Abusive Partnership Tax Shelters
    • Brandon Ridge Partners, 2007-2 USTC ~¶~50,573 (7/30/2007); Salman Ranch, Ltd., 2007-2
      USTC ~¶~50,803 (11/9/2007)
    • Other "Son of BOSS" Cases Decided in 2007 as Well
    • Corporation Owning Significant Interest in LLC Meets Active Trade or Business Test for Tax-Free Spin-Off, Despite No Active Management
      • Rev. Rul. 2007-42 (6/21/2007)
    • Transfer of Property to Pay Guaranteed Payment to Partner is a Taxable Exchange
      • Rev. Rul. 2007-40 (6/04/2007)
    • IRS Disallows Partnership Treatment Where Purpose of Partners' Investment Was to Obtain State
    • Tax Credits
      • CCA 200704028, CCA 200704030, AM 2007-002
    • Economic Substance Doctrine Does Not Invalidate Tax-motivated Structure Where Underlying Business Purpose Is Valid
    • Taxpayer's Rental Income Meets"Insubstantial" Passive Activity Loss Exception
      • Candelaria, 2007-2 USTC ~¶~50,785 (10/5/2007)
    • Family Limited Partnership Disregarded - Again!
      • Family Limited Partnerships - in General
      • Bigelow, 2007-2 USTC ~¶~60,548, (CA-9, 9/14/2007)
    • Chain of LLCs in Like-Kind Exchange Does Not Prevent Tax-Favored Treatment
      • LTR 200732012
    • Questions
  • Chapter 2 - Disproportionate Distributions
    • Learning Objectives
    • Introduction
    • Hot Assets
      • Unrealized Receivables
      • Substantially Appreciated Inventory
    • Distributions Affected
      • In General
      • Some Flexibility Remains
      • "Exempt" Distributions
    • Determining the Consequences of a Disproportionate Distribution under Section 751(b)
      • Mechanics
      • Partnership or LLC May Also Have Gain
    • Filing Requirements
    • Questions
  • Chapter 3 - Distributions of Contributed Property
    • Learning Objectives
    • Introduction
    • Section 704(c)(1)(B) - Mechanics
      • Distributions of Contributed Property within Seven Years
      • Adjustments to Basis
      • Successors in Interest
      • Interaction with Section 708
    • Exceptions
      • Complete Liquidations
      • Certain Distributions of"Like-Kind" Property
    • Sec. 737: Recognition of Built-in Gains on Partnership or LLC Distributions
      • Section 704(c)(1)(B)
      • Section 737
      • Broad Scope of 737
      • Basis Adjustments
      • Exceptions and Special Rules
    • Questions
  • Chapter 4 - Section 707(a)(2): Disguised Sales between Partners or LLC Members and Partnerships/LLCs
    • Learning Objectives
    • Introduction
    • General Principles
      • Legitimate Interest in Partnership Capital
      • Partial Sales
    • Requirements for Sale Treatment
    • Presumption for Transfers within Two Years
    • Circumstances Suggesting that Transactions Not Occurring within Two Years Are Related
    • Offsetting Factors
      • Repayment Required
      • Risk Related Factors
    • Transfers Disguised as Cash Flow Distributions
    • Payments Exempted from Sale Treatment
      • Guaranteed Payments for Capital
      • Cash Flow Distributions
      • Reimbursement of Pre-Formation Expenditures
    • Treatment of Liabilities
      • Liabilities Assumed by the Partnership
      • Exception for"Qualified" Liabilities
    • Treatment of Qualified Liabilities When Transfer Is Treated as Part of a Sale
    • Debt-Financed Distributions to a Partner or LLC Member
    • Disguised Sales by a Partnership or LLC to a Partner or Member
    • Disclosure Requirements
    • Questions
  • Chapter 5 - Death or Retirement of a Partner: Capital-Intensive vs. Service Partnerships
    • Learning Objectives
    • Introduction
    • Sale of an Interest in a Partnership or LLC
      • Generally
      • Effect of Liabilities
      • Hot Assets and Section 751(a)
    • Death or Retirement of a Partner from Professional Services Partnerships - Application of Section 736
      • General Application of Section 736
      • Structuring the Transaction to Avoid Section 736
      • Character of the Departing Partner's Capital Gain
      • Amortization of Goodwill Payments by the Partnership
      • Multiple Payments
    • Partnerships in Which Capital is a "Material Income-Producing Factor" and Section 751(b)
      • Section 751(b)
      • Potential Costs of Section 751(b) to the Partnership
    • Questions
  • Chapter 6 - Troubled Debt Transactions
    • Learning Objectives
    • Introduction
    • Options Available to the Lender and the Borrower
    • Foreclosure
      • Recourse Debts
      • Nonrecourse Debts
    • Changes in the Terms of a Loan
    • Partial or Total Forgiveness
      • Recourse Debts
      • The Insolvency Exception of Section 108
      • Nonrecourse Debts
      • Seller Financing
    • Section 108(c): Qualified Real Property Business Indebtedness
      • Overview
    • What Is Qualified Real Property Business Indebtedness?
    • Subsequent Disposition of Property
    • Section 108(g): Qualified Farm Indebtedness
      • Overview
      • Qualified Farm Indebtedness
    • Special Problems for Partnership and LLC Debtors
      • Overview
      • Who Recognizes COD Income?
      • Allocation of COD Income
      • Timing of Partnership COD Income
      • Partnership or LLC Real Property Business Indebtedness
      • Exchange of Debt for a Partnership or LLC Interest
    • Summary and Concluding Remarks
    • Questions
  • Chapter 7 - Advanced Capital Structure - Tiered Partnerships, Mergers, Divisions and the Use of Non-compensatory Options
    • Learning Objectives
    • Tiered Partnerships
      • Introduction - Overview of Tax Issues Arising from the use of Tiered Partnerships
      • Formation - Transfer of Property or Cash to a Lower-Tier Partnership
      • Flow-Through of Lower-Tier Partnership Items to Partners in Upper-Tier Partnerships
      • Allocation of Income, Deductions, Etc.
      • Basis Adjustments under ~§~734(b) or ~§~743(b)
      • Measurement of Hot Assets under ~§~751
    • Coordination with ~§~1032 when One of the Partners Is a Corporation
    • Partnership Mergers and Divisions
      • Overview - Merger or Consolidation of Two or More Partnerships/LLCs
      • Tax Consequences of a Partnership Merger
      • Tax Returns and Elections
      • Which Partnership Survives?
      • Partnership Divisions
    • Tax Consequences Associated with Noncompensatory Options
      • Issuance, Exercise, and Lapse of Noncompensatory Options
      • Accounting for the Exercise of Non-compensatory Options
      • Option Holder Treated as a Partner in Certain (Rare) Circumstances
    • Questions
  • Chapter 8 - Ethics Focus: Taxation
    • Ethics Overview
    • Recent Developments
    • Spotlight on Independence in Tax Services
    • Key Ethical Dilemmas and Judgment Calls
    • Addressing Ethical Dilemmas
    • Available Resources
  • Chapter 9 - Latest Developments
  • Appendix A - Partnership Return of Income Checklist
  • Appendix B - Form 1065 and Schedule K-1

731537

Excerpts

Chapter 1 - Partnership Tax Update

Learning Objectives

After completing this chapter, you should be able to

  • Compute the qualified production activities deduction for partners based on tax law in effect for partnership years beginning on or after May 17, 2006;
  • Evaluate the use of family limited partnerships to reduce estate taxes in light of the recent Korby decision;
  • Consider the use of certain contingent estate tax liabilities in reducing the amount of taxable gifts in a family limited partnership situation similar to that in the recent McCord decision;
  • Determine how to treat certain obligations of disregarded entities under the new final regulations;
  • Know when Schedule M-3 is required for a partnership and what items are required to be disclosed on Schedule M-3; and
  • Assess the probable position of the IRS with respect to the tax treatment of the distribution of a house to a partner as addressed in CCA 200650014.

W-2 Wages, Partnerships, and the Qualified Production Activities Deduction

Among the changes brought about by the American Jobs Creation Act of 2004 was a significant new deduction, the qualified production activities deduction (QPAD). In 2006 the annual QPAD is 3% of the lesser of (1) a taxpayer’s qualified production activities income (QPAI) or (2) taxable income (adjusted gross income (AGI) for individuals). However, the deduction cannot exceed 50% of the W-2 wages paid by the taxpayer during the calendar year that ends in the taxpayer’s taxable year. The percentage used to compute the deduction is 3% in taxable years beginning in 2006, 6% from 2007 to 2009, and 9% thereafter.

W-2 Wages Limitation

The QPAD for any year is limited to 50% of the W-2 wages paid by the taxpayer during the calendar year that ends in the taxable year in question. The term W-2 wages means the sum of the aggregate amounts the taxpayer is required to include on the Forms W-2 of the taxpayer's employees during the calendar year ending during the taxpayer's taxable year.

Example 1-1

The Local Corporation has QPAI for the fiscal and taxable year ending October 31, 2007 of $200,000. Its taxable income for that year is $30,000, and it pays W-2 wages for that fiscal year of $16,000. For the calendar year ending December 31, 2006, it only paid W-2 wages of $10,000, and for the 2007 calendar year it only paid W-2 wages of $5,000. Its QPAD before the W-2 wage limitation is $200,000 × .03 = $6,000 for the taxable year ending October 31, 2007. Since its W-2 wages for the 2006 calendar year are only $10,000, the W-2 wage limitation for the taxable year ending October 31, 2007 would be $10,000 × 50% = $5,000. The amount of fiscal year W-2 wages paid by the taxpayer is irrelevant in calculating the QPAD, and the calendar year 2007 W-2 wages paid would only affect the QPAD for the taxable year ending October 31, 2008. In general, a partner will add his or her share of the partnership’s W-2 wages to the partner’s other W-2 wages paid to come up with an aggregate W-2 wage amount that is used to calculate the W-2 wage limitation. However, for tax years beginning before May 18, 2006, for purposes of the 50%-of-W-2-wages limitation, W-2 wages did not have to be allocable to domestic production gross receipts, and a partner's share of the partnership's W-2 wages was limited to twice the specified percentage (3% in 2006) of the QPAI allocated to that partner by the partnership.

For partnership taxable years beginning on or after May 17, 2006, the partner's share of socalled “threshold” wages of a partnership (basically all wages of the partnership, whether or not related to domestic production gross receipts (DPGR)) equal the partner's allocable share of those wages for purposes of determining the partner's wage limitation. Threshold wages are also referred to as paragraph (e)(1) wages because the definition of these types of wages is found in §1.199-2T(e)(1). The partnership must generally allocate the amount of threshold wages among the partners in the same manner it allocates wage expense among those partners. The partner must add its share of the threshold wages from the partnership to the partner's threshold wages from other sources, if any. The partner’s W-2 wages (used to actually calculate the W-2 wage limitation) are the amount of the partner's total threshold wages properly allocable to DPGR.

Example 1-2

A and B, both individuals, are partners in PRS. PRS is a partnership that engages in manufacturing activities that generate both DPGR and non-DPGR. QPAI of the partnership is $500. A and B share all items of income, gain, loss, deduction, and credit equally. PRS has $200 in threshold wages, $150 of which are related to DPGR. A has trade or business activities outside of PRS (non-PRS activities). With respect to those activities, A has $50 of threshold wages. B has no trade or business activities outside of PRS. A has $150 of threshold wages ($100 from PRS + $50 from A's non-PRS activities). A determines, under a reasonable method satisfactory to the Secretary, that $75 of the PRS wages and $25 of the non-PRS wages are properly allocable to A's DPGR from PRS and non-PRS activities. A's tentative section 199 deduction is subject to the W-2 wage limitation of $50 (50% of W-2 wages of $100). B's W-2 wage limitation is $37.50 (50% of W-2 wages of $75). Note that the partnerships W-2 wages used to calculate the W-2 wage limitation of the partners are no longer dependent on the QPAI of the partnership.

Use of Family Limited Partnerships in Gift and Estate Planning

The family limited partnership is commonly used as a vehicle to reduce the estate tax, particularly on real estate or marketable securities that are to be eventually transferred to younger family members. The common approach has been for the parent or grandparent to transfer property to a family limited partnership, retain control of the assets through the partnership, and use the argument that the limited partnership interests lacked marketability to limit their value for estate tax purposes. Unfortunately, in 2002 the IRS began to be successful in attacking these types of arrangements.

Use of Family Limited Partnerships to Limit the Gross Estate

Section 2036 requires that the gross estate will include any transfers where the decedent retained possession, enjoyment, or the right to income from the transferred property. In order for the property to be included in the gross estate, however there does not have to be a legally enforceable right in favor of the decedent. There must, however, be an agreement that the decedent will retain some benefit from the transferred property. In addition, if the decedent sold the property to the recipient in a bona fide sale for full and adequate consideration, the property will not have to be included in the gross estate. Possibly the most significant recent case in this area is Strangi.1 However, a number of significant cases preceded Strangi, including Kimbell, another case from the Fifth Circuit Court of Appeals.

Kimbell

Ruth A. Kimbell died March 25, 1998. In 1991, she created a Trust, administered by Mrs. Kimbell and David as co-trustees. In January 1998, the Trust, David and his wife formed a limited liability company. The Trust contributed $20,000 to the LLC for a 50% interest. David and his wife each contributed $10,000 for 25% interests each. David was the sole manager of the LLC.

Later in January 1998, the Trust and the LLC formed a limited partnership. The Trust contributed approximately $2.5 million in cash, oil and gas working interests and royalty interests, securities, notes and other assets for a 99% pro rata limited partner interest. The LLC contributed approximately $25,000 in cash for a 1% pro rata general partner interest. As a result of these transfers, Mrs. Kimbell, through the Trust and the LLC, owned 99.5% of thepartnership. Not all of Mrs. Kimbell's assets were conveyed to the LLC and the partnership. She retained over $450,000 in assets outside of the LLC and the partnership for her personal expenses.

The estate claimed a 49% discount on the value of Mrs. Kimbell's interest in the partnership and her interest in the LLC for lack of control and lack of marketability of the partnership interest. The IRS disagreed with that discount, and the District Court found for the IRS. On appeal, the Fifth Circuit found that the assets were transferred by Mrs. Kimbell to the partnership for full and adequate consideration.

Strangi

While Kimbell provided many hints concerning what steps taxpayers should take to help ensure that a family limited partnership will reduce their estate tax obligations, Strangi provides a cautionary tale of what should not be done with respect to these arrangements. One of Strangi’s daughters from his first marriage was married to Michael J. Gulig, a local attorney. In 1993, Gulig took over management of Strangi's daily affairs.

In 1994 Gulig attended a seminar that explained a plan to use limited partnerships as a tool for (1) asset preservation, (2) estate planning, (3) income tax planning, and (4) charitable giving. The next day Gulig took actions to implement the recommendations he heard in the seminar. The result of Gulig's efforts was a three- tiered entity, with the Strangi Family Limited Partnership (SFLP) – and the roughly $10 million in assets Strangi had transferred into it – at the top. Strangi owned a 99% interest in SFLP, but was a limited partner, and thus had no formal control.

The IRS did not allow the discount in value that Gulig said resulted from this arrangement, and the Tax Court ruled against Strangi. The estate then appealed the decision of the Tax Court to the Fifth Circuit Court of Appeals. The Court of Appeals found that repeated distributions from the estate for Strangi’s expenses, both before and after death, provide strong circumstantial evidence of an understanding between Strangi and his children that partnership assets would be used to meet Strangi's expenses. The Court also found that Strangi's continued occupancy of his home after its transfer to the partnership was evidence of an implied agreement that Strangi would retain enjoyment of the assets of the partnership. Likewise, the Court considered Strangi's lack of liquid assets after the transfer to SFLP to be evidence that some arrangement to meet his expenses must have been made. The Court found that upon creation of SFLP, Strangi retained assets barely sufficient to meet his own living expenses for the low end of his life expectancy – that is, for about one year – assuming he was never required to pay rent, estate administration costs, outstanding personal debts, funeral expenses, or taxes. At the same time, Strangi began receiving substantial monthly payments out of SFLP's coffers. Given these circumstances, the Court could not say that the Tax Court clearly erred in holding that Strangi and his children had some implicit understanding by which Strangi would continue to use his assets as needed.

The Court noted that a sale is bona fide if the sale serves a “substantial business [or] other nontax” purpose. The estate proffered five discrete non- tax rationales for Strangi's transfer of assets

Videocourse Details

NASBA Field of Study: Taxes
Level: Advanced
Recommended CPE Credit: 16
Tax Planning
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