Identifying Partners' Interests in Profits and Capital
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March 2007 Identifying Partners’ Interests in Profi ts and Capital: Uncertainties, Opportunities and Traps By Sheldon I. Banoff* The Problem 198 §1.706-1(b)(4) 215 Overview 200 Computation of PIPP—Other Administra- I. Survey of Operative Provisions Involving PIPP tive Guidance 216 and/or PIPC 202 Measuring PIPP: Judicial Guidance 218 II. Partner’s Interest in Partnership Profi ts: Mea- III. Partner’s Interest in Partnership Capital: Mea- surement Issues 230 surement Issues 223 Example 1—Proportionate Ownership of Example 17—Proportionate Ownership of Profi ts and Capital 205 Profi ts and Capital 224 Example 2—Changes in Profi ts and Losses Example 18—Disproportionate Allocation Mandated by Form of Passthrough Entity 205 of Losses 224 Example 3—Disproportionate Profi ts and Example 19—Disproportionate Contribu- Capital Due to Additional Profi ts Interest tions and Distributions 225 for Services 207 Example 20—Code Sec. 704(c) Built-in Example 4—Disproportionate Profi ts and Capital Gain or Loss 225 Due to Service Partner’s Profi ts Interest 208 IV. Practical and Administrative Aspects 226 Example 5—Guaranteed Payments 208 1. When Should PIPP and PIPC Be Measured? 226 Example 6—Code Sec. 707(a) Payments 209 2. What Is the Effect of Valid Retroactive Al- Example 7—Profi ts Interest for Services by locations of Profi ts and Losses in Measuring Partner’s Affi liate 209 PIPP and PIPC Through the Year? 228 Example 8—Differing Profi ts Interests for 3. What Is the Potential Impact of Changes or Shifts Differing Sources of Income 210 in Current and Future Profi ts Interests? 229 Example 9—Disproportionate Capital and Prof- 4. What Types of Changes in PIPP or PIPC its Interest Subject to Recharacterization 210 Should Be Recognized As Requiring a Change Example 10—Impact of Recognition in the Measurement of PIPP or PIPC? 229 of Losses 210 5. How Should PIPP and PIPC Be Computed Example 11—Priority Allocation of Profi ts 210 When Partners Have Different Allocations of Example 12—Priority Allocation of Profi ts and Rights to Distributions from Different Gross Income 212 Properties Owned by the Partnership? 230 Example 13—Special Allocations of 6. Can Partnerships and Partners Validly Take Nonrecourse Deductions 213 Different Positions As to the Measurement Example 14—Minimum Gain Chargebacks 213 of PIPP and PIPC, Without Substantial Risk Example 15—Code Sec. 704(c) Built-in Gain 213 of Penalty? 230 Example 16—Curative Allocations/ V. Opportunities and Traps in Identifying PIPP Qualifi ed Income Offset 214 and PIPC 231 Measuring PIPP: Congressional Guidance 214 A. Planning Opportunities 231 Measuring PIPP: Administrative Guidance 215 1. The Use of Guaranteed Payments 231 Computation of PIPP Under Reg. 2. Preferred Returns and Special Allocations 232 Sheldon I. Banoff, P.C. is a Partner in the Chicago offi ce of Katten Muchin Rosenman LLP. ©2007 S.I. Banoff TAXES—THE TAX MAGAZINE 197 Identifying Partners’ Interests in Profi ts and Capital 3. Fees to Affi liates 232 17. The “Most Likely Allocation of 4. Debt in Lieu of Additional Equity 233 Marginal Profi ts” Approach 243 5. Retroactive Allocations 233 18. The “Highest Profi ts Percentage” 6. Prospective Changes in Profi ts Alloca- Approach 243 tions 234 19. The “Highest Profi ts Percentage of 7. Determining PIPP in Loss Years 234 Any Signifi cant Item” Approach 244 8. Partial Redemptions 234 20. The “Lowest Profi ts Percentage of Any B. Traps for the Unwary 235 Signifi cant Item” Approach 244 1. Improper Reliance on the Provisions in 21. The “Multiple PIPPs” Approach 245 the Partnership Agreement 237 22. The “Whatever the Partnership Agree- 2. The Use of Guaranteed Payments 238 ment Says It Is” Approach 246 3. Differences in Interpretation of Measure- 23. The “Whatever It Says on the Partner’s ment Methodologies 238 K-1 Tax Return” Approach 246 4. Unexpected Losses 238 24. The “Any Reasonable Method” Approach 247 VI. Conceptual Issues; Defi nitional Consistency Through- 25. The “Elective Combinations” Approach 247 out the Code, or Section-by-Section Analysis? 236 C. Principles for Proper Measurement of PIPC 247 A. Principles for Proper Measurement of PIPP 236 D. Potential Approaches to PIPC 248 B. Potential Approaches to PIPP 237 1. The “Liquidation Value” Approach 248 1. The “Bottom-Line Taxable Profi ts” 2. The “Partner’s Withdrawal Payment” Approach 237 Approach 248 2. The “Book Operating Income” Approach 238 3. The “Disjunctive Liquidation Value or 3. The “Book Gain on Sale” Approach 238 Withdrawal Value” Approach 248 4. The “Hybrid Book Operating Income/ 4. The “Tax Basis Capital” Approach 249 Gain on Sale” Approach 238 5. The “Tax Basis of Assets” Approach 249 5. The “Initial Tier of Signifi cant Book Prof- 6. The “Book Capital” Approach 249 its” Approach 239 7. The “Facts and Circumstances” 6. The “Last Tier of Signifi cant Book Prof- Approach 250 its” Approach 239 8. The “Whatever the Partnership 7. The “Gross Book Income” Approach 240 Agreement Says It Is” Approach 250 8. The “Net Book Profi ts” Approach 240 9. The “Whatever It Says on the 9. The “Gross Taxable Income” Approach 240 Partner’s K-1 Tax Return” Approach 250 10. The “Net Taxable Profi ts” Approach 241 10. The “Elective Combinations” Approach 250 11. The “Expected Net Taxable Profi ts” E. Simplifi cation 251 Approach 241 VII. The Corporate Analogs for Defi ning 12. The “Any Signifi cant Economic Item” “Relatedness” 253 Approach 241 VIII.Alternative Approaches to “Relatedness” 13. The “Any Signifi cant Item, or Anything for Partnerships and Partners 254 in Between” Approach 242 IX. Conclusions 255 14. The “Facts And Circumstances” APPENDIX I 255 Approach 242 APPENDIX II 276 15. The “Historical Profi ts” Approach 243 APPENDIX III 294 16. The “Average Future Profi ts Interest” APPENDIX IV 299 Approach 243 APPENDIX V 299 The Problem and/or a partner’s interest in partnership capital (PIPC). The operative consequences of meeting (or A large and increasing number of Code provisions, failing to meet) the requisite percentage interest in regulations and rulings (both inside and outside profi ts and/or capital can have profound favorable or Subchapter K) refer to the ownership percentages unfavorable tax consequences, affecting all types of of a partner’s interest in partnership profi ts (PIPP) partners and partnerships1. 198 March 2007 Historically, the most frequently cited situations Stated simply, when a partner has a specifi ed owner- referring to PIPP and PIPC (dating back to the 1954 ship interest in a partnership, certain tax consequences Code) involved consequences arising from operation may arise. When a partner does not have the specifi ed of the partnership termination, merger and division ownership interest, different tax consequences may rules under Code Sec. 708(b).2 Of the same vintage arise. The specifi ed ownership interest is typically is Code Sec. 707(b), which relates to certain sales or measured with respect to PIPP and/or PIPC.9 (Whether exchanges of property that result in disallowance of PIPP and/or PIPC are the optimal tools for identifying losses (pursuant to Code Sec. 707(b)(1)) and treat- situations where partners “control” their partnership is ment of certain gains as ordinary income (pursuant a valid question, discussed later in this article.) to Code Sec. 707(b)(2)) involving partnerships and/or The level of ownership that establishes “related- partners, which also are triggered by reference to PIPP ness” varies from provision to provision. In some and PIPC standards.3 Planning techniques to avoid (or, cases, a threshold as high as 80 percent of PIPP10 or as not infrequently occurs in the case of Code Sec. 90 percent of PIPC11 must be reached for the relevant 708(b)(1)(B), to intentionally trigger) such thresholds Code provision to cause relatedness to occur. At the in partnership profi ts or capital interests have peri- other extreme, some Code sections provide that any odically been discussed by commentators.4 Other ownership interest in the partnership12 technically examples illustrate the effects on corporations, indi- causes suffi cient “relatedness” to trigger operative tax viduals, partnerships with foreign-source income, and consequences. Several hundred other Code and regu- partnerships with taxable and tax-exempt partners. lations provisions delineate “relatedness” based upon Presumably, the general goal of the delineations that any of a number of percentages that fall somewhere use PIPP and/or PIPC is to distinguish between the own- in between.13 In some cases, only PIPP is the relevant ership of economic interests in the pass-through entity measurement stick; in others, only PIPC is relevant. In that meet or fail to meet some policy of “relatedness” most cases, the presence of a suffi cient percentage in- underlying the applicable Code provision. To illustrate, terest in either PIPP or PIPC triggers the operative Code let us look at the policies underlying Code Sec. 707(b), provision.14 In some cases, the requisite percentage of which has several operative provisions that turn on both PIPP and PIPC must be met to cause the operative “relatedness.” Buying and selling property generates provision to apply.15 Appendix III refl ects your author’s tax consequences which, in the absence of restrictions, attempt to delineate the differing categories of percent- could be manipulated by a person having control over age interest thresholds for operative Code provisions the other party to the transaction. (In contrast, in most and regulations. (As discussed herein, we were quite transactions, unrelated parties deal at arm’s length.) surprised to see the multitude of categories that have Manipulation may take the form of realizing a tax de- found their way into the Code and regulations.) ductible loss not otherwise allocable5 or by converting There is a lack of uniformity as to the meanings of ordinary income into capital gain.6 Congress enacted the terms “partnership profi ts interest” and “partner- Code Sec.