Proposed Regulations for Partnership Interests Permits Estate, Income and Charitable Planning Opportunity

Once the partnership is formed, the parents transfer a small portion of their limited partnership interests to their children. They contribute their remaining limited partnership interests to charity, claiming a charitable income tax deduction for their full fair market value at their appropriate valuation.

The partnership then sells the appreciated property. Because the partnership income is allocated to partners in accordance with their pro-rata shares and the charity owns nearly all of the limited partnership interests, nearly all of the gain is allocated to the charity, which is tax-exempt. Therefore, most of the gain escapes taxation. This eliminates the need for the partnership to make tax distributions (assuming the other partners are otherwise able to pay their relatively small tax), and leaves more property in the partnership from which the children will benefit.

The proceeds of this sale are reinvested. Eventually the partnership liquidates, and the charity receives its share of the reinvested assets. The partnership also may make pro-rata distributions to the partners that could provide an immediate benefit to charity and to the children, as well as to the general partners, but probably to a more limited extent.

An alternative to giving the charity a steady share of the reinvested assets is giving it a “put” right, which requires the partnership to buy the charity's interest after a period of time. The price that the charity will receive may be discounted to reflect the lack of marketability of the limited partnership interest and the fact that the charity has no management control. A discount also may be appropriate because the charity will be liquidating its interest before the end of the partnership's term. The remaining assets then belong to the other partners, usually the donor's children and the donors themselves, who receive a lesser portion. Because the amount the partnership pays to redeem the charity's limited partnership interest is discounted, the amount of the discount is effectively transferred to the remaining partners. Thus, significant wealth is transferred to the children, free of gift and estate taxes, making this technique superior to some of the more familiar wealth-transfer devices, such as charitable lead annuity trusts and charitable remainder trusts.

Before the gift of the partnership interest to the charity, it is vital that there is no agreement for the partnership to buy back that interest. Such an arrangement could lead to a finding that the gift was not complete and cause the collapse of one of the pillars upon which this technique stands.

Remember that if the charity does not exercise its put right and instead retains its limited partnership interest until the dissolution of the partnership, the charity will realize the full, non-discounted value of its interest. In such cases, the CFLP's estate planning benefits — the transfer of the amount of the discount reflected in the purchase price for the charity's limited partnership interests — is forever lost. The use of this planning device was affected by UBTI, and charities would be subject to income tax and therefore not supportive of this avenue.

The Treasury Department and Internal Revenue Service (IRS) recently published proposed regulations that will facilitate real estate partnerships to buy and hold debt-financed property without causing partners that are qualified organizations (QO) to recognize UBTI. QO-partners include, among others, university endowments and pension plans. Specifically, the Proposed Regulations modify existing regulations under § 514(c)(9)(E) of the Internal Revenue Code, as amended, the so-called fractions rule, to permit certain allocations resulting from common business practices that may have otherwise violated the fractions rule. See RIN 1545-BL22 (Nov. 23, 2016).

Background on the Fractions Rule

Organizations otherwise exempt from U.S. federal income taxation are subject to federal income tax at graduated corporate tax rates on UBTI, which includes gross income derived from debt-financed property. However, if certain requirements are met, a QO can incur debt to acquire or improve real property without recognizing UBTI.

The rules are more complicated when a QO owns debt-financed property indirectly through one or more partnerships. One method for partnerships to avoid generating UBTI for their QO-partners is to comply with the statutory allocation provisions of the fractions rule. The fractions rule limits the ability of a partnership to allocate income disproportionately to QO's and loss disproportionately to taxable partners.

Proposed Regulations

Practitioners have been concerned that many common arrangements in real estate partnerships, such as the use of targeted tax allocations and negotiated management fees, could violate the fractions rule and cause QO-partners to recognize UBTI. While the Proposed Regulations do not address the impact of targeted allocations on the fractions rule, they provide relief for other specific areas of concern.

The Proposed Regulations will apply to tax years ending on or after the date that the regulations are published as final regulations. However, real estate partnerships and their partners may elect apply the Proposed Regulations for tax years ending on or after Nov. 23, 2016.

Preferred Returns

Under current law, items of partnership income and gain with respect to a reasonable preferred return are disregarded when computing overall partnership income for purposes of the fractions rule if certain requirements are satisfied. Regulations limit the amount disregarded to the aggregate amount that has been distributed to the partner as a reasonable preferred return in the current and prior taxable years, less the aggregate amount of corresponding income and gain allocated to the partner in all prior years.

The Proposed Regulations eliminate the current distribution requirement and disregard allocations of income and gain attributable to a reasonable preferred return if the partnership agreement requires accrued preferred returns to be distributed prior to all other distributions (other than tax distributions), to the extent any such accrued but unpaid preferred return has not otherwise been reversed by an allocation of loss.

Partner-Specific Management Fees

Large partnerships often provide certain investors with reduced management fees. Variable management fees would require disproportionate allocations of items of deduction attributable to these management expenses in a manner that follows the economic arrangement. These disproportionate allocations would violate the fractions rule.

The Proposed Regulations permit disproportionate allocations attributable to variable management fees by adding management and similar fees to the list of partner-specific expenditures that are excluded in computing overall partnership income or loss for purposes of the fractions rule. The aggregate amount of fees excluded cannot exceed 2% of the partner's committed capital.

Unlikely Losses

Existing regulations generally disregard specially allocated losses or deductions in computing overall partnership income or loss under the fractions rule if such item of loss or deduction has a “low likelihood of occurring” based on all of the facts and circumstances. The Proposed Regulations note that the Treasury Department and the IRS have received comments suggesting that a “more likely than not” standard is more appropriate for determining whether an item of loss or deduction should be disregarded. The Treasury Department and the IRS are considering changing the standard and request additional comments explaining why a “more likely than not” standard is appropriate.

Chargebacks of Partner-Specific Expenditures and Unlikely Losses

As noted above, allocations of partner-specific expenditures and special allocations of unlikely losses are generally disregarded in computing overall partnership income or loss for purposes of the fractions rule. However, allocations of items of income or gain to reverse prior allocations of partner-specific expenditures or unlikely loss could violate the fractions rule. Existing regulations generally disregard an allocation of part of the overall partnership income or loss to chargeback a prior disproportionate allocation only if that part consists of a proportionate amount of each item included in computing overall partnership income or loss.

The Proposed Regulations modify the existing chargeback exception to disregard an allocation of what would otherwise have been an allocation of overall partnership income to chargeback a prior special allocation of a partnership-specific expenditure or unlikely loss.

Acquisition of Partnership Interests After Initial Formation

It is common for real estate partnerships to admit partners in sequential closings but treat all partners as having been admitted at the same time for purposes of allocating profits and losses. The use of staged closings could have violated the fractions rule in two ways under current law. First, as partners are admitted to the partnership in later closings, partnership interests are necessarily redistributed among the partners. Changes in allocations resulting from these shifts in partnership interests are closely scrutinized and could potentially violate the fractions rule. Second, the partnership may disproportionately allocate income or loss to the partners as a means to readjust partners' capital accounts to account for the staged closings. These disproportionate allocations could also violate the fractions rule.

The Proposed Regulations permit changes in allocations and certain disproportionate allocations which result from staged closings. In addition, disproportionate allocations made to adjust partners' capital accounts will be disregarded if: 1) the new partner acquires its interest no later than 18 months following the formation of the partnership; 2) the partnership documents contemplate staged closings by outlining the terms of the various closings; 3) the partnership agreement identifies the method of determining any applicable interest factor to adjust partners' capital accounts; and 4) the interest rate for such applicable interest factor is not greater than 150% of the highest applicable federal rate at the time the partnership was formed.

The Treasury Department's and IRS's view is that changes in allocations resulting from unanticipated defaults do not violate the fractions rule if such changes are provided for in the partnership agreement. Therefore, the Proposed Regulations provide that allocations of partnership income or loss to adjust the partners' capital accounts will be disregarded in computing overall partnership income or loss for purposes of the fractions rule.

Applying the Fractions Rule to Tiered Partnerships

Where a QO-partner holds an indirect interest in real property through a chain of one or more partnerships, existing regulations provide that the fractions rule is satisfied where tax avoidance is not the principal purpose of using the tiered-partnership structure and the relevant partnerships can demonstrate compliance with the regulations under one of three methods. Under the independent chain approach, different lower-tier partnership chains are examined independently of each other only if the upper-tier partnership allocates the items of each lower-tier partnership separately from the items of another lower-tier partnership.

In practice, real-estate partnerships will not make separate allocations to its partners of items of income or loss from lower-tier partnership. The Proposed Regulations remove the requirement that an upper-tier partnership allocate items from lower-tier partnerships separately from one another under the independent chain approach.

De Minimis Exceptions from Application of the Fractions Rule

Existing regulations provide two de minimis exceptions under the fractions rule. First, if QO-partners own, in the aggregate, no more than 5% in the capital or profits of the partnership and taxable partners own a substantial amount of interests, the partnership is not required to comply with the fractions rule and the partnership can acquire debt-financed property without causing its QO-partners to recognize UBTI.

The use of these planning tools together should provide a resurgence in as the client is looking for planning tools in a still volatile setting.

*****
Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP®, AEP, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions. To learn more, visit www.mycpo.net.

The new Administration has areas of taxation estate planning and philanthropy on the front burner. No one is sure what will be happening with the minority discounts regulations of § 2504 in turmoil and proposed guidance of the modification of charities partnership interest and unrelated business taxable income (UBTI). By integrating a number of tried and tested tools, we may create a platform for substantial savings.

The idea is the Charitable Family Limited Partnership (CFLP), which is a charitable giving vehicle that provides a substantial gift to charity, produces income tax savings for the donor, transfers significant wealth to the donor's descendants and allows a means for the donor's family to retain control over the transferred assets.

The basic structure of the CFLP is that senior members, usually parents, contribute appreciated assets to a limited partnership in exchange for general and limited partnership interests. The general partners, also usually the parents, manage the affairs of the partnership and typically receive a reasonable management fee for their services. (If this fee is unreasonable, the base of this planning option perishes.) The limited partners do not participate in the CFLP's management. As general partners, the parents retain control over the property transferred to the partnership. In addition, they control the entity or person selected as investment adviser, so they determine the partnership's investments and when and if any distributions will be made out of the partnership.

Once the partnership is formed, the parents transfer a small portion of their limited partnership interests to their children. They contribute their remaining limited partnership interests to charity, claiming a charitable income tax deduction for their full fair market value at their appropriate valuation.

The partnership then sells the appreciated property. Because the partnership income is allocated to partners in accordance with their pro-rata shares and the charity owns nearly all of the limited partnership interests, nearly all of the gain is allocated to the charity, which is tax-exempt. Therefore, most of the gain escapes taxation. This eliminates the need for the partnership to make tax distributions (assuming the other partners are otherwise able to pay their relatively small tax), and leaves more property in the partnership from which the children will benefit.

The proceeds of this sale are reinvested. Eventually the partnership liquidates, and the charity receives its share of the reinvested assets. The partnership also may make pro-rata distributions to the partners that could provide an immediate benefit to charity and to the children, as well as to the general partners, but probably to a more limited extent.

An alternative to giving the charity a steady share of the reinvested assets is giving it a “put” right, which requires the partnership to buy the charity's interest after a period of time. The price that the charity will receive may be discounted to reflect the lack of marketability of the limited partnership interest and the fact that the charity has no management control. A discount also may be appropriate because the charity will be liquidating its interest before the end of the partnership's term. The remaining assets then belong to the other partners, usually the donor's children and the donors themselves, who receive a lesser portion. Because the amount the partnership pays to redeem the charity's limited partnership interest is discounted, the amount of the discount is effectively transferred to the remaining partners. Thus, significant wealth is transferred to the children, free of gift and estate taxes, making this technique superior to some of the more familiar wealth-transfer devices, such as charitable lead annuity trusts and charitable remainder trusts.

Before the gift of the partnership interest to the charity, it is vital that there is no agreement for the partnership to buy back that interest. Such an arrangement could lead to a finding that the gift was not complete and cause the collapse of one of the pillars upon which this technique stands.

Remember that if the charity does not exercise its put right and instead retains its limited partnership interest until the dissolution of the partnership, the charity will realize the full, non-discounted value of its interest. In such cases, the CFLP's estate planning benefits — the transfer of the amount of the discount reflected in the purchase price for the charity's limited partnership interests — is forever lost. The use of this planning device was affected by UBTI, and charities would be subject to income tax and therefore not supportive of this avenue.

The Treasury Department and Internal Revenue Service (IRS) recently published proposed regulations that will facilitate real estate partnerships to buy and hold debt-financed property without causing partners that are qualified organizations (QO) to recognize UBTI. QO-partners include, among others, university endowments and pension plans. Specifically, the Proposed Regulations modify existing regulations under § 514(c)(9)(E) of the Internal Revenue Code, as amended, the so-called fractions rule, to permit certain allocations resulting from common business practices that may have otherwise violated the fractions rule. See RIN 1545-BL22 (Nov. 23, 2016).

Background on the Fractions Rule

Organizations otherwise exempt from U.S. federal income taxation are subject to federal income tax at graduated corporate tax rates on UBTI, which includes gross income derived from debt-financed property. However, if certain requirements are met, a QO can incur debt to acquire or improve real property without recognizing UBTI.

The rules are more complicated when a QO owns debt-financed property indirectly through one or more partnerships. One method for partnerships to avoid generating UBTI for their QO-partners is to comply with the statutory allocation provisions of the fractions rule. The fractions rule limits the ability of a partnership to allocate income disproportionately to QO's and loss disproportionately to taxable partners.

Proposed Regulations

Practitioners have been concerned that many common arrangements in real estate partnerships, such as the use of targeted tax allocations and negotiated management fees, could violate the fractions rule and cause QO-partners to recognize UBTI. While the Proposed Regulations do not address the impact of targeted allocations on the fractions rule, they provide relief for other specific areas of concern.

The Proposed Regulations will apply to tax years ending on or after the date that the regulations are published as final regulations. However, real estate partnerships and their partners may elect apply the Proposed Regulations for tax years ending on or after Nov. 23, 2016.

Preferred Returns

Under current law, items of partnership income and gain with respect to a reasonable preferred return are disregarded when computing overall partnership income for purposes of the fractions rule if certain requirements are satisfied. Regulations limit the amount disregarded to the aggregate amount that has been distributed to the partner as a reasonable preferred return in the current and prior taxable years, less the aggregate amount of corresponding income and gain allocated to the partner in all prior years.

The Proposed Regulations eliminate the current distribution requirement and disregard allocations of income and gain attributable to a reasonable preferred return if the partnership agreement requires accrued preferred returns to be distributed prior to all other distributions (other than tax distributions), to the extent any such accrued but unpaid preferred return has not otherwise been reversed by an allocation of loss.

Partner-Specific Management Fees

Large partnerships often provide certain investors with reduced management fees. Variable management fees would require disproportionate allocations of items of deduction attributable to these management expenses in a manner that follows the economic arrangement. These disproportionate allocations would violate the fractions rule.

The Proposed Regulations permit disproportionate allocations attributable to variable management fees by adding management and similar fees to the list of partner-specific expenditures that are excluded in computing overall partnership income or loss for purposes of the fractions rule. The aggregate amount of fees excluded cannot exceed 2% of the partner's committed capital.

Unlikely Losses

Existing regulations generally disregard specially allocated losses or deductions in computing overall partnership income or loss under the fractions rule if such item of loss or deduction has a “low likelihood of occurring” based on all of the facts and circumstances. The Proposed Regulations note that the Treasury Department and the IRS have received comments suggesting that a “more likely than not” standard is more appropriate for determining whether an item of loss or deduction should be disregarded. The Treasury Department and the IRS are considering changing the standard and request additional comments explaining why a “more likely than not” standard is appropriate.

Chargebacks of Partner-Specific Expenditures and Unlikely Losses

As noted above, allocations of partner-specific expenditures and special allocations of unlikely losses are generally disregarded in computing overall partnership income or loss for purposes of the fractions rule. However, allocations of items of income or gain to reverse prior allocations of partner-specific expenditures or unlikely loss could violate the fractions rule. Existing regulations generally disregard an allocation of part of the overall partnership income or loss to chargeback a prior disproportionate allocation only if that part consists of a proportionate amount of each item included in computing overall partnership income or loss.

The Proposed Regulations modify the existing chargeback exception to disregard an allocation of what would otherwise have been an allocation of overall partnership income to chargeback a prior special allocation of a partnership-specific expenditure or unlikely loss.

Acquisition of Partnership Interests After Initial Formation

It is common for real estate partnerships to admit partners in sequential closings but treat all partners as having been admitted at the same time for purposes of allocating profits and losses. The use of staged closings could have violated the fractions rule in two ways under current law. First, as partners are admitted to the partnership in later closings, partnership interests are necessarily redistributed among the partners. Changes in allocations resulting from these shifts in partnership interests are closely scrutinized and could potentially violate the fractions rule. Second, the partnership may disproportionately allocate income or loss to the partners as a means to readjust partners' capital accounts to account for the staged closings. These disproportionate allocations could also violate the fractions rule.

The Proposed Regulations permit changes in allocations and certain disproportionate allocations which result from staged closings. In addition, disproportionate allocations made to adjust partners' capital accounts will be disregarded if: 1) the new partner acquires its interest no later than 18 months following the formation of the partnership; 2) the partnership documents contemplate staged closings by outlining the terms of the various closings; 3) the partnership agreement identifies the method of determining any applicable interest factor to adjust partners' capital accounts; and 4) the interest rate for such applicable interest factor is not greater than 150% of the highest applicable federal rate at the time the partnership was formed.

The Treasury Department's and IRS's view is that changes in allocations resulting from unanticipated defaults do not violate the fractions rule if such changes are provided for in the partnership agreement. Therefore, the Proposed Regulations provide that allocations of partnership income or loss to adjust the partners' capital accounts will be disregarded in computing overall partnership income or loss for purposes of the fractions rule.

Applying the Fractions Rule to Tiered Partnerships

Where a QO-partner holds an indirect interest in real property through a chain of one or more partnerships, existing regulations provide that the fractions rule is satisfied where tax avoidance is not the principal purpose of using the tiered-partnership structure and the relevant partnerships can demonstrate compliance with the regulations under one of three methods. Under the independent chain approach, different lower-tier partnership chains are examined independently of each other only if the upper-tier partnership allocates the items of each lower-tier partnership separately from the items of another lower-tier partnership.

In practice, real-estate partnerships will not make separate allocations to its partners of items of income or loss from lower-tier partnership. The Proposed Regulations remove the requirement that an upper-tier partnership allocate items from lower-tier partnerships separately from one another under the independent chain approach.

De Minimis Exceptions from Application of the Fractions Rule

Existing regulations provide two de minimis exceptions under the fractions rule. First, if QO-partners own, in the aggregate, no more than 5% in the capital or profits of the partnership and taxable partners own a substantial amount of interests, the partnership is not required to comply with the fractions rule and the partnership can acquire debt-financed property without causing its QO-partners to recognize UBTI.

The use of these planning tools together should provide a resurgence in as the client is looking for planning tools in a still volatile setting.

*****
Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP®, AEP, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions. To learn more, visit www.mycpo.net.