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Archive for September 3rd, 2014

There are two basic types of business combinations – taxable and nontaxable.

Taxable Business Combinations (Asset Purchase):

In a taxable business combination, new tax bases for acquired assets and assumed liabilities are generally determined on the basis of the fair market value. The acquirer “steps up” the acquiree’s historical tax bases in the assets acquired and liabilities assumed to fair market value.  Under the U.S. federal income tax law (IRC Section 338), certain stock purchases can be treated as taxable business combinations if an election to treat the stock purchase as a taxable asset purchase is filed.

Both the seller and purchaser of a group of assets that makes up a trade or business generally must use Form 8594 to report the transaction and both must attach the form to their respective income tax returns.  The taxpayers are not required to file Form 8594 when a group of assets that makes up a trade or business is exchanged for like-kind property in a transaction to which section 1031 applies and when a partnership interest is transferred. For stock purchases treated as asset purchases under Sections 338(g) or 338(h)(10), the purchaser and seller must first file Form 8023, to make the 338 election.  Form 8883 is then filed by both the purchaser and the target to supply information relevant to the election.

There is no legal requirement that the target and acquiring company take consistent positions on their respective tax returns, and therefore each could in principle take a different position favorable to itself.  However, if they do so, the IRS is likely to discover this fact and protect itself by challenging the positions taken by both parties.  To avoid this result, acquisition agreements almost always provide that the parties will attempt to agree on an allocation of price among the assets within a relatively short time after the closing of the transaction. 

Non-Taxable Business Combinations (Stock Purchase):

In a nontaxable business combination, the acquirer assumes the historical tax basis of the acquired assets and assumed liabilities. In this case, the acquirer retains the “historic” or “carryover” tax bases in the acquiree’s assets and liabilities. Generally, stock acquisitions are treated as nontaxable business combinations (unless a Section 338 election is made). Nontaxable business combinations generally result in significantly more temporary differences than do taxable business combinations because of the carryover of the tax bases of the assets acquired and liabilities assumed. To substantiate the relevant tax bases of the acquired assets and assumed liabilities, the acquirer should review the acquired entity’s tax filings and related books and records. This information should be evaluated within the acquisition’s measurement period.

The non-taxable corporate reorganization Internal Revenue Code provisions are concerned with the form, rather than the substance, of the transaction.  Therefore, it is important to document that the correct procedures have been followed.  Regulation Section 1.368-3 sets forth which records are to be kept and which information needs to be filed with tax returns for the year that such a transaction is completed.  Each corporate party to a non-taxable reorganization must file a statement with its tax return for the year in which the reorganization occurred that contains the names and EINs of all parties, the date of the reorganization, the FMV of the assets and stock transferred, and the information concerning any related private letter rulings.  All parties must also maintain permanent records to substantiate the transaction.  While there are no statutory penalties for failure to comply with the reporting requirements, the IRS has argued that failure to comply with the requirements could indicate that a transaction was a sale and not a non-taxable reorganization.

Authored by Robert Cutolo

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One of the major advantages of owning real estate in a partnership is the ability to leverage the real estate and distribute the proceeds of the borrowing to the partners on a tax free basis. 

FOR EXAMPLE: 

Individuals A & B equally own a Limited Liability Company that is treated as a partnership for tax purposes.  The LLC owns real estate with a tax basis of $1 million and a fair market value of $5 million.  The LLC borrows $3 million from a bank on a non-recourse basis, that is, the bank can only look to the property for repayment.  Neither partner is personally obligated to repay the bank.  Immediately after the borrowing, the LLC distributes the $3 million equally to the two partners.

As long as the non-recourse liability is allocated equally to the two partners, the withdrawal of $1.5 million by each partner is a tax free transaction.  This follows Section 752 of the Internal Revenue Code which states that any increase in a partner’s share of the liabilities of a partnership shall be considered a contribution of money by such partner to the partnership.  In effect, the partner’s outside tax basis is deemed to increase by his share of the increase in the partnership’s liabilities.  This increase can provide sufficient tax basis to allow a withdrawal of funds to be considered a tax-free return of basis. Additionally, such an increase in outside tax basis can permit the use of valuable deductions, the benefit of which may have been deferred absent the increase in liabilities and tax basis.     

While an increase in a partner’s share of partnership liabilities increases the partner’s outside basis, a decrease in the partner’s share of partnership liabilities decreases the partner’s outside basis.  Thus, it is important for partner A and B that their share of the partnership’s liabilities does not significantly decrease.  A significant decrease may have the same effect as withdrawing money in excess of tax basis, i.e. resulting in a current taxable gain. 

Thus, a partnership that is contemplating taking in new partners or contributing its property to a larger partnership (for example, a real estate venture fund) must examine how the reallocation of its liabilities will affect the tax liability of its current partners.

A partner who is facing a taxable event due to the reallocation of liabilities may find it beneficial to guarantee a portion of the partnership’s non-recourse liabilities.  A guarantee will convert a portion of the non-recourse liability to a recourse liability.  Partnership recourse liabilities are allocated to that partner who may be ultimately liable for the debt. Thus, by guaranteeing the debt, the partner may be able to maintain a sufficient allocation of partnership liabilities to avoid gain.     

While a guarantee of debt is good for tax purposes, most partners are not willing to take on a possible liability that they did not have previously.  A guarantee may not be a good economic choice.

BOTTOM DOLLAR GUARANTEE

A method of guaranteeing the debt while mitigating the economic risk of satisfying the guarantee is a so-called “bottom dollar guarantee.”  This is a guarantee where the partner agrees to repay partnership debt only if the bank collects less than the guaranteed amount from the partnership. In the example above, if partner A signs a bottom dollar guarantee for $1 million, partner A will only have to satisfy this guarantee if the bank cannot collect at least $1 million of the $3 million debt from the partnership.  Once the bank collects $1 million from the partnership, partner A is relieved of all further liability on the debt.  This is contrary to a normal guarantee, where the guarantor is liable for any and all amounts of the debt left unsatisfied by the partnership up to the stated guarantee amount.

The Internal Revenue Service has been struggling with the issue of whether a bottom dollar guarantee is a real guarantee and should be respected as such for tax purposes.  Recently released proposed regulations under Section 752 make it clear that the IRS will not recognize bottom dollar guarantees as valid guarantees of partnership debt. Under the proposed regulations, a partner only bears the economic risk of loss if the partner is liable for amounts that the partnership does not satisfy. 

The new proposed regulations will not be effective until published in final form.  However, for those partners who have bottom dollar guarantees in place at the time the regulations are finalized, a seven year transition rule is provided. In conclusion, the proposed regulations, if finalized in their current form, will provide that a partner is not able to both mitigate his or her economic risk and increase his or her outside tax basis when he or she guarantees partnership debt.  Accordingly, maintaining a partner’s share of partnership debt will require that the partner take on a real economic burden.  

By Robert E. Demmett, CPA, MS, Partner | rdemmett@withum.com

If you have any questions about this real estate update, please contact your WithumSmith+Brown professional or a member of WS+B’s Real Estate Services Group. 

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