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Mixing Oil & Water
Exempt Organizations and Troubled Real Estate Partnerships
Pension plans and certain other exempt organizations known as "Qualified Organizations" have been significant investors in leveraged real estate partnerships. Although Qualified Organizations are normally subject to tax on unrelated trade or business income (UBTI) if they invest in partnerships directly or indirectly using borrowed funds, there is an exception for partnerships with debt-financed real property if certain conditions are met. These conditions include compliance with the substantial economic effect rules under Internal Revenue Code (IRC) §704(b) and compliance with the so-called Fractions Rule under IRC §514(c)(9)(E) (the Fractions Rule).
With respect to real estate partnerships that solicit Qualified Organizations as investors, it is common for their partnership agreements to provide the partnership will not undertake actions that would cause the generation of UBTI or will take extraordinary measures to avoid generating UBTI. It is not uncommon for the Qualified Organizations to have obtained representations from the general partner or manager of the partnership to that effect, the violation of which may create personal liability to such general partner or manager. Unfortunately, in a time of market stress and the unwillingness of traditional lenders to loan against or refinance loans backed by real estate, the Fractions Rule creates additional challenges for a partnership attempting to raise capital and salvage its investment. For an attorney attempting to work out a structure for raising additional capital, renegotiating loans, and otherwise attempting to preserve some economics for the existing partners, the Fractions Rule presents additional challenges that are not intuitive and sometimes economically irrational.
An attorney working to restructure a distressed real estate partnership should inquire as to whether there are any Qualified Organization partners and whether any of the partners are in turn partnerships that may have Qualified Organization partners. If there are direct or indirect tax-exempt partners, care should be taken to follow properly all partnership procedures, to comply fully with the partnership agreement and any other relevant agreements, and for the partnership not to violate the Fractions Rule accidentally. An analysis should be undertaken to affirm that the general partner or manager is fully complying with its fiduciary duties (to both the taxable and Qualified Organization partners) as well as all of the terms of the partnership agreement and any other applicable agreements. Often having discussions with the Qualified Organization(s) and their advisors to identify alternatives to a clear violation of the Fractions Rule is wise.
Under the Fractions Rule, generally a partnership's allocation of items to a Qualified Organization partner cannot result in such partner having an overall share of partnership income for any partnership taxable year greater than such partner's percentage share of overall loss for the partnership taxable year in which such partner's percentage share of overall loss will be the smallest. No tax motivation is required. No use of the Qualified Organization's exempt status to benefit a taxable partner is required. Unless a variation fits within an exception or exclusion, any allocation that causes the Qualified Organization to have a share of partnership income (either actually or prospectively for any future tax year) greater than such partner's percentage share of overall loss for the year in which such loss share shall be the smallest, triggers UBTI with respect to "debt-financed real property". Once triggered, UBTI will continue to be generated in future years. If the Fractions Rule is violated, a portion of the income and gain from the debt-financed real property based on the ratio of the average acquisition indebtedness with respect to the real property over the average adjusted basis of the real property for the relevant taxable year will constitute UBTI and be subject to tax.
Qualified Organizations often react with great hostility to any action that would lead to the creation of UBTI. Generally the reaction is not simply because the entity that is otherwise exempt from tax is required to pay tax, but more importantly there is a perception that the public (for exempt organizations) and the beneficiaries (for pension and retirement plans) believe that the Qualified Organization and its board and officers have done something wrong if the entity is subjected to the tax. Therefore, Qualified Organizations are usually adverse toward any action, even if such action facilitates the saving of a troubled investment, that would cause them to report UBTI and be required to pay the tax.
Many partnership agreements contain procedures for obtaining additional capital and many have procedures for adjustments if a capital call is made and missed, which can alter the economics of the existing partners. Often these procedures are "boilerplate" and do not consider the impact on the Fractions Rule. The general partner or manager may also attempt to negotiate additional capital contributions from partners or even parties that are not then partners in order to attempt to relieve the financial stress on the partnership and retain the investment. Common scenarios that may arise in these situations and may cause a leveraged real estate partnership with a Qualifying Organization partner to violate the Fractions Rule and generate UBTI include:
- additional capital calls where some partners actually provide additional capital and others do not, resulting, per the terms of the partnership agreement, with the partners providing the additional capital receiving (i) punitively large preferred returns or (ii) a disproportionate increase in the contributing partners' interest in the partnership.
- the general partner or another member agreeing to contribute additional capital and to absorb some losses with respect to the real estate on the condition that the member receives the tax benefit of such losses and is repaid in the event the property values rebound and the partnership is ultimately profitable;
- the granting of a preferred return to a Qualified Organization with an allocation of income to the Qualified Organization in excess of the actual current cash distribution received in a given year; and
- a change in the terms of the partnership agreement whereby the contributing partners are assured of receiving additional amounts during operations or upon liquidation regardless of ending capital account balances or through forced capital account balances.
In addition, if an upper-tier partnership with one or more Qualified Organizations as partners has invested in a number of real estate partnerships (the sub-partnerships) and one or more of the sub-partnerships restructures and violates the Fractions Rule, all of the income attributable to all debt-financed real property from all sub-partnerships thereon may be classified as generating UBTI. According to the Regulations this will occur unless the upper-tier partnership's partnership agreement allocates the upper-tier partnership items by the non-compliant Sub-Partnership separately from those items allocated to the upper-tier partnership by compliant sub-partnerships. Allocating items of such tainted Sub-Partnership separately will often be difficult or even impossible without changing the partner economics. Counsel must be cognizant of this dynamic.
Some of these scenarios may be navigated with reasonable comfort and assurance if addressed concurrently with the events and the partnership agreement is timely amended. Others may be navigated with a degree of logical comfort without authoritative support if the partnership agreement is timely amended. Others simply cannot be navigated under current authority without changing what would otherwise be a rational economic transaction reflecting difficult financial circumstances. None of these scenarios are apt to be successfully navigated unless counsel to the affected partnership carefully analyzes the situation, the proposed structure to implement a work out, and affirmatively deals with the Fractions Rule and any required amendments to the documents. Often consultation with the Qualifying Organization partner(s) and advisors has led to a workable structure that is acceptable to the Qualified Organization partner(s), even if it is not absolutely certain the Fractions Rule is not violated. The recent IRS announcement that audited entities will soon be required to complete a new form disclosing any uncertain tax positions and quantifying the maximum exposure will not make reaching an acceptable structure easier.
On Jan. 19, The American Bar Association of Taxation submitted "Comments Concerning Partnership Allocations Permitted Under Section 514(c)(9)(E)" to both the Internal Revenue Service and the Treasury requesting guidance and/or amendment of the applicable Treasury Regulations as these issues are difficult, real, and pressing. The submission was a result of the distressed economic conditions and real world problems being faced on a daily basis and was not in response to a request of the IRS. Additional guidance under Section 514(c)(9)(E) is not on the 2009-2010 IRS. Whether guidance will be forthcoming in a timely manner is unclear.
- IRC §514(c)(9)(C) defines "Qualified Organization" to include (i) certain education organizations described in §170(b)(1)(A)(ii), (ii) qualified trusts under §401, (iii) title holding organizations as described in IRC §501(c)(25), and (iv) retirement income accounts described in IRC §403(b)(9).
- The term "partnership" means any form of entity that is treated as a partnership for federal income tax purposes. This includes domestic general partnerships, limited partnerships, limited liability partnerships, limited liability limited partnerships and limited liability companies that have not elected to be treated as an unincorporated association taxable as a corporation.
- See IRC §514.
- All reference to the Internal Revenue Code are to the Internal Revenue Code of 1986 as amended.
- IRC §514(c)(9)(E)(i)(I) and Treas. Reg. §1.514(c)-2(b)(1)(i), -2(c)(2).
- IRC §514(a)(1).
- For a preferred return to be ignored for purposes of determining compliance with the fractions rule, it must be reasonable under Treas. Reg. §1.514(c)-2(d)(2). Often, the preferred return for failure to make a mandatory capital contribution is designed to be punitive (i.e., encourages the making of the contribution). If a punitive preferred return is not reasonable, the Fractions Rule is violated.
- At the present time there is little or no guidance for determining whether changes to the partners' shares of income and losses resulting from either a default or reduction in committed or contributed capital causes a partnership to violate, on a prospective basis (after the default or lowered capital contribution), the Fractions Rule.
- Whether (i) the contributing partner receives a special allocation of income or gain at such time in advance of receiving cash or (ii) the contributing partner is entitled to such amount on liquidation if it has not been previously returned regardless of capital account balance is in both cases a violation of the Fractions Rule.
- Under Treas. Reg. §1.514(c)-2(d)(6) the allocation of income with respect to a reasonable preferred return must be accompanied by a cash distribution of equal amount made no later than the due date of the return without extensions. Even if the preferred return was reasonable, the making of the allocation without a timely distribution of cash generally will be a violation of the Fractions Rule. The failure to make the allocation, however, until cash is available for distribution when combined with the requirement that capital account balances must control liquidation proceeds places economic risk on the contributing partners that they will not receive the agreed upon consideration even if the partnership is ultimately profitable.
- This would appear to automatically violate the Fractions Rule by separating liquidation proceeds from capital account balances. IRC § 514(c)(9)(E)(i)(II) and Treas. Reg. §1.514-2(b)(ii). Allocations that are commonly used to attempt to force the capital account balances may also result in the violation of the Fractions Rule.
- Treas. Reg. §1.514(c)-2(m)(2), Example 3 proviso.
- Commissioner Schulman's announcement of January 26, 2010, as reported by Tax Analysts Doc. 2010-1915. See also Announcement 2010-9.
J. LEIGH GRIFFITH JD, LLM, CPA, is a fellow of the American College of Tax Counsel and the Tax Group Practice Leader of Waller Lansden Dortch & Davis LLP in Nashville.