ECONOMIC AND TAX ISSUES
IN DRAFTING PARTNERSHIP AGREEMENTS
PART ONE: CHOICE OF ENTITY
Dan Kroll
Christopher Morales
Austin Carlson
January 28, 2015
© 2014 Gray Reed & McGraw, P.C.
The information contained herein is subject to change without notice
Before We Begin
Highway to the Next Level
Next Tax Level
Professor Kroll
You
Objectives
 Better
understanding of the two main
drivers for choice of entity:
 Liability Planning
 Tax Planning
 Better
understanding of why many
investment structures are so complex.
4
Business Entity Choices

Corporation
 C Corporation
 S Corporation

 REIT
 Tax Exempt
Partnership
 General
 Limited
 LLP
 MLP

Limited Liability Company

Check the box flexibility
5
Non-Tax Considerations

Limited Liability for Owners
 Management
 Corporation -- Board of Directors
 LLC -- Board of Managers or Managing Member/Sole
Member
 Limited Partnership -- General Partner
 General Partnership -- Managing Partner
6
Non-Tax Considerations
 Ownership
Flexibility
 Preferred Equity
 Junior Equity
 Economic Waterfalls
 Profits Interests
 Disproportionate Distributions
7
Tax Considerations

Double Tax v. Single Tax
 Losses Trapped in Entity
 Basis Increase to Owners for Entity Income
 Tax Basis to Owners for Entity Debt
 Flexible Allocation of Tax Items
 Taxable In Kind Distributions
 Tax-Free Merger
 Inside Basis Increase to Buyer Upon Equity Sale
 “Blocker” function
8
C Corporation
 Double
Tax
 Losses Trapped
 No Outside Basis Increase for Current Earnings
 In Kind Distributions Are Taxable
 Tax-Free Merger Possible
9
Double Tax Example
Non-Corporate
Shareholder
$13
5
IRS
$65
4
C Corporation
$200
$100
2
1
Customer
Revenue
Expenses
Net Income
Less: 35% Corporate Tax
After-Tax (Corporate)
Less: 20% Dividend Tax
To Shareholder After All Taxes
10
Expenses
200
-100
100
-35
65
-13
52
$35
3
IRS
If the $65 of after-tax earnings
are retained in the C
Corporation, Shareholder's Tax
Basis in the Shares does not
increase
Single Tax Example
$20
Owners
5
IRS
$100
4
S Corporation or
Partnership
$200
1
11
2
Expenses
Customer
Revenue
Expenses
Net Income
Less: Corporate Tax
After-Tax (Corporate)
Less: 20% Shareholder Tax
Retained Earnings
$100
200
-100
100
-0
100
-20
80
$0
3
IRS
Pass through entity
distributes $100 to Owners
Taxes; Owners pay $20 in
tax, retain $80.
Trapped Losses
Shareholder
Loss Allocation
C Corp
Losses incurred by C Corp may not be used by the Shareholder
12
Corporate Reorganizations
Target
Shareholders
Target Corp
Acquisition Corp
Shares
merger
Acquisition Corp
Merger Sub
Exchange of Target Shares for Acquisition Corp Shares are tax-free to
Target Shareholders
13
S Corporation

Single Class of Stock

Limited Number and Type of Shareholders

No Allocation Flexibility

Technical Election Procedures and Footfaults

No basis allocation for Shareholder Debt

In-Kind Distributions are Taxable

No Disproportionate Distributions Allowed
 But Redemption Safe Harbor
But,

No Trapped Losses

Basis Increase for Retained Operating Earnings
14
S Corporation Example
A
50 Shares
$50
$50
AB S Corp
B
50 Shares
AB S Corp spends $100 on deductible expenses
Losses allocated 50/50
15
S Corporation Example - (continued)
A
$0
$100
AB S Corp
B
100 Shares

AB S Corp needs an additional $100 for Year 2 operations

A does not have any money

B funds all $100

AB S Corp issues 100 shares to B for the extra $100 investment

Sharing Ratio is now 50 shares to A and 150 shares to B

Year 2 losses allocated $25 to A and $75 to B even though losses were all
funded by B
16
Basis Increase for S Corporation
$40
Shareholder
5
IRS
$40
4
S Corporation
$200
1
17
2
$0
3
Expenses
Customer
Revenue
Expenses
Net Income
Less: Corporate Tax
After-Tax (Corporate)
Less: 40% Shareholder Tax
Retained Earnings
$100
200
-100
100
-0
100
-40
60
S Corporation distributes
$40 to Shareholder for
Taxes; retains $60.
Shareholder's Tax Basis
Increases for the $60 of
Retaining Earnings
IRS
Friends don’t let friends form an S Corp or a C Corp for a privatelyowned business.

Exceptions
 Small business service companies with one owner and no
possibility whatsoever of capital gain transactions
 C Corp to S Corp conversions
• Basis Increase for Earnings
• Avoid Trapped Losses
• In-Kind Distribution Rule Usually Prevents an LLC Conversion
 Over 100 equity owners and cannot qualify as a Publicly
Traded Partnership
 Business is certain it will exit in a stock-for-stock merger or
will be purchased in a 338(h)(10) deal
 Blockers
18
Initial Public Offerings
A
B
C
merger
ABC LLC
A
B
ABC Corp
Public
C
$
ABC Corp
Unless the business can qualify as a publicly traded partnership, ABC LLC will
need to convert to a corporation before it consummates an initial public
offering.
19
Blocker Corporations
Blocker corporations allow investors to indirectly receive
income from domestic partnerships without being a
direct partner.
• Inbound foreign investment domestic corporate blocker
• Tax exempt entity domestic corporate blocker
• REIT subsidiary domestic corporate blocker
20
Blockers: Inbound Foreign Investment Blocker
Foreign Investors
A
B
C
Domestic Corp
(Blocker)
Domestic Investors
B
C
U.S. Partnership
U.S. Real Estate Assets
The blocker corporation pays tax on its share of the partnership's income.
Foreign investors avoid US trade or business income tax and instead are
only subject to tax in their home country on any dividends received. Foreign
investors will not be required to file a U.S. income tax return.
21
Blockers: Tax Exempt UBTI Subsidiary
Tax Exempt
Entity
Tax Free
Dividends
Domestic Corp.
(Taxable
Subsidiary)
Other Investors
B
C
UBTI
Income
U.S. Partnership
Domestic corp. will hold all investments that generate UBTI income.
Income will be taxed as corporate rates at the subsidiary level and passed
tax free to the tax exempt entity.
22
Blockers: REIT Taxable Subsidiary Blocker
REIT
“Good” REIT
Income
Dividends
Real
Estate Assets
Domestic Corp.
(Taxable REIT
Subsidiary)
“Bad” REIT
Income
Management, Development, and Sales
Contracts relating to Real Estate Assets
(Concierge services, minor dealer gain)
Subsidiary structure allows REIT to indirectly receive income that
would otherwise disqualify the entity’s REIT status. Equity value of
subsidiaries may not collectively represent more than 25% of REIT
assets.
23
Delaware Filing Fees - As of December 31, 2014
Certificate Type
Limited Partnerships - Domestic & Foreign
Limited Partnership - Certificate
Amendment
Cancellation (plus taxes to cancel)
Limited Liability Companies
Certificate of Formation - domestic
State Tax & Filing
Fee
Certified
Copy (each)
Same Day Fee
24-Hour Fee
$200.00
$200.00
$200.00
$50.00
$50.00
$50.00
$100.00
$200.00
$200.00
$50.00
$100.00
$100.00
$90.00
$50.00
$100.00
$50.00
Priority 1 (1-Hour) Service is available at a cost of $1000 per document/request and Priority 2 (2-Hour) Service is available at a cost of
$500 per document/request.
Cancellation (plus annual taxes to cancel) domestic & foreign
Certificate Type
$200.00
$50.00
$200.00
Fee
Same Day
Fee
24-Hour Fee
Good Standings - Short
Limited Partnership
Limited Liability Company
$50.00 (per certificate)
$50.00 (per certificate)
$50.00
$50.00
$40.00
$40.00
Certified Copies
Limited Partnership
$50.00 (per document)
$60.00
$50.00
$60.00
$50.00
plus $2 per page for
copies
Limited Liability Company
$50.00 (per document)
plus $2 per page for
copies
Fee
Names Reservations
Limited Partnership (120 days)
Limited Liability Company (120 days)
Limited Liability Partnership (120 days)
Corporate Name Reservation (120 days)
24
$75.00
$75.00
$75.00
$75.00
$100.00
Texas Filing Fees - As of December 31, 2014
Fees
Domestic For-Profit Corporations
Certificate of Formation
Expedited Processing Fee per document
$300
$150
Foreign For-Profit Corporations, Foreign
Professional Corporations, Foreign
Professional Associations, Foreign REITS,
and Foreign Business Trusts
Application for Registration to do Business
$750
Limited Partnerships (domestic & foreign)
Reservation/Renewal of Entity Name
Certificate of Formation
Certificate of Amendment
Application of Registration to do Business
Expedited Processing Fee per document
Limited Liability Companies
Fees same as domestic and foreign for-profit
corporation filing fees
25
$40
$750
$150
$750
$25