By Christian M. McBurney
Thanks to the U.S. Treasury Department, investors that are non-U.S. sovereign funds or other non-U.S. government entities enjoyed some good news. Recently issued proposed regulations will dramatically reduce their U.S. tax risks.
Section 892 of the Internal Revenue Code contains a broad exemption from U.S. federal income tax for sovereign funds and other entities controlled by non-U.S. governments earning U.S. sourced income. Previously, as you are aware, if a sovereign fund (or other non-U.S. controlled entity) was treated as engaged in a commercial activity, it automatically became a controlled commercial entity, with the result that the entity’s U.S. income tax exemptions were entirely lost. Previously, the operations of an entity taxed as a partnership were attributed to the sovereign fund (or other non-U.S. controlled entity). In theory, therefore, $1 of business income generated by a partnership and passed through to the sovereign fund would result in the sovereign fund entirely losing its U.S. tax exemption. Under an “attribution exception” in the proposed regulations, this draconian result is now much less likely to occur. A sovereign fund (or other non-U.S. controlled entity) will not be treated as engaged in commercial activities solely because it holds an interest as a limited partner in a limited partnership. For example, (i) if a sovereign fund owns a limited partnership interest in a private equity fund, (ii) this fund in turn invests in a portfolio company taxed as a partnership, (iii) the portfolio company one year generates $100,000 of operating income, and (iv) $5,000 of that income is allocated to the sovereign fund, then the sovereign fund will not entirely lose its U.S. tax exemption. The same result would exist if the private equity fund allocated $5,000 of management fees it earned to the sovereign fund. However, the sovereign fund will have to pay any U.S. tax if its share of the income that is treated as U.S.-sourced effectively-connected income (ECI); still, that is a much less riskier regime than was previously the case.
An important matter now for a sovereign fund will be whether the investment its makes qualifies for the attribution exception. To do so, the sovereign fund must hold a limited partnership interest in a limited partnership. An entity that is not in form a limited partnership or a U.S. entity could still so qualify. An interest as a limited partner in a limited partnership is defined in the proposed regulations as an interest in an entity classified as a partnership for federal tax purposes if the holder of the interest does not have rights to participate in the management and conduct of the partnership’s business at any time during the partnership’s taxable year under the law of the jurisdiction in which the partnership is organized or under the governing agreement. A right to participate does not include consent rights in the case of certain extraordinary events.
Care must be taken that a private equity fund organized outside the U.S. qualifies for the attribution exception. The attribution exception will likely be another factor driving some funds to organize as Delaware limited partnerships, and for sovereign funds (and other non-U.S. controlled entities) to invest in Delaware limited partnerships where they have the choice.
The attribution exception does not apply if the private equity fund (or other partnership) is a controlled commercial entity. This can occur if the sovereign fund (or non-U.S. controlled entity) that is a limited partner owns more than 50% of the partnership interests by value in the private equity fund (or other partnership).
In another favorable development, gain from the disposition of a direct interest in U.S. real property, or from an indirect interest held through a partnership or through a controlled U.S. real property holding corporation, will not be attributed to the sovereign fund (or other non-U.S. controlled entity) as a commercial activity, resulting in the sovereign fund (or other non-U.S. controlled entity) entirely losing its U.S. tax exemption. However, such income would continue to be subject to U.S. tax filing and liability obligations.
In many ways, a sovereign fund and other non-U.S. controlled entity is treated for U.S. tax purposes similar to any other non-U.S. investor.
The proposed regulations contain a number of other beneficial rules for sovereign funds and other non-U.S. controlled entities. Importantly, the proposed regulations can now by relied on, even before the final regulations are issued.
By Christian M. McBurney
This alert provides a brief background of the potential impact of FATCA on investment funds and focuses on what investors and fund managers should do now in terms of inserting FATCA-related provisions in their fund agreements. While some fund managers are now beginning to do this, not all of them do, and few investors currently press for such provisions, despite the importance of the matter to them. With many types of U.S.-source payments to offshore funds potentially subject to U.S. 30% withholding tax under FATCA commencing in 2013, these provisions may be important to any fund investor, regardless of whether it is a U.S. or non-U.S. person.
By Forrest Milder
Over the years, several theories have been applied by the courts in considering whether a transaction was undertaken for tax avoidance reasons so that the transaction should not be “respected” as a matter of federal income tax law. Courts differed in how they considered this issue and which tests they applied. Some in government thought there should be a uniform standard for the application of these tests, often referred to as the “economic substance doctrine”, and in March, 2010, Congress passed, and the President signed into law, the “Health Care and Education Affordability Reconciliation Act of 2010 .Part of the 2010 Act included the “codification” of the economic substance doctrine in Section 7701(o) of the Internal Revenue Code. The new law is effective for transactions entered into after March 30, 2010.
On September 13, 2010,the IRS published a notice on the new economic substance doctrine that is found in Section 7701(o). In my humble opinion, it is remarkable in its failure to actually say anything "new". It largely recites the statute, and then says that the IRS will rely on existing authorities to interpret the applicable tests.
As a quick refresher of the rules and commentary on the notice --
(1) 7701(o) has a two part test -- (A) the transaction must change, in a meaningful way (apart from tax effects) the taxpayer's economic position, and (B) the taxpayer must have a substantial purpose (apart from Federal income tax effects) for entering into the transaction. The IRS makes clear that this is a "conjunctive test", by which they mean to remind taxpayers that BOTH tests must be passed.
(2) The notice mentions the provision of section 7701(o) stating that these rules apply only if "economic substance is relevant to a transaction", although it provides no additional guidance on that issue.
(3) If the taxpayer wants to rely on "profit" as a motivation, the computation must be based on the present value of the pre-tax profit.
(4) A 40% penalty will apply, rather than a 20% penalty, if the taxpayer does not disclose the transaction on his/her/its return. The notice states which forms should be used.
(5) Under regulations to be issued, foreign taxes will be considered in determining pre-tax profit.
(6) As I noted above, the notice includes words like"the IRS will continue to rely on relevant case law" throughout.
(7) The notice does not mention tax credits, or other congressionally-favored tax incentives . Some will remember that footnote 344 of the Technical Explanation that accompanied the Act included a sort of "savings provision", suggesting that these rules did not apply to transactions which featured those Congressionally favored tax provisions. So, we seem to still be awaiting guidance on that front.
By Christian M. McBurney and Sarah A. Nelson
The Health Care and Education Affordability Reconciliation Act of 2010 (the “Act”), signed by President Obama on March 31, 2010, includes a number of revenue-raising provisions that will adversely affect private equity investors and fund managers. These tax increases are on top of the expected expiration of the “Bush tax cuts,” which, after the end of this year, absent action by Congress, would automatically result in the increase of (i) the current maximum rate of 15% on capital gains and dividends to 20%, and (ii) the current maximum rate of 35% on regular ordinary income to 39.6%. In addition, while “carried interest” legislation was ultimately not included in the Act, it is still possible that Congress could enact it in the near term and thereby convert the treatment of capital gain allocable to fund managers to ordinary compensation income.
2.9% Medicare tax increase on wages and self-employment income
Starting with income received after December 31, 2012, the Act increases by .9% the Medicare tax from its current rate of 2.9% to 3.8% on an individual’s wages as an employee and self-employment income in excess of $250,000 (married filing jointly) or $200,000 (individual). Unlike current FICA and Medicare taxes, this additional tax is imposed solely on the employee and self-employed worker, and is not deductible. Employers will have, however, certain withholding obligations with respect to the Medicare tax increase.
3.8% Medicare tax imposed on individual net investment income
The Act modifies the Medicare tax to include a tax on individual’s, trust’s and estate’s net investment income. Currently, Medicare is not subsidized by a levy against net investment income and is financed primarily by payroll taxes.
Implementation of the Medicare tax. Beginning in 2013, the Act imposes a tax of 3.8% on the lesser of (i) annual net investment income or (ii) the excess of modified adjusted gross income (AGI) over the threshold amount ($250,000 in the case of a joint return, or $200,000 in the case of a single return). Net investment income is defined as:
Gross income from interest, dividends, royalties, and rents;
Net gains from the disposition of property, such as the sale of stocks, bonds, and real estate;
Gross income derived from a business constituting a passive activity to the taxpayer (including operating income and gain on sale from an operating business that flows up to the taxpayer-investor in a fund that is taxed as a partnership for income tax purposes); and
Gross income derived from a trade or business comprised of trading in financial instruments or commodities (whether or not the taxpayer is active in the business).
Gain from the sale of a partnership interest or stock in an S corporation is taken into account as if the entity had sold all of its properties at fair market value immediately before the disposition. Net investment income is reduced by properly allocable deductions to such income, including passive losses that offset passive gain.
The tax does not apply to income from, or gain on the sale of, a business, where the taxpayer is an active participant. The Medicare tax also does not apply to nonresident aliens, trusts that are exempt under Code section 501, and certain other charitable trusts. Moreover, the Medicare tax does not apply to distributions from qualified retirement plans, tax-exempt bonds, and gain on the sale of a residence to the extent excluded from income.
Example 1: For tax year 2013, Investor X (married filing jointly) has $275,000 of net unearned income (interest and dividends less any allowable deductions). Investor X also has $500,000 of W-2 income. The Medicare tax is calculated as follows: 3.8% times the lesser of (a) $275,000 (net investment income) and (b) $775,000 (modified AGI) minus $250,000 (threshold amount). This results in a tax of $10,450 (3.8% of Investor X’s net investment income).
Example 2: For tax year 2013, Investor Y (married filing jointly) has $255,000 of net investment income and $125,000 of W-2 income. The Medicare tax is calculated as follows: 3.8% times the lesser of (a) $255,000 (net investment income) and (b) $380,000 (modified AGI) minus $250,000 (threshold amount). This results in a tax of $4,940 (3.8% of the excess of Investor Y’s modified AGI less the threshold amount).
How the Medicare tax impacts private equity investors and fund managers. Investors in private equity funds will feel the impact of the additional 3.8% Medicare tax, including on disposition gains previously taxed at low capital gains rates. Carried interest from the sale of underlying portfolio companies allocated to fund managers, which is currently taxed at a favorable capital gains rate, will now also be subject to the 3.8% Medicare tax. U.S. investors in and managers of hedge funds where active trading of financial instruments or commodities is conducted will be subject to the 3.8% tax hike. While U.S. investors could shield this type of trade or business income from the Medicare tax by investing through a corporation, it would seem that the resulting double taxation would still make a corporation less tax-efficient than the typical pass-through structure (note that dividends from a corporation are also subject to the new Medicare tax to the extent the taxpayer’s AGI exceeds the threshold amount). Foreign investors who are nonresident aliens for U.S. federal income tax purposes will continue to be exempt from U.S. tax on their portfolio income if they invest through a blocker entity and will also be exempt from the Medicare tax even if they invest directly in a U.S. fund taxed as a partnership.
As the Medicare tax does not go into effect until 2013, there is time for some tax planning. Funds could consider selling “winners” in 2010 (while the low maximum 15% capital gains rate remains in effect and before the rate increases to 20%) or in 2011 or 2012 (before the new 3.8% Medicare tax takes effect, increasing the top capital gains rate to 23.8%). Additionally, investment income can be sheltered by any passive losses. It appears that passive losses that are not used to offset investment income can be carried forward to offset investment income in a future year. How the carry-forward will work in all circumstances is unclear. For example, it is not certain whether passive losses that a taxpayer carries forward from years previous to 2013 may be carried forward.
Addition of economic substance legislation
The Act adds new Section 7701(o) to the Code, which could adversely affect how private equity funds dispose of their portfolio companies. In general, new section 7701(o) provides that a taxpayer whose facts otherwise satisfy the technical legal requirements for a tax benefit shall be denied that tax benefit if in the opinion of the IRS (a) the taxpayer was motivated to arrange the transaction for the purpose of obtaining that tax benefit, (b) the benefit was not among the purposes Congress had contemplated in enacting the pertinent statute, and (c) the taxpayer fails to prove satisfaction of the economic substance test once the IRS asserts its application. A transaction that is properly challenged by the IRS will be treated as having economic substance only if (1) the transaction changes in a meaningful way (apart from U.S. federal income tax effects) the taxpayer’s economic position, and (2) the taxpayer has a substantial purpose (apart from U.S. federal income tax effects) for entering into such transaction.
The judicial “economic substance” doctrine has existed for many years and new section 7701(o) is not intended to depart radically from that judicial doctrine. The most important feature of section 7701(o) is its penalty regime. In general, if a taxpayer is found to have violated section 7701(o), a 20% penalty is imposed on the amount of underpaid tax. The penalty is increased to 40% if the transaction is not adequately disclosed on the taxpayer’s timely-filed tax return. There is no exception for reasonable reliance on a tax opinion or other reasonable cause or good faith, as was the case under prior law.
In the past, the economic substance doctrine has been applied most frequently in perceived “tax shelter” cases. On occasion, in the late 1990s and early 2000s, a few private equity funds engaged in such a transaction in disposing of a portfolio company or permitted the portfolio company to engage in such a transaction. The IRS successfully challenged many of these “tax shelter” transactions. With the new penalty regime, the stakes are higher for taxpayers.
There has been concern expressed in a few quarters that a tax-exempt investor’s use of a “blocker” entity that is taxed as a C corporation could run afoul of new section 7701(o). The application of section 7701(o) to this common planning technique would certainly be a surprisingly result. Given the harsher penalty regime, this and other areas might be appropriate for the IRS to resolve by issuing express guidance. There is case law supporting a taxpayer’s ability to make a “check-the-box” election under the IRS’s own regulations, regardless of the taxpayer’s tax planning motives.
Clients are encouraged to consult their tax advisors if there is any doubt that a proposed transaction could violate the new economic substance law.
To ensure compliance with IRS requirements, we inform you that any federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed in this communication.
For more information on this issue or any private equity matter, please contact your regular Nixon Peabody attorney or:
By Susan P. Reaman
Among the many welcome changes to the low-income housing credit program under the Housing and Economic Recovery Act of 2008 (“HERA”) was the establishment of the Capital Magnet Fund (CMF). With direct funding of $80 million under the president’s 2010 budget, the CMF will provide grants to finance affordable housing and related community development projects. Eligible grantees include community development financial institutions (CDFIs) and nonprofit organizations having the development or management of affordable housing as one of their principal purposes.
The CMF was established as a permanent trust fund and will be administered by the Treasury Department’s Community Development and Financial Institutions (CDFI) Fund. The CDFI Fund administers other grant programs, including the CDFI Grant Program which provides financial and technical assistance to CDFIs serving low-income people and communities and the New Markets Tax Credit Program, which provides investors a tax credit for investing in businesses located in under-served areas.
As its name suggests, CMF grant dollars are to be used to attract private capital for and increase investment in the development, preservation, rehabilitation, or purchase of affordable housing primarily for extremely low-, very low-, and low-income families, and related economic development activities or community service facilities such as day care centers, workforce development, and health care clinics.
Awards of CMF grants are intended to stabilize and revitalize low-income or under-served rural areas. Grantees may use grant monies to establish loan loss reserves, to capitalize a revolving loan fund, an affordable housing fund, or a fund to support economic development activities or community service facilities, and to provide risk-sharing loans.
In March 2009, the CDFI Fund published a Request for Public Comment on how the CDFI Fund should design, implement, and administer the CMF. In July 2009, the CDFI Fund released, on its website (www.cdfifund.gov), 37 comment letters it received in response to its request for public comment. Many commentators urged the CDFI Fund to use definitions and criteria from existing programs, such as the CDFI Grant Program, to fashion similar rules for the CMF. As for what constitutes “affordable housing,” many commentators suggested that housing units meet the income, rent, or purchase price term requirements of either the Low-Income Housing Tax Credit (LIHTC) for rental properties or the HUD HOME Investments Partnerships Program for rental and home ownership. At least one commentator suggested that a percentage of the affordable housing funding be used for workforce housing or specific populations, including but not limited to artists, teachers, firefighters, and police officers. The CDFI Fund specifically asked for comments on whether it should support economic development activities, and/or community service facilities in conjunction with affordable housing activities financed by sources other than CMF grants such as the LIHTC, HOPE VI, or private sources.
The CDFI Fund will administer competitive application rounds to distribute CMF grants. Officials from the CDFI Fund estimate that an Interim Final Rule should be released this year as early as late February. A final application should be published shortly thereafter. Administration of the CMF program will most likely be similar in many respects to the CDFI Grant Program.
On its website, the CDFI Fund describes some of the information that the application will require, including: a detailed description of the types of affordable housing, economic, and community revitalization projects the grantee would fund with a grant through the CMF; the specific use of grant funds; the types, sources, and amounts of other funding for such projects; and the timeframe for use (deployment) of grant funds.
In addition, selection criteria, prioritization, and compliance requirements must ensure that the CMF grants support activities in geographically diverse areas, including (to the extent practical) metropolitan and under-served areas in every state.
As required under the HERA, no more than 15 percent of the aggregate amount of funds available in a given round may be awarded to any one grantee (or its affiliates and subsidiaries); grantees must leverage their CMF awards by at least 10 times the award amounts; and the grant funds must be committed for use within two years of allocation. We expect clarification of these statutory criteria will be forthcoming under the Interim Final Rule and application.
The funding of the CMF comes at a critical time for developers in the affordable housing industry who are eager to jumpstart the industry in 2010. Grants available through the CMF Program provide yet another government economic tool toward realizing that goal.
Please feel free to contact your regular Nixon Peabody attorneys, or Susan P. Reaman at 202-585-8327 or email@example.com, with your thoughts and questions. We look forward to hearing from you.
By Richard Michael Price and Susan P. Reaman
We often refer to affordable housing as a public-private partnership, in that it often takes public and private resources working together to create lasting affordable housing. Generally, affordable housing includes some form of government involvement, ranging from direct subsidies (e.g., the Section 8 rent subsidy program) to financing programs (e.g., low-income housing tax credits( LIHTCs)), which bring with them substantial compliance obligations.
As a refresher, it is important to be mindful of how the actual or perceived lack of compliance is manifested. The Inspector General Act of 1978 authorized inspectors general to audit program operations and examine waste, fraud, and abuse. Often, seemingly innocuous activities can be questioned as inefficient, ineffective, or occasionally incorrect. Any such finding can bring with it significant issues, ranging from civil to criminal penalties.
The HUD Office of Inspector General (HUD OIG) has been in existence since before the 1978 act. The HUD OIG has a three-step audit process. If you are contacted by the HUD OIG, this is what you should expect. The first step is the entry conference, where OIG representatives explain what they plan to review. The second step is a review of the books, records, and condition of any property in question. The last step is the exit conference, where the OIG reveals findings.
It is very important to prepare for the OIG in advance, because preparation will help avoid misunderstandings. Ideally, you should consult experienced counsel, because even parties confident that they are complying with agency rules often receive adverse OIG findings, which can bring sanctions. These sanctions can range from 2530 flags to administrative and even criminal sanctions. Administrative sanctions can include debarments, suspensions, and fines, such as civil money penalties (CMPs). Suspensions become effective upon issuance of HUD OIG findings and before any appeal may be taken, but debarments become effective only after administrative appeals are exhausted. CMPs are initiated through a letter process. If a target fails to respond to a CMP letter, it may inadvertently waive the right to respond later on, when HUD files a formal administrative complaint.
HUD rules allow the imposition of these sanctions for a variety of violations, but program participants should pay special attention to certain catch-all provisions, which provide that sanctions may be applied for any material breach of a contract related to a HUD project, any violation of an applicable HUD regulation, or the making of any false statement in connection with a HUD-financed project. Sanctions against a person or a company generally extend to all of the subsidiaries and affiliates of that person or company.
Similar rules exist in other non-HUD housing programs. The largest single multifamily housing loan program outside of HUD is at Rural Development (RD), which is part of the U.S. Department of Agriculture (USDA). RD programs are subject to audit and review by the USDA’s Inspector General, also under the Act, but also USDA specific procedures. RD does not utilize 2530s to the same extent as HUD but does have an informal review of borrower qualification to perform new transactions. RD also can assess CMPs.
Affordable housing owners receiving LIHTCs also must meet low-income housing eligibility and compliance requirements under the LIHTC program. This includes cash grants or loans under the recently enacted Section 1602 Credit Exchange Program, and the Tax Credit Assistance Program (TCAP Program) under the American Recovery and Reinvestment Act of 2009.
State agencies are responsible for compliance monitoring for these programs throughout the 15-year compliance period. Compliance issues include: meeting health and safety standards, rent ceilings and income limits, and tenant qualifications. Failure to meet these requirements may result in recapture of the housing credit or, in the case of the Section 1602 Credit Exchange Program, the full amount of the 1602 award minus 6.67 percent (1/15th) for each full year of the building’s 15-year compliance where a Section 1602 recapture event has not occurred.
When noncompliance is identified or there has been disposition of a building (or interest therein), state agencies must notify IRS using Form 8823, “Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition.” In the case of the Section 1602 Credit Exchange Program, where no tax credits are involved, no Form 8823 is sent to IRS to report noncompliance. However, states may use Form 8823 to notify owners of compliance issues. Upon receipt of Form 8823, the IRS sends a Notification Letter to the owner, identifying the type of noncompliance reported on Form 8823. The Notification Letter states that owner may not include any nonqualified low-income units when computing the LIHTC and that the noncompliance may result in recapture of the LIHTC. The Notification Letter instructs the owner to contact the state agency to resolve the matter. Forms 8823 are routinely analyzed by IRS and may result in an audit of an owner’s tax returns.
The Internal Revenue Service recently updated its Guide for Completing Form 8823: Low-Income Housing Credit Agencies Report of Noncompliance or Building Disposition as of October 2009. This publication provides in-depth analysis, including examples of the categories of noncompliance as identified on Form 8823. The guide also incorporates the changes to the LIHTC program enacted under the Housing and Economic Recovery Act of 2008, revisions to HUD’s Handbook 4350.3, and the amended IRS utility allowance regulations published in July 2008. (For more information on the new utility allowance rules, see Nixon Peabody Tax Credit Alert, May 17, 2009).
As the affordable housing programs continue to evolve, HUD, RD and IRS vigilance should be expected to continue to be felt through audits and reviews and owners, managers and other housing providers will have to be mindful of ongoing and perhaps new compliance requirements.
For more information, please contact:
Richard Michael Price at 202-585-8716 or firstname.lastname@example.org
Susan P. Reaman at 202-585-8327 or email@example.com
By Christian McBurney
Earlier this year the Treasury Inspector General for Tax Administration issued a report recommending that the IRS create an agency-wide employment tax program to address the issue of worker classification and to conduct a compliance study to measure the impact of worker misclassification on the tax gap. Starting this month, November 2009, the IRS will begin conducting random audits as part of this program. The IRS recently announced that 6,000 companies will be audited and that they have hired and trained approximately 200 new agents to work on employment tax issues. This is expected to be the most comprehensive IRS examination of employment tax compliance since 1984, with the main focus on whether businesses are properly classifying their workers as employees or independent contractors. Companies that have not considered this issue recently should spend time analyzing their circumstances.
In addition to this effort at Treasury, it is still possible that legislative action in this area could occur later this year, although not until Congress has completed action on health care reform. In July, Rep. Jim McDermott (D-WA) introduced H.R. 3408 to clarify the rules classifying workers as independent contractors versus employees to ensure proper tax filing. It would replace Section 530 with a new safe-harbor provision that fewer taxpayers could satisfy and whose protections would be retroactive in nature. There has been no further activity on H.R. 3408 since it was referred to the House Ways and Means Committee. We will continue monitoring this area.
By Christian McBurney and Charles Jacobs
A recent development in the state and local tax area has been the increasing number of states that impose withholding tax on partnerships with respect to state-sourced income that is allocated to, or distributions that are made to, partners who are not residents of the state. Such states include California, New York, New Jersey and Massachusetts. Typically, these states have certificates that a tax-exempt corporation qualifying under IRC Section 501(c) can submit to the partnership to avoid withholding (even if the tax-exempt partner is allocated UBTI income). But, typically, these exemption certificates do not expressly address government pension entities and other state and local entities, which are tax-exempt under the U.S. Constitution, but not under Section 501(c). The question has arisen as to what government entities should do in this case, focusing on California and New York.
California. California Form 590, Withholding Exemption Certificate, is used by partners to certify to the partnership that the partner is a non-resident and is exempt from California withholding tax on distributions. The block for tax-exempt entities only has the following: "The above-named entity is exempt from tax under California R&TC Section 23701___ (insert letter) or Internal Revenue Code Section 501(c)___ (insert number)." Since government pension entities are exempt under the U.S. Constitution and not under Section 501(c), this form is not helpful.
There is also California Form 588, Nonresident Withholding Waiver Request, which is an application form for a California nonresident to apply to the Franchise Tax Board for a determination letter that the partner is exempt from withholding. The partner can then provide the determination letter to the partnership to avoid withholding. In the Reason for Waiver Request, there is "E. Other - Attach specific reason and include substantiation that would justify a waiver of withholding." Thus, the best course is for a government pension entity to make this application for an exemption. The instructions indicate that the FTB should issue a determination letter within twenty-one days of filing. This approach was confirmed in a recent telephone conference we had with an FTB official.
New York. New York technically does not have nonresident withholding tax. Instead, it imposes on partnerships operating in New York nonresident partner estimated tax on New York source income. By their terms, the estimated tax provisions apply only to nonresident individuals and corporations. NY Tax Law Section 658(c)(3)(A). Accordingly, if the government public pension entity is a trust or other non-corporate entity, this estimated tax provision does not apply.
If the government entity is a corporation, which is infrequent, New York State Form CT-2658-E provides that the exemption only applies if the corporation "is exempt from any taxes imposed by the New York State Tax Law, Articles 9, 9-A, 32 and 33." It may be that a government entity that is organized as a corporation qualifies under this standard, since New York State starts its taxable income calculations with federal taxable income, and government entities organized as corporations may be excluded from having federal income under either the U.S. Constitution or IRC Section 115(1).
If you have any questions, please contact:
Christian McBurney at (202) 585-8358 or firstname.lastname@example.org or
Charles Jacobs at (212)940-3170 or email@example.com.
By Susan Reaman
The Federal Court of Claims in Thompson v. U.S., 104 AFTR 2d 2009-XXXX, 07/20/2009 granted the Taxpayer summary judgment in deciding that its LLC member interest was not a limited partner interest for purposes of the passive activity rules under IRS Code § 469 and the regulations therunder. This case follows another recent taxpayer favorable case Tax Court opinion in Paul D. Garnett, et ux. v. Commissioner, 132 T.C. No. 19.
In Thompson the Taxpayer structured his business activity in the form of a limited liability company (“LLC”) under State law that treated LLCs as hybrid entities that are neither partnerships nor corporations. The taxpayer held directly a 99% member interest in LLC and indirectly the remaining 1% through a Subchapter S corporation.
Because LLC did not elect to be treated as a corporation for federal tax purposes, by default the Code treated it as a partnership, see Treas. Reg. § 301.7701-3 (b)(1)(i). The Taxpayer claimed losses of the LLC on its individual income tax return. The IRS denied the losses because it concluded that the taxpayer did not materially participate in the business of the LLC.
Generally, under Treas. Reg. § 1.469-5T(a). an individual may establish his material participation for a given taxable year by demonstrating any of the following:
(1) The individual participate[d] in the activity for more than 500 hours during such year;
(2) The individual's participation in the activity for the taxable year constitute[d] substantially all of the participation in such activity of all individuals ... for such year;
(3) The individual participate[d] in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year [was] not less than the participation in the activity of any other individual ... for such year;
(4) The activity was a significant participation activity ... for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeded 500 hours;
(5) The individual materially participated in the activity ... for any five taxable years ... during the ten taxable years that immediately precede[d] the taxable year;
(6) The activity is a personal service activity ..., and the individual materially participated in the activity for any three taxable years ... preceding the taxable year; or
(7) Based on all of the facts and circumstances ..., the individual participated in the activity on a regular, continuous, and substantial basis during such year.
The Code treats limited partners differently because it presumes that they do not materially participate in their limited partnerships. Section 469(h)(2) provides that except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates. In fact, under the Treasury Regulations implementing § 469, if a taxpayer holds a limited partnership interest, only three of the seven tests described above—(1), (5), and (6)—are available to measure the taxpayer's material participation in the partnership.
Except as provided in paragraph (e)(3)(ii) of this section, Treas. Reg.§ 1.469-5T(e)(3)(i)(B) provides that a partnership interest shall be treated as a limited partnership interest if the liability of the holder of such interest for obligations of the partnership is limited, under the law of the State in which the partnership is organized.
Treas. Reg. § 1.469-5T(e)(3)(ii) provides that a partnership interest of an individual shall not be treated as a limited partnership interest for the individual's taxable year if the individual is a general partner in the partnership at all times during the partnership's taxable year ending with or within the individual's taxable year (or the portion of the partnership's taxable year during which the individual (directly or indirectly) owns such limited partnership interest).
The government argued that it was proper for the IRS to treat taxpayers’ interest in LLC as a limited partnership interest under Treasury Regulation § 1.469-5T(e)(3)(i)(B) because the taxpayer elected to have LLC taxed as a partnership for income tax purposes and because plaintiff's liability is limited under the laws of the state in which was organized.
However, the court in agreeing with the taxpayer, concluded the IRS’s own regulations literally requires that the ownership interest be in a business entity that is, in fact, a partnership under state law—not merely taxed as such under the Code. In addition, the Court raised the possibility that the taxpayer could also prevail under the general partner exception from treatment as a limited partner given the high degree of control taxpayer exerted over business operations as its sole manager.
The court ultimately concluded that the terms—“material participation” and “passive activity”—indicate that Congress was primarily concerned with the taxpayer's level of involvement in the activity in question and not the extent to which liability is limited.
The IRS raised the same argument in Garnett, in which the petitioners owned interests in both LLCs and limited liability partnerships (“LLPs”).
The Tax Court held that members of LLPs and LLCs, unlike limited partners in State law limited partnerships, are not barred by State law from materially participating in the entities' business. It cannot be presumed that they do not materially participate, but rather, it is necessary to examine the facts and circumstances to ascertain the nature and extent of their participation.
For more information, please contact Susan Reaman at (202) 585-8327 or firstname.lastname@example.org.
By Christian McBurney
Fund managers are beginning to realize that new Section 457A of the Internal Revenue Code has a broader scope than initially thought. Congress enacted Section 457A, effective January 1, 2009, with the idea of addressing cash parked by hedge fund managers in offshore tax-haven entities to be paid out as compensation in future years. But Section 457A also applies to many partnerships and limited liability companies organized in the U.S.
Under Section 457A, nonqualified deferred compensation from a “nonqualified entity” will be taxed when there is no substantial risk of forfeiture. In other words, the tax becomes due when the right to payment vests even if it is an unfunded and unsecured promise to pay. The law also provides that difficult–to-value compensation from a nonqualified entity will be taxed later at payment, but it will be subject to a 20% excise tax and interest calculated from the time of deferral.
Section 457A is focused on entities that are indifferent about whether they obtain a tax deduction with respect to the payment of compensation. The concern is that if these entities do not care about obtaining the tax deduction to reduce their U.S. income, they may participate in arrangements to defer compensation to fund managers and corporate executives, which Congress now deems to be undesirable.
A foreign corporation is a “nonqualified entity” generally unless substantially all of its income is effectively connected with the conduct of a United States trade or business (“ECI”), it is subject to a comprehensive foreign income tax, or it is eligible for a comprehensive income tax treaty with the U.S. Even if the corporation is subject to a comprehensive foreign income tax, no more than 20% of its income can be “excluded income,” which generally includes, among other types of income, gains on sale that are not covered in the prior sentence.
A partnership, whether organized in the U.S. or not, will be treated as a nonqualified entity unless 80% or more of its gross income is allocated to “eligible persons.” In general, gross income will be treated as allocable to an eligible person to the extent such income is allocable (directly or indirectly through tiered partnerships) to (1) a U.S. individual or corporation (and certain other U.S. taxpayers), (2) a U.S. tax-exempt entity to the extent such gross income is derived in an unrelated trade or business and is taxable to such entity under the UBTI rules, (3) a non-U.S. person to the extent such gross income represents ECI, and (4) a non-U.S. person who is actually subject to a comprehensive foreign income tax with respect to such gross income.
Here are some examples of circumstances in which the partnership is a nonqualified entity that is subject to Section 457A:
· A U.S. operating fund has two 50% partners: a U.S. fund with U.S. taxable partners, and an offshore, tax-haven fund with non-U.S. partners and U.S. tax-exempt entities. The U.S. fund is taxed as a partnership for U.S. federal income tax purposes. The offshore fund is taxed as a corporation for U.S. income tax purposes. Most of the U.S. fund’s income is from gains on the sale of portfolio investments and is not ECI. The U.S. operating fund is a nonqualified entity subject to Section 457A.
· State and local U.S. pension plans own directly or indirectly (through pass-through entities) 25% of the interests of a U.S. fund that is taxed as a partnership for U.S. federal income tax purposes. Such pension plans typically take the position that they are not subject to the UBTI rules. The U.S. fund is a nonqualified entity subject to Section 457A.
· AB partnership has two partners: A, a U.S. taxable corporation, and B, a U.S. tax-exempt entity. XY partnership has $1,000 in ordinary income (UBTI), $300 of deductions, and $8,000 of gains. Under the AB partnership agreement, A is specially allocated the first $700 of net income and 75% of the gains ($6,000). AB partnership is nonqualified because A receives less than 80% of the gross income allocations ($1,000 + $6,000 is < $7,200). AB partnership is a nonqualified entity subject to Section 457A.
· Here is an example from IRS Notice 2009-8; it shows how complex the analysis can be. K and B are partners in KB partnership, which is a partnership organized under the laws of Foreign Country 1 that is fiscally transparent under the laws of Foreign Country 1. KB is a partnership for U.S. federal income tax purposes. K is an entity organized under the laws of Foreign Country 2, and K is fiscally transparent under the laws of Foreign Country 2 and has in effect an election to be treated as a corporation for U.S. federal tax purposes. B is a U.S. taxable C corporation. The owners of K are S, an individual who is a citizen and resident of Foreign Country 3, and J, a foreign corporation. S is eligible for the benefits of a comprehensive income tax treaty with the U.S. and takes into account under the income tax laws of Foreign Country 3 her share of gross income of K on a current basis at a sufficiently high rate. J is not subject to tax on its share of income of K. Income of KB is not ECI. Neither Foreign Country 1 nor Foreign Country 2 imposes a tax on the income of KB.
o Gross income of KB allocated to B is income allocated to an eligible person.
o Gross income of KB allocated to K is not income subject to a comprehensive foreign income tax since K is fiscally transparent under the laws of Foreign Country 2.
o Gross income of KB allocated to S that is allocated to an eligible person since S is eligible for the benefits of a comprehensive foreign income tax treaty with the U.S. and S includes her share of K’s gross income whether it is distributed or not and such income is generally taxed under the laws of Foreign Country 3 at a rate not less than the generally applicable rate.
o Gross income of KB that is allocated to K and taken into account by J is not income that is allocated to eligible persons because neither K nor J is subject to a comprehensive foreign income tax with respect to such income.
The statute provides that an entity is nonqualified unless the taxpayer can establish that it is qualified. In cases of multiple tiered entities, it may be difficult to obtain the proper information to make the determination accurately each year.
Once it is determined that an entity is nonqualified, then it is necessary to determine if there is any nonqualified deferred compensation. The definition of deferred compensation is not certain and could include certain special distributions. Compensation is not treated as deferred if the compensation is paid not later than twelve months after the end of the first taxable year of the entity during which the right to the payment of such compensation is no longer subject to a substantial risk of forfeiture. A partnership “profits interest” or “carried interest” is not subject to Section 457A.
Accordingly, entities that have deferred compensation arrangements that are organized in tax havens exempt from U.S. and foreign income tax, or that are partnerships a substantial portion of which are owned by U.S. tax-exempt investors or foreign investors, could be subject to Section 457A. Such firms may need to restructure these agreements in order to avoid the impact of Section 457A.