How Partnerships Can Avoid Tax Surprises –

“You got to be very careful if you don’t know where you’re going, because you might not get there.” -Yogi Berra

Although it was presumably not Yogi’s intent, his words are certainly applicable to the consequences of poor tax planning. Accordingly, we have chronicled certain tax planning ideas that should be useful for those in the venture capital industry.

Establishing Partnership Status. The “check-the-box” rules generally permit unincorporated organizations to elect to be treated as either (i) associations (taxable as a corporation) or (ii) partnerships, for federal tax purposes without regard to the number of corporate characteristics (limited liability, continuity of life, centralized management, and free transferability of interests) they possess.1 However, certain business entities are excluded from these rules, such as entities that are organized as corporations under state statutes and specified foreign entities resembling U.S. corporations.2

Entities that do not elect a particular classification are classified under “default” rules.3 These default rules vary, depending on the nature of the non-electing entity. For example, noncorporate domestic organizations with more than one member are treated as partnerships. Single-member domestic entities are disregarded for federal tax purposes. Foreign organizations operate under a completely different set of “default” rules.

Thus, most domestic entities will likely attain their desired federal tax classification without even filing an election with IRS. However, there may be situations when an entity should consider making a “protective” classification election. For example, an election might be valuable if an entity is uncertain whether it is considered domestic or foreign and is therefore uncertain of its default classification. In that case, as well as other cases of uncertainty, the entity should consider protectively filing Form 8832 (Entity Classification Election).

Contribution Requirements. The abovementioned check-the-box regulations appear to supplant the original “1% contribution” requirement of general partners. The IRS issued this 1% requirement when outlining the pre-conditions for ruling requests relating to the classification of an entity organized as a limited partnership.4 Simply put, the IRS would not consider determining whether an organization was a limited partnership unless the general partners, in the aggregate, possessed at least a 1% interest in each material item of partnership income, gain, loss, deduction or credit, and a minimum capital account balance of the lesser of 1% of the total capital account balances of the partnership or $500,000. The IRS later extended the 1% requirement to LLCs.5 However, with the implementation of the check-the-box rules in Regulation 301.7701-3, the IRS has effectively rendered the 1% rule obsolete, but has not yet updated its Revenue Procedure to reflect this change.

Although the new regulations provide guidance in electing partnership status, they do not define the necessary attributes of a “partner” or “member” for tax and legal purposes. Generally, a partner is presumed to be a taxpayer with an equity interest in the entity. Nevertheless, it is now unclear whether every taxpayer with a nominal equity interest will legally achieve partner status. As a result, it may be prudent to adhere to the 1% test to assure that the smaller general partner percentages will not be disregarded.6 If smaller general partners are disregarded, distributions to these “partners” could lose their “pass-through” characterizations of capital gain and possibly be taxed at ordinary income rates.

Lastly, with the definition of “partner” being unclear, it is possible that an entity’s election to “check the box” as a partnership can impact who will be considered a partner. For example, let’s presume that two taxpayers create a joint venture. Taxpayer A provides essentially all the equity and Taxpayer B provides only nominal equity. Normally, a joint venture with only one equity investor would be prohibited from claiming partnership status. Under the Uniform Partnership Act, all partnerships must have at least two partners.7 However, if the joint venture elects to be treated as a partnership, perhaps both taxpayers-even the one investing nominal equity-would be regarded as partners. Thus, it is another reason to make the protective Form 8832 election.

Capital Account Allocation. Capital accounts are used to reflect each partner’s share of partnership assets or capital.8 Capital accounts also directly affect a partner’s ability to receive distributions over the life of the fund (both timing and amount). One key component of capital accounts is the allocation of income and loss because they adjust the partners’ capital account balances. The partnership agreement can provide for any partner to share capital, profits and losses in different ratios, provided that the allocations have “substantial economic effect,” as defined in IRC 704(b). However, in venture capital firms, a common allocation, after some distribution hurdle, is 20% to the general partner and 80% to the limited partners (even though the GP generally contributes 1% of the capital and the LPs contribute 99%).

“Net profits and losses” is the term often used in partnership agreements when describing the allocation of the partner’s capital accounts. Each partnership agreement should clearly define this term. However, if a partnership agreement fails to define this term altogether, it is common practice for the partners to share each item of income according to their pro rata share of the capital.9 Additionally, it would be advisable for VC funds to generally limit the definition of “profits and losses” to realized income (in contrast to having the term encompass realized and unrealized income). This limitation would help the partners avoid unnecessary volatility in their capital accounts.

Tax Basis Allocation. A partner’s tax basis in his partnership could directly impact a partner’s personal tax liability in numerous ways. Here are three scenarios. (1) If a partner would sell his partnership interest, the partner’s calculation of taxable gain or loss would depend on the partner’s tax basis. (2) A partner may only deduct his distributive share of partnership losses up to the basis in his partnership interest.10 (3) When a partner receives a distribution, he will recognize gain to the extent that his cash distribution exceeds the basis in his partnership interest. As a result, tax basis allocation takes on enhanced significance in a partner’s tax planning.

Generally, a taxpayer’s tax basis in his partnership represents the cost of his partnership interests (for tax purposes). Each partner’s basis account is continually adjusted to reflect partnership taxable income, taxable losses and distributions. The primary difference between the calculation of a partner’s tax basis account and tax capital account (discussed above) is the partner’s allocable share of the partnership debt. The partner’s allocable share of the partnership’s debt increases his tax basis account but does not affect his tax capital account.

Distributions. The partnership agreement should provide specific guidelines on how and when to make partnership distributions. Generally, venture capital distributions are first made to return each partner’s cash capital investment. Once that has been achieved, distributions are often devised so that the GP receives 20% and the LPs receive 80% of all future distributions.

Care should be taken to avoid taxable distributions when a “clawback” occurs, which would cause tax distortions if not properly handled in the partnership agreement.

State Filing Requirements. There are some tax traps that pertain exclusively to a state’s treatment of a partnership and an LLC. One such example concerns VCs that invest in an LLC. If the LLC is in an active trade or business, the VC will have nexus in those states in which the LLC has nexus. Accordingly, a VC that invests in a single LLC may unwittingly find itself required to file numerous state tax returns.

There are additional state tax traps for which a VC should be wary. However, these traps often exist in certain states while being a non-issue in others. For example, some states require partnerships to file state tax returns when one of their partners is a state resident. Other states do not have this requirement. A second example relates to a state’s tax treatment of LLCs. Some states tax LLCs as corporations, while others follow the federal treatment. As of this writing, New Jersey enacted new legislation that will tax operating LLCs as corporations and will require most venture capital-type partnerships to pay $150 per every K-1 up to $250,000 maximum. Since the regulations issued by New Jersey are not clear as to the way the fee is computed, please consult your tax advisor before filing. For a list of several states and a brief description of their tax rules regarding LLCs and partnerships.

There are many tax issues facing venture funds. Inevitably, every fund will encounter certain tax challenges throughout its life cycle. A Venture Capital Fund would be well advised to ascertain that their tax strategies are appropriately tailored to address their specific circumstances.

Murray Alter is a Tax Partner in the New York office of PriceWaterhouseCoopers and the National Tax Leader of the firm’s Venture Capital Practice. His clients include venture capital firms, SBICs, venture-backed companies and technology companies of all kinds. Jonathan Rosenstock helped to research and prepare this article.