A major focus of a private equity fund acquiring a target or a business contributing cash to a joint venture is to ensure that it receives depreciation based on the relative fair market value of its contributions to the partnership. Depreciation or amortization is a critical issue for these entities because this deduction can shield economic income from taxes. If a private equity fund or business investor receives less than its economic share of depreciation, that entity would pay more current income taxes on the same amount of economic income than it otherwise would, which reduces the investors’ return on investment.
The general rule for property contributions to a partnership is that the partnership has a carryover basis in the property equal to the contributing partner’s basis in that property. The partnership’s tax depreciation is based on its property’s tax basis. This means that, under the general carryover basis rule, the partnership’s tax depreciation for appreciated property contributions will be less than the depreciation would be if it were based on that property’s fair market value. The partnership tax rules permit two alternative deal structures to address this depreciation problem:
- In one structure, the investor purchases the partnership interest from the seller across the top, receives a Section 743(b) basis adjustment, and receives a corresponding depreciation deduction outside of the partnership.
- In the other structure, the investor contributes money into a partnership and receives a remedial Section 704(c) allocation of additional expense inside the partnership. (The other partner is allocated a corresponding amount of income.)
In our experience, it is a common shorthand to say that investors are economically indifferent between the additional depreciation expense from a Section 743 step-up on the one hand and the additional remedial expense allocation on the other hand. However, as explained below, these two alternatives have different effects on an investor’s Section 1245 recapture amount, and thus these two alternatives can cause different results at exit for both the investor and the founder of the target acquisition. Private equity investors and business joint venture partners need to be aware of these potential recapture differences when planning their investments.
Section 743(b) applies when a private equity or cash investor purchases a partnership interest from an existing partner. If a Section 754 election is in place at the underlying partnership level, the amount of the basis adjustment will be equal to the difference between the purchasing partner’s basis in its partnership interest (generally the price paid for that interest) and the selling partner’s basis attributable to the interest that it sold. This basis step-up is attributable only to the purchasing partner. This basis step-up does not affect the partnership’s basis in its assets or the amount of gain or loss that the partnership would otherwise allocate to other partners.
Section 704(c) applies when a partner contributes property to a partnership, and the fair market value of that property differs from the partnership’s basis in the property at the time of the contribution. (IRC 704(c)(1)(B)(i)) Most transactions in which a private equity fund acquires a target company (by investing cash into the business) involve either an operating partnership with substantially appreciated assets or a business that has a significant amount of self-created goodwill (which generally does not have any tax basis). Section 704(c) applies to both of those situations because the value of the partnership’s historical assets exceeds the target partnership’s basis in the assets.
The regulations under Section 704 provide for three methods of allocating taxable income to address the built-in gain (or loss) that exists in a partnership’s assets when property is contributed to the partnership: the traditional method, the traditional method with curative allocations, and the remedial method. (Treas. Reg. 1.704-3) Both the traditional method and the traditional method with curative allocations may not allow the private equity fund or other cash investor to receive depreciation or amortization deductions based on the fair market value of the partnership’s property. Accordingly, this article will focus on the implications of the remedial method under Section 704(c).
In the remedial method, a partnership calculates depreciation and amortization based on the fair market value of the partnership’s property at the time of the contribution to the partnership. In the private equity context, to the extent that the cash investor’s share of the fair-market-value-based depreciation exceeds the total depreciation calculated based on the partnership’s tax basis in its assets, the remedial method allows a partnership to calculate a “notional” deduction amount for the cash investors equal to that excess amount. The partnership then offsets this notional deduction amount by allocating the same amount of notional income to the partner that contributed the appreciated property to the partnership. In situations where there is an existing partnership that has appreciated in value and the partner who is making the cash contribution buys in at the appreciated value, the same concepts apply. There will be a reverse Section 704(c) allocation to the partners who gave up ownership in the entity.
While the immediate trade-offs between a Section 743 basis step-up and a Section 704(c) remedial allocation structure are well understood in the private equity industry, the potential impact of the Section 1245 recapture rules on those two structures is not as well known. In certain circumstances, the Section 1245 recapture rules can permanently convert a portion of the founding partner’s gain on their business assets from capital gain to ordinary gain, and these recapture rules can have the opposite effect on the private equity investor.
Section 1245 discusses situations where certain types of depreciable property are sold and says that the seller of the depreciable property must recognize, as ordinary income, the amount of accumulated depreciation associated with the sold property. (IRC 1245(a)(1)) This ordinary income recognition can’t exceed the amount of total accumulated depreciation. In situations where intangibles are involved, Section 1245(a)(8) states that when Section 197 amortizable assets are disposed of, they are subject to Section 1245 recapture in the same manner that qualifying depreciable assets are. (IRC 1245(a)(8))
The regulations under Section 1245 provide for very different results when calculating recapture for depreciation or amortization of a Section 743 basis step-up compared with a Section 704(c) remedial allocation. Treas. Reg. Section 1.1245-1(e)(3) provides that a partner takes into account both its Section 743 basis step-up and any depreciation or amortization of that basis step-up when calculating the partner’s Section 1245 recapture with respect to partnership property. (Treas. Reg. 1.1245-1(e)(3)) Thus, the treatment of amortization or depreciation of a Section 743 basis step-up is consistent with the general goal of Section 1245 to have ordinary income treatment of gain from a disposition of property flow to the taxpayers who recognized the depreciation or amortization deductions on that property.
However, under Treas. Reg. Section 1.1245-1(e)(2), the depreciation recapture for remedial Section 704(c) allocations can have unexpected results. In particular, the combination of remedial allocations of income and Section 1245 recapture can result in the partner that contributed appreciated property to the partnership recognizing more cumulative ordinary income from that property than with a structure that resulted in a Section 743 basis adjustment. This unexpected result occurs because the remedial income allocations to the partner that contributes appreciated property are based on the property’s fair market value. In contrast, the Section 1245 recapture associated with that property is based on the property’s tax basis and its accumulated tax depreciation.
Alvarez & Marsal Taxand Says:
There are varying points of negotiation when entering into a transaction, and often an overlooked item is the possibility of an ordinary income remedial allocation exceeding the overall accumulated depreciation of a partner with built-in gain. In these cases, a business founder or other partners who are considering taking on a cash investor as a partner will need to consider the potential conversion of a portion of their capital gain into ordinary income over time. The types of transactions where this is likely to occur will be in deals involving self-created goodwill and operating businesses because those assets have much shorter cost recovery periods than real estate does, and the conversion of capital gain into ordinary income will happen more quickly. However, keep in mind this can be planned for and structured around.