Editor: Greg A. Fairbanks, J.D., LL.M.
Questions arise about the proper tax treatment of costs incurred by taxpayers when forming a new partnership. Even if these expenditures do not give rise to an immediate deduction, careful analysis is necessary to ensure that they are properly reflected in the partners' capital accounts and tax bases in their partnership interests. As discussed below, proper accounting for these costs requires consideration of facts that go beyond merely identifying the party that makes the payment.
Sec. 709 and the associated regulations deny deductions for partnership organizational expenses and syndication costs. Examples of potential syndication costs include brokerage fees, registration fees, and legal and accounting fees incurred in connection with issuing and marketing of interests in a partnership. A partnership may elect to amortize its organizational expenses under Sec. 709(b), but no such election is available for syndication costs, which must be capitalized.
This item briefly discusses the tax basis and partnership capital accounting impacts of partner-incurred syndication costs, that is, syndication costs paid by a partner on the partnership's behalf. The regulations require that syndication costs be capitalized, but they otherwise provide limited guidance about how these costs impact the partners' capital accounts and tax bases in their partnership interests when paid by a partner and not the partnership. Further, the tax accounting impact of syndication costs can vary depending on who ultimately bears the economic burden associated with those costs pursuant to the agreement(s) between the parties.
Whose costs are they?
When a partner pays syndication costs on behalf of a partnership, an initial issue to consider is who is treated as paying those costs for federal income tax purposes. As a general rule, where a partner pays syndication costs on behalf of a partnership, the partnership is nevertheless treated as paying those syndication costs for federal income tax purposes.
For instance, in Rev. Rul. 81-153 the IRS ruled that an investor could not deduct syndication costs that it paid in connection with its acquisition of a partnership interest. In that ruling, a partnership (or its promoter) agreed to make payments to various investment and tax advisers in order to obtain their assistance in selling the partnership's interests to their clients. Rev. Rul. 81-153 discusses two methods through which the advisers could receive payment for their services. In situation 1, the partnership rebated a certain amount of the cash it received from the investor in exchange for a partnership interest to the investor, who paid that amount to the adviser. Because the payment to the adviser represented a syndication cost, the IRS ruled that no deduction was allowed to the partnership under Sec. 709.
In situation 2, the investor paid the adviser's fee directly, and the partnership reduced the amount that the investor was required to pay for its partnership interest by an identical amount. Although it was the investor who actually remitted the cash to the adviser, the IRS ruled the partnership was treated as making the payment for federal income tax purposes. Again, neither the investor nor the partnership was entitled to a deduction for the syndication cost.
In Egolf, 87 T.C. 34 (1986), a partnership agreement required one of the partners to pay for and bear the economic burden of the partnership's syndication costs. The partnership also paid the partner a management fee and claimed a deduction for it. The partner reported the management fee as income but also claimed offsetting deductions for the syndication costs that it incurred on behalf of the partnership. The Tax Court viewed the arrangement as an attempt to circumvent Sec. 709 at the partnership level by transforming the syndication costs into a deductible management fee. The court denied the partnership's deduction for the portion of the management fee that represented a reimbursement to the partner for syndication costs paid on behalf of the partnership (and the amount of management fee income recognized by the partner was reduced by an identical amount).
In Rev. Rul. 89-11 the IRS considered another situation in which a partner paid syndication costs on behalf of a partnership under facts that bore some resemblance to those in Egolf. In that ruling, a corporation, which was the general partner in a partnership, incurred syndication costs in connection with an offering of the partnership's interests. The IRS cited Rev. Rul. 81-153 in concluding that the corporation was treated as making a capital contribution to the partnership in the amount of the syndication costs. The partnership was then treated as paying the syndication costs and was required to record the syndication expenditures as an intangible asset on its balance sheet.
Thus, in many situations in which a partner incurs syndication costs on behalf of a partnership, the partnership will be treated as paying those costs for federal income tax purposes. The partner instead is treated as making a capital contribution to the partnership in an amount equal to the syndication costs it incurred on the partnership's behalf.
Impact on outside basis and capital accounts
What are the consequences to a partnership where it is deemed to make an expenditure for syndication costs that were paid on its behalf by a partner? From the partnership's perspective, it receives cash from its partner as a capital contribution, pays the syndication costs, and capitalizes those costs as an intangible asset on its balance sheet. The next consideration is the effect the deemed capital contribution and partnership-level expenditure have on the partner's basis in its partnership interest and the partnership's Sec. 704(b) capital accounts.
Under Sec. 722, the partner increases its tax basis in its partnership interest by the amount of capital it is deemed to contribute to the partnership by virtue of paying syndication costs on the partnership's behalf. The IRS expressly confirmed this conclusion in Rev. Rul. 81-153. A partnership that maintains capital accounts in accordance with the Sec. 704(b) regulations would also credit the amount of the deemed contribution to the partner's capital account.
In certain circumstances, additional analysis may be needed to accurately identify the partner that is treated as funding syndication costs through a capital contribution. Consider the following example:
Example: LP1 and LP2 each contribute $1,000 to a partnership, PRS, upon its formation, and each receives in exchange an equal limited partnership interest. Each limited partner's initial capital account and outside basis in its PRS interest equals $1,000. GP, a general partner in PRS, incurs $150 of syndication costs on behalf of the partnership. However, immediately after formation, PRS reimburses GP for the syndication costs incurred. PRS's partnership agreement provides that LP1 and LP2 are entitled to a return of their $1,000 capital contributions before GP is entitled to any distributions.
Although GP pays the syndication costs in the example, it does not actually bear the economic burden of those costs due to its rights to reimbursement from PRS. Rather, the reimbursement of the syndication costs incurred by GP depletes PRS's assets by $150. Immediately after the reimbursement payment to GP, LP1 and LP2 would each be entitled to receive only $925 of their initial capital contributions upon PRS's liquidation. Even though GP paid cash to the provider, PRS is treated as paying the syndication costs, and the impact of those expenditures should be reflected in the limited partners' capital accounts. Careful analysis of the partnership agreement or other relevant documents is necessary to correctly identify the partner who bears the economic burden of syndication costs paid by or on behalf of a partnership.
The impact on basis is different from a capital account. As discussed above, a partner's initial tax basis and capital account reflect any deemed capital contributions for syndication costs borne by the partner on behalf of the partnership. Unlike a capital account, though, a partner's basis in its partnership interest is generally not affected when the partnership is treated as the payer of the syndication costs. Although Sec. 705(a)(2)(B) requires a partner to reduce its basis in its partnership interest for its distributive share of nondeductible expenditures, that provision only impacts those costs that are "not properly chargeable to capital account." Because syndication costs must be capitalized, partners are not required to reduce their outside basis by their shares of the partnership's syndication costs.
However, a different result occurs for purposes of Sec. 704(b). Regs. Sec. 1.704-1(b)(2)(iv)(i)(2) treats syndication costs as Sec. 705(a)(2)(B) expenditures for purposes of maintaining the partnership's capital accounts. A partner's Sec. 704(b) capital account is reduced by its share of the partnership's Sec. 705(a)(2)(B) expenditures, including its share of a partnership's syndication costs. Thus, Sec. 704(b) takes into account that the syndication cost, as an expenditure of the partnership in that tax year, ultimately reduces the amount the partners will receive on liquidation. In contrast, a partner that pays syndication costs will recognize less capital gain (or more capital loss, as the case may be) upon its disposition of its partnership interest. In other words, there is a permanent difference between a partner's basis in its partnership interest and its Sec. 704(b) capital account equal to the amount of the syndication cost.
In the example, each limited partner would still have a basis of $1,000 in its partnership interest after taking its share of the $150 of syndication costs into account. However, each limited partner's capital account is reduced to $925.
Properly reflecting costs in basis
Syndication costs are frequently incurred in connection with the formation of partnerships. Where a partnership's partners directly or indirectly pay those costs on the partnership's behalf, careful analysis is required to ensure that those costs are properly reflected in the partners' bases in their partnership interests as well as the partnership's capital accounts. Determining whether the syndication cost is incurred by a partnership versus a partner could affect, for example, a partner's distribution entitlement upon a liquidation of the partnership or of a partnership interest.
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Contributors are members of or associated with Grant Thornton LLP.