ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Partnership Taxation and
Oil and Gas Assets
By Roger D. Aksamit
Thompson & Knight LLP
Houston, Texas
Brian Dethrow
Jackson Walker L.L.P.
Dallas, Texas
State Bar of Texas
Section of Taxation/Energy and Natural Resources
Webcast-November 6, 2008
1
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Program Description and Overview:
This program will go in-depth into partnership tax issues involved with the ownership of
oil and gas assets, either via joint ownership or under an express partnership
agreement.
There will be
●
explanations of tax and depletion rules for partnerships, including capital
account, simulated basis and simulated depletion
●
service providers, "promotes," and profits interests
●
real-life examples and illustrations of how these rules operate day-to-day
●
sample partnership agreement provisions for oil and gas partnerships
A general understanding and grasp by the attendee of the tax rules relating to
depletion, partnerships and partnership capital accounts will be assumed.
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ALGIERS
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MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
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LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Table of Contents:
A.
Express and Resulting Partnerships from Ownership of Oil and Gas Assets
B.
Joint Operations and Electing Out of Subchapter K
C.
Partnership Tax Issues Unique to Tax Partnerships
D.
IRC § 613A and Allocation of Depletable Basis
E.
Allocation Rules With Respect to Depletable Basis, Depletion and Simulated
Depletion
F.
Miscellaneous Issues With Respect to Allocating Depletion
G.
Texas Margin Tax
H.
Service Partner Issues in Oil and Gas Partnerships Common Issues
I.
Other Partnership Rules Relating to Depletion
J.
Form Partnership Agreement Provisions
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MONTERREY
DALLAS
NEW YORK
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LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
A. Express and Resulting Partnerships from Ownership
of Oil and Gas Assets
● A tax partnership can be created by either
►
(i) the formation of a general partnership, limited partnership or
limited liability company to hold property that has multiple owners
and that has not elected to be an association under the check-thebox Treas. Regs. §§ 1.7701-1 to 1.7701-3.
►
(ii) joint ownership and operation of natural resource property
● If otherwise a tax partnership in the above situations and the
parties do not want to be a tax partnership, then the parties
may have the ability to elect out of partnership status for
federal tax purposes and treat the relationship as a joint
ownership arrangement. This is discussed in detail below.
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● Why Have a Tax Partnership?
►
►
1. Avoids the results of Rev. Rul. 77-176
−
Because the drilling party was receiving multiple operating
interests/properties in return for its drilling services, some of which did
not relate to where drilling was to occur, the drilling party had income
from the receipt of the unrelated operating interests.
−
The “pool of capital” doctrine does not operate to exclude receipt of the
unrelated properties from taxation. See General Rule under GCM 22730,
1941-CB 214.
−
HOWEVER, a tax partnership avoids the income recognition to the
drilling party.
2. Avoids the “complete payout” rule
−
The party providing cash for drilling can deduct 100% of the expense
(subject to the IDC deduction limits) notwithstanding that it will receive
less than 100% of the revenues from production. Treas. Reg. §1.6124(a); Rev. Rul. 69-332,1989-1CB87.
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3. Ability to specially allocate tax items
− This is a variation of the above
■
Subject to the economic effect, substantiality and shifting/transitory
allocation rules, a tax partnership allows the parties to specially
allocate tax items.
►
4. Ability to take advantage of the “profits interests”
exception under Rev. Rul. 93-27 with respect to any “sweat
equity” or service partners. Otherwise, without a tax
partnership, – ordinary income to service partners upon
receipt of an interest. See Rev. Rul. 83-46.
►
5. Reason why most forms of Joint Operating Agreements
and Participation Agreements include a placeholder or
option for the parties to elect to be a tax partnership and
attach a tax partnership agreement.
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● Disadvantages of a Tax Partnership
►
1. If the relationship is a partnership for tax purposes, then it is
subject to the entire regime of rules under Subchapter K that
include, among others, the following rules and restrictions
−
IRC § 704(b) and maintenance of capital accounts
−
IRC § 704(c) and its effect on special allocations of built-in gain/loss and
depreciation, depletion and amortization
−
IRC § 706 – requirements relating to a tax year for the partnership
−
IRC § 707 – disguised sales rules, sales to a related partnership
−
IRC § 708 – partnership terminations
−
IRC § 709 – limits on deduction of organizational expenses
−
IRC § 731 – taxation of certain property distributions
−
IRC § 732 – tracking tax basis in the partnership
−
IRC § 737 – anti-mixing bowl rules
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−
IRC §§ 743 and 754 – Step up and step down of the tax basis of the
assets held by the partnership upon the transfer of a partnership
interest.
−
IRC § 752 – Rules relating to the allocation among the partners of
recourse and nonrecourse liabilities.
−
IRC § 1446 – required withholding by the tax partnership if there are
foreign partners.
−
Compliance involved with the bookkeeping, preparation and filing of a
partnership return.
−
IRC §§ 6111,6112,6707 and 6708 – tax shelter registration and
compliance
−
TEFRA audit rules
−
Complexity that many in the oil patch would sooner avoid
2. Depending on the tax status of the partner, application of the atrisk (IRC § 465) and passive activity loss (IRC § 469) rules, which
can dramatically limit expenses and losses currently.
−
Many use a general partnership during exploration and drilling but
convert to LP or LLC status after completion to avoid passive activity
loss limits.
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ALGIERS
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B. Joint Operations and Electing Out of Subchapter K
1. Joint Operations
●
A joint operation of natural resource properties generally constitutes a
partnership for tax purposes unless the parties elect to be excluded from
Subchapter K. IRC § 761(a).
●
This seems to be true even if the parties elect to take their share of production
in kind thereby potentially defeating the joint profit objective.
2.
Election Out – History
●
Congress provided for the election out as a practical solution.
●
Many taxpayers in the oil & gas industry did not (and don’t today) want to deal
with the complexity of Subchapter K.
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Election Out - Eligibility
●
The organization must be availed of for the joint production, extraction or use
of property, but not for the purpose of selling services or property produced or
extracted.
●
The income of the members can be adequately determined without the
computation of partnership taxable income. IRC § 761(a).
●
The election must be made by all members of the organization. (See below).
●
For the parties to a Joint Operating Agreement (“JOA”) to “elect out,” the
parties must
►
(a) own the property as co-owners (either in fee or lease);
►
(b) reserve the right separately to take in kind or dispose of their shares of any
property produced, extracted or used;
►
(c) not jointly sell services or the property produced or extracted (“no joint
marketing”), although each participant may delegate the authority to sell its share of
the property produced or extracted for the time being for his account, but not for a
period of time in excess of the minimum needs of the industry but in no event for more
than one year; and
►
(d) the organization does not have as one of its principal purposes cycling,
manufacturing or processing for persons who are not members (e.g., third-party gas
processing). IRC § 761-2(a)(3).
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●
Note: Joint marketing can be avoided where each party signs a gas
sales agreement and liability is several.
●
Gas processing for members will not prevent an election out (but processing
for third parties will).
4. Election Out – Manner
●
The election can be evidenced by the intent of the parties (e.g., written
agreement). Treas. Reg. § 1.761 – 2(3)(2)(ii).
Note: No formal election is required if the parties’ intent is clear. (This is the
so-called “deemed election out.”) Also, note that a member can object to
election out within 90 days. Treas. Reg. § 1.761 – 2(b)(i).
●
A formal election is made on a blank Form 1065. Treas. Reg. § 1 .761 – 2(b)(2)(i).
(Atypical in the industry, overall)
●
The election can be made at any time during the life of the arrangement, but
once you are past the return filing deadline for the first year of the partnership,
it is only effective prospectively.
●
If the election is made, the parties will not file partnership tax returns.
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ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
5. Election Out - Consequences
●
Some concern exists that the exclusion is only from Subchapter K. See
Madison Gas (probably wrong). But it is fairly clear that a sale of assets of an
elected out partnership is treated as a sale of assets, not partnership interests.
But see Section 1031 legislative history.
●
An elected out partnership is still a partnership for purposes of the investment
tax credit (Bryant v. Comm’r, 399 F.2d 800 (1968), and self-employment tax
(Frances Cokes v. Comm’r, 91 TC 222 (1988)).
●
The statute provides for an election out of only specified portions of
Subchapter K but only with the consent of the Commissioner. Taxpayers
seeking a partial election out can expect heavy scrutiny.
●
Taxpayers are treated as direct owners of undivided interests in the oil & gas
properties.

Taxpayers need not file a partnership tax return.

Each taxpayer makes its own elections and reports all income, gains,
deductions and losses separately. Eligibility to make elections are then
specific to that taxpayer.
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ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
C. Partnership Tax Issues Unique to Tax Partnerships
1.
Take in kind -- deemed distributions of oil or gas?
--- no revenues on the return?
2.
Functional allocations.
3.
Keep your own method under Section 704(c).
4.
Can the partners capital accounts ever go negative? Is a QIO
necessary?
--- note: tax partnership has no debt.
---note: gas balancing, if allowed under the JOA.
5.
Party with the IDCs should avoid early liquidation of the
partnership.
6.
Can the tax partnership distribute a property to the partners?
13
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
D. IRC § 613A and Allocation of Depletable Basis
1. Overall
● Many of the normal concepts dealing with the partnership’s
determination of built-in gain, allocation of cost recovery
deductions, gains or losses from dispositions of partnership
property, etc. are altered with respect to depletable oil and gas
property that is owned by a tax partnership.
● This is because IRC § 613A(c)(7)(D) of the Code provides “in
the case of a partnership, the depletion allowance . . . shall be
computed separately by the partners and not by the
partnership.
● NOTE: A similar rule is provided for S Corporations under IRC
§ 613A(c)(11) of the Code- “In the case of an S corporation, the
allowance for depletion with respect to any oil or gas property
shall be computed separately by each shareholder.”
14
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
● The effect of IRC § 613A(c)(7)(D) is as follows:
►
1) Each partner is allocated separately its proportionate share of
the adjusted tax basis of each depletable oil and gas property.
►
2) The partners are considered the taxpayers for purposes of
determining the appliability of the limitations that apply to cost or
percentage depletion.
►
3) Depletion -- cost or percentage -- is computed separately by
each partner on the basis of depletable basis allocated to each
partner.
►
4) But in other respects, for example, in determining who is a
related person if there is a sale of the property, the partnership is
considered as the taxpayer and owner of the property.
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ALGIERS
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DALLAS
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SAN ANTONIO
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2. Determining a Partner’s Basis in Depletable Property
●
Generally the partnership allocates to each partner his proportionate share of
the adjusted basis of each oil and gas property as of the date of acquisition. A
partner’s initial share of the adjusted basis is determined in accordance with
his interest in capital or income and, in the case of contributed property, will be
governed by IRC § 704(c). Treas. Reg. § 1.613A-3(d) provides that a partner’s
share of such adjusted basis of each property shall be determined in
accordance with his interest in partnership capital.
●
Treas. Reg. § 1.613A-3(e)(2)(ii) provides, however, that if the partnership
agreement provides for an allocation determined in accordance with the
taxpayers’ proportionate interest in partnership income and such interest is
reasonably expected to remain unchanged throughout the life of the
partnership, then such an allocation will be respected.
●
Adjusted basis of one property may be allocated in accordance with capital and
another allocated in accordance with income.
●
Where the property is contributed and has an adjusted basis different from its
value and is subject to the provisions of IRC § 704(c), or where book value and
basis differ as a result of partnership revaluation, the principles of IRC § 704(c)
or Treas. Reg. § 1.704-1(b)(4)(i) apply.
16
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3. Changes in Partner’s Interests
● Where the interests of the partners change as a result of the
admission of a new partner or by additional capital
contributions by an existing partner, the partnership must
reallocate the partnership’s basis in each existing property.
● Where a change in partnership interests results in a
“revaluation” (as described in Treas. Reg. § 1.704(b)(2)(iv)(f))
the basis in the property must be allocated among the partners
based upon the principles used under Treas. Reg. §
1.704(b)(4)(i) for allocating tax items to take into account
variations between the adjusted basis of the property and its
fair market value. Treas. Reg. § 1.613A-3(e)(5).
● Examples of the foregoing rules relating to changes in partner
interests are contained in Reg. § 1.613A-3(e)(7).
17
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● Example 7: For example (with respect to a change in
partnership interests) A and B have equal interests in capital in
Partnership, which owns unproven domestic oil property
having a basis of $2MM, and such basis is initially allocated
$1MM to each partner in accordance with their proportionate
interests in partnership capital. On January 1, 2009 C is
admitted as an equal partner, and at such time the Partnership
has an aggregate adjusted basis in the oil property of $1.5MM.
As a result the Partnership must allocate $500K of the basis of
the property to C, which is one-third of the aggregate adjusted
basis of the property. A and B must each reduce their basis in
the property by one-third.
● Example 5: G has a basis of $5MM in domestic oil property and
transfers its partnership interest to I for $100MM and a §754
election is in effect. For cost depletion purposes, I now has a
basis in domestic oil property of $100MM.
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4. Other Adjustments
●
After the allocation of basis has been made, appropriate adjustments
shall be made to the partners’ adjusted basis for any partnership
capital expenditures relating to such properties which are made after
the original allocation.
●
Each partner must then keep separate records of his share of adjusted
basis of each property under IRC § 1016, including the adjustment for
depletion. This adjusted basis each year is used for cost depletion
purposes or in the computation of gain or loss upon disposition.
●
Upon the disposition of an oil or gas property by the partnership, each
partner shall subtract his adjusted basis in such property from his
allocable portion of the amount realized to determine his gain or loss.
●
For purposes of IRC § 732 (relating to basis of distributed property
other than money), the partnership’s adjusted basis in an oil or gas
property is the sum of the partners’ adjusted bases in such property.
●
The adjusted basis of a partner’s interest in a partnership shall be
decreased (but not below zero) pursuant to IRC § 705 by the amount of
the partner’s deduction for depletion (allowed or allowable) to the
extent such reduction does not exceed the share of the partnership’s 19
adjusted basis allocated to the partner under IRC § 613A(c)(7)(D).
ALGIERS
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5. What IRC § 613A Does Not Affect
●
Rev. Rul. 84-142 held that, notwithstanding IRC § 613A(c)(7)(D),
property elections under IRC § 614(b) (relating to what constitutes
separate and identifiable properties) must be made by the partnership
instead of the individual partners. Accordingly, the property election is
not one of the exceptions to the general rules of IRC § 703(b) of the
Code. Thus, the partnership makes the separate property election.
●
IRC § 613A does nothing to change the tax year of the partnership or
the timing requirements as to when partnership income is included in
the tax return of a partner. IRC § 706 still requires a partner to include
partnership income in his income by reference to the partnership year
that ends with or within the partner’s tax year.
●
Also, the partnership’s tax year would seem to control the calculation
of any percentage depletion allowable under the independent
producers and royalty owners exemption by reference to partnership
gross income from the properties during the partnership tax year.
●
No difficulties regarding the calculation of percentage depletion
allowable under subsection (c) by a partner on partnership properties
in situations where the partner’s tax year is the same as the tax year of
20
the partnership.
ALGIERS
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●
However, there is no specific guidance as to the method of calculating
percentage depletion allowable under subsection (c) in cases where a
partner’s tax year is different from the partnership’s tax year.
●
Assume, for example, a March 31 taxpayer who is a partner in a
calendar year partnership. Under the income inclusion rules, taxpayer
includes in its March 31 return its share of partnership income for the
calendar year ending in the taxpayer’s fiscal year.
●
Assume that the partnership only has nine months of income through
December 31. Although the March 31 taxpayer reports only nine (9)
months of partnership income, does it get a full twelve (12) months of
depletion?
●
If depletion follows income, it appears only reasonable to deduct
depletion attributable to the partnership income included on the
taxpayer’s March 31 return.
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6. Special Rules for Estates and Trusts
●
Treas. Reg. § 1.613A-3(g) provides that the depletion allowance initially
shall be computed by the estate or trust with the determination of
whether cost or percentage depletion is applicable to be made at the
trust or estate level.
●
The limitations contained in IRS § 613A(c) and (d) are then applied at
the trust or estate level in the computation of percentage depletion
and again applied by a beneficiary with respect to any percentage
depletion apportioned to him by the trust or the estate.
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7. Disposition of Depletable Property – Determining Gain or Loss
●
When a partnership sells an oil or gas property, IRC § 613A(c)(7)(D)
governs the allocation shares of the amount realized unless governed
by the contributed property rules (or related principles regarding
revaluations of partnership property). See Treas. Reg. § 1.7041(b)(4)(v).
●
When a partner’s capital account is adjusted for the simulated
depletion of an oil or gas property, generally the amount realized by
the partnership upon a taxable disposition will be allocated to the
partners in the same proportion that the aggregate adjusted tax basis
of such property was allocated to such partners (or their predecessors
in interest). See Treas. Reg. § 1.704-1(b)(4)(v).
23
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●
When a partner’s capital account is adjusted to reflect the actual
depletion of an oil or gas property, generally the amount realized by
the partnership upon a taxable disposition will be allocated to the
partners in proportion to their respective remaining adjusted tax bases
in such property. See Treas. Reg. § 1.704-1(b)(4)(v).
●
If the partnership agreement provides for an allocation that exceeds
the total amount realized under either of the previous two rules, as
applicable, the amount realized will be made in accordance with the
partners' allocable shares, provided (i) such allocation does not give
rise to capital account adjustments the economic effect of which is
insubstantial and (ii) all other allocations and capital account
adjustments under the partnership agreement are recognized under
the partnership allocation rules. See Treas. Reg. § 1.704-1(b)(4)(v).
●
Otherwise, the partners' allocable shares of the total amount realized
by the partnership on its taxable disposition of an oil or gas property
shall be determined in accordance with the partners' interests in the
partnership. See Treas. Reg. § 1.704-1(b)(4)(v).
24
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Example #1 - D and J form a general partnership for the purpose of drilling
oil wells. D contributes an oil lease, which has a fair market value and
adjusted tax basis of $100,000. J contributes $100,000 in cash, which is
used to finance the drilling operations. The partnership agreement provides
that each of D and J is credited with a capital account of $100,000. The
partnership agreement also contains the provisions necessary to meet the
economic effect requirements. The partnership chooses to adjust capital
accounts on a simulated cost depletion basis and elects to reduce the
amount of investment tax credit in lieu of adjusting basis. The agreement
further provides that (1) all additional cash requirements of the partnership
will be borne equally by D and J, (2) the deductions attributable to the
property (including money) contributed by each partner will be allocated to
such partner, (3) all other income, gain, loss, and deduction (and items
thereof) will be allocated equally between D and J, and (4) all cash from
operations will be distributed equally between D and J. In the partnership's
first taxable year $80,000 of partnership intangible drilling cost deductions
and $20,000 of cost recovery deductions on partnership equipment are
allocated to J, and the $100,000 basis of the lease is, for purposes of the
depletion allowance under IRC § 611 and IRC § 613A(c)(7)(D), allocated to D.
The allocations of income, gain, loss, and deduction provided in the
partnership agreement have substantial economic effect. Furthermore, if it
is clear that the allocation of the entire basis of the lease to D will not result
in capital account adjustments the economic effect of which is
insubstantial, and since all other partnership allocations are recognized
under the partnership allocation rules, the allocation of the $100,000
adjusted basis of the lease to D is recognized as being in accordance with
the partners' interests in partnership capital for purposes of IRC §
25
613A(c)(7)(D). See Treas. Reg. § 1.704-1(b)(5), Example 19(i).
ALGIERS
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Example #2 - Assume the same facts as in Illustration (1) except
that the partnership agreement provides that (1) all additional cash
requirements of the partnership for additional expenses will be
funded by additional contributions from J, (2) all cash from
operations will first be distributed to J until the excess of such
cash distributions over the amount of such additional expenses
equals her initial $100,000 contribution, (3) all deductions
attributable to such additional operating expenses will be allocated
to J, and (4) all income will be allocated to J until the aggregate
amount of income allocated to her equals the amount of
partnership operating expenses funded by her initial $100,000
contribution plus the amount of additional operating expenses paid
from contributions made solely by her. The allocations of income,
gain, loss, and deduction provided in the partnership agreement
have economic effect. In addition, the economic effect of the
allocations provided in the agreement is substantial. In addition, if
it is clear that the allocation of the entire basis of the lease to D will
not result in capital account adjustments the economic effect of
which is insubstantial, and since all other partnership allocations
are recognized under the partnership allocation rules, the
allocation of the adjusted basis of the lease to D is recognized as
being in accordance with the partners' interests in partnership
capital under IRC § 613A(c)(7)(D). See Treas. Reg. § 1.704-1(b)(5),
Example 19(ii).
26
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
D. Allocation Rules With Respect to Depletion and Simulated Depletion
●
In order to satisfy the capital account rules, a partnership must adjust
partners' capital accounts for depletion and gain and loss with respect
to its oil and gas properties under the simulated depletion method, or
under the actual depletion method.
●
In addition, under the appropriate circumstances, adjustments to
partners' capital accounts with respect to depletion and gain or loss
on such properties must be made in accordance with the book value
rule and the revaluation rule. See Treas. Reg. § 1.704-1(b)(2)(iv)(k)(1).
27
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Simulated Depletion Method of Maintaining Partners’ Capital Accounts
●
Under the simulated depletion method, a partnership must compute, at the
partnership level, simulated depletion allowances on its oil and gas
properties.
●
The depletion allowances determined at the partnership level under the
simulated depletion method are fictitious, and are computed solely for the
purpose of maintaining partners' capital accounts in accordance with the
capital account rules. The simulated depletion allowances may be determined
under either the cost depletion method or the percentage depletion method.
●
If the percentage depletion method is elected, the simulated depletion
allowances must be computed under IRC § 613 at the IRC § 613A(c)(5) rates
without regard to any limitations which theoretically could apply to any
partner under IRC § 613A (e.g., net income).
●
The partnership must choose a particular method of computing simulated
depletion allowances on a property-by-property basis. Accordingly, it may use
the cost depletion method for some properties and the percentage depletion
method for others. The choice is binding for all later taxable years during
which the partnership holds that property. NOTE: The partnership makes
these determinations.
28
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
●
Each partner's capital account must be reduced by the amount of the simulated
depletion allowances for each of the partnership's oil and gas properties
allocated to the partner. A partner's allocable share of the simulated depletion
allowance with respect to a particular property is equal to his (or his
predecessor-in-interest's) proper allocable share of the adjusted tax basis of
that property.
●
The aggregate capital account adjustments for simulated percentage depletion
allowances with respect to an oil or gas property of the partnership may not
exceed the aggregate adjusted tax basis allocated to the partners with respect
to the property.
●
If a disposition of the property results in simulated gain, the partners' capital
accounts must be increased by their allocable shares of that gain. A partner's
allocable percentage share of the partnership's simulated gain with respect to a
particular property is equal to the partner's allocable percentage share of the
excess of the total amount realized from the disposition over the partnership's
simulated adjusted basis in the property.
●
If the disposition results in simulated loss, the partners' capital accounts must
be reduced by their allocable shares of that loss. A partner's allocable share of
a partnership's simulated loss with respect to a particular property is that
percentage of the loss which is equal to the partner's allocable share,
expressed as a percentage, of the total amount realized from the disposition
that represents recovery of the partnership's simulated adjusted tax basis in
the property.
29
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Actual Depletion Method of Maintaining Partners’ Capital Accounts
●
Under the actual depletion method, a partnership reduces a partner's capital
account with respect to depletion on its oil and gas properties by an amount
equal to the depletion allowance claimed by that partner with respect to those
properties. Thus, the reduction is based on the type of depletion, cost or
percentage, deducted by the partner.
●
The reduction is made for the partner's taxable year that ends with or within the
partnership's taxable year for which the depletion allowance is claimed. The
aggregate reductions of a partner's capital account for depletion allowances
with respect to an oil or gas property of the partnership may not exceed the
adjusted tax basis of the property that is allocated to that partner. See Treas.
Reg. § 1.704-1(b)(2)(iv)(k)(3).
●
Under the actual depletion method, partners' capital accounts are adjusted for
gain or loss on taxable dispositions of a partnership's oil and gas properties.
This adjustment is made by increasing the capital account of each partner by
the amount of any excess of the partner's allocable share of the total amount
realized from the disposition of the property over the partner's remaining
adjusted tax basis in the property.
●
If there is no excess, the capital account of the partner is reduced by the
amount of any excess of the partner's remaining adjusted tax basis in the
property over the partner's allocable share of the total amount realized from the
disposition of the property.
30
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
F. Texas Margin Tax
●
1% of Gross Receipts less cost of goods sold
►
●
Depletion may not be allowable as a cost of goods sold deduction based
on informal Texas Comptroller remarks. See Rule §3.588(d)(6) for the
deduction for cost recovery items “reported on the federal tax return on
which the report under this chapter is based.”
Passive Entity Exception
►
Passive entities are non-taxable entities.
►
Applies only to limited and general partnerships and trusts, not LLCs
►
At least 90% of federal gross income must be from passive sources.
Passive includes:
−
Net capital gain from sale of real property (e.g., working interests)
−
Royalties, bonuses, and delay rental income from mineral properties
−
Income from non-operating mineral interests (BUT, this includes working
interests if the owner is not the operator – See Rule §3.582(f)(1))
31
ALGIERS
AUSTIN
MONTERREY
●
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Special Operator Rule – Rule §3.582(d)(2)
►
Income received by a non-operator from mineral properties under a JOA,
so long as another member of the affiliated group is not the operator
►
If the GP owns more than 50% of the partnership and it (or an affiliate) is
the operator, the partnership will not be passive.
►
If GP owns less than 50%, then passive.
►
Many LP Agreements require the GP or an affiliate (not the partnership) to
be the operator. Margin tax results.
►
Partnerships generally are passive because the partnership is not the
operator and the GP does not own more than 50% of the partnership,
including post-flip.
32
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Texas Margin Tax
LP Owner
100%
LP
GP
98%
No Texas nexus
Distributive share not apportioned to TX
2%
TX
LP
Texas oil and gas properties
Unrelated GP (or affiliate contract operator), so passive
33
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
G. Service Partner Issues in Oil and Gas Partnerships
Common Issues
●
●
Up-Front Promotes
►
Capital Interests to Management Group
►
Alternative Drafting Provisions
Profits Interests
►
IRC § 83(b) Elections
►
Proposed Legislation for “Carried Interests.”
►
Section 409A
●
Partners as Employees
●
Self-Employment Tax
34
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
1. Up-Front Promotes
●
Issue: Does service partner (SP) have taxable compensation income upon receipt of
partnership interest?
●
Yes, if capital interest.
►
●
“To the extent that any of the partners gives up any part of his right to be repaid his
contributions (as distinguished from a share in partnership profits) in favor of another
partner as compensation for services (or in satisfaction of an obligation), IRC § 721
does not apply.” Treas. Reg. § 1.721-1(b)(1).
What is a capital interest?
►
Immediate liquidation analysis: If the partnership immediately liquidated after SP
received its interest, would SP receive distributions in excess of its capital
contributions (based on FMV)?
►
Example:
−
Relative capital contributions: 97/3 (SP)
−
Relative distributions: 95/5 (SP)
−
Up-front promote (capital interest) of 2%
35
ALGIERS
AUSTIN
MONTERREY
2.
●
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Up-Front Promotes Alternative Drafting Provisions
Liquidate in accordance with positive capital accounts.
►
Re-allocate income in year of liquidation to make capital accounts
proportionate to distribution percentages, to the extent possible.
►
If payout is achieved, the parties economic arrangement remains
intact.
►
If payout is not achieved, the parties' economic deal is achieved as
much as possible without adverse tax consequences to SP.
36
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
COMPANY, LLC
Capital Contributions
Management Members
Investors
Total
3,000,000
97,000,000
100,000,000
Operating Distributions
Management Members
Investors
Total
3%
97%
100%
5%
95%
100%
Liquidating Distributions
Positive Capital Account Balances
Balancing allocations at liquidation
37
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Management
Members
Investors
Single Property with $5M of gain
Contributions
3,000,000
3.00%
97,000,000
Gain
2,250,000
45.00%
2,750,000
Capital Accounts
5,250,000
5.00%
99,750,000
Sufficient gain to allocate in year of liquidation to overallocate gain
to Management Members to bring capital accounts to 95/5 ratio.
Total
97.00% 100,000,000
55.00%
5,000,000
95.00% 105,000,000
38
ALGIERS
AUSTIN
MONTERREY
●
●
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Make pre-payout distribution percentages equal to contribution percentages
and adjust post-payout percentages to preserve the economics as much as
possible.
►
97/3 Pre Payout
►
93/7 Post Payout No. 1
►
95/5 Post Payout No. 2
Impose a limited contribution obligation that is triggered upon liquidation to
the extent that SP’s relative capital account balance is not equal to its
distribution percentage.
►
97/3 Contribution Percentage
►
96/4 Relative Capital Account Balances
►
SP has contribution obligation to get relative capital account balance to
95/5 Distribution Percentage
39
ALGIERS
AUSTIN
MONTERREY
●
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Require the unanimous consent of the members to liquidate before a
specified future date (e.g., the end of 2010).
►
The Company cannot immediately liquidate, so there can be no
capital shift upon formation.
−
►
But the IRS test is a hypothetical liquidation.
What if SP’s capital account has not been built up to its 5%
distribution percentage by the specified date?
−
Does the issue arise again at the end of 2010?
−
Or is taxability determined solely when SP receives the
interest?
40
ALGIERS
AUSTIN
MONTERREY
●
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Make no changes to the LLC agreement but take the position that the
fair market value of the additional capital interest, based on the facts
and circumstances, is a nominal amount.
►
E.g., A significant portion of the capital contributions will be used
immediately to fund drilling, so the future distribution of capital is
speculative.
►
Apply minority and marketability discounts.
►
Quite risky because not following the IRS safe harbor. Return
preparer issues?
41
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Profits Interests and IRC § 83(b) Elections
●
Background
►
IRC § 83 taxes FMV of property received for services.
►
Litigation
−
Does IRC § 83 apply to partnership interests?
−
How is a partnership interest valued?
42
ALGIERS
AUSTIN
MONTERREY
●
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
IRS Safe Harbor: Partnership interest is not taxable upon receipt or
vesting and no 83(b) election is required if:
►
Profits Interest (not a capital interest)
►
Not Substantially Certain and Predictable Stream of Income
►
Employee Treated as Partner
►
Not a Publicly Traded Partnership
►
No Compensation Deduction by Partnership
►
Held for Two Years
−
Protective 83(b) election recommended
43
ALGIERS
AUSTIN
MONTERREY
●
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
2005 Proposed Regulations
►
Not taxable upon receipt
−
Requires making of 83(b) election
−
Requires election of liquidation value safe harbor
■ Protective language included in LLC agreements to cover
profits interests issued after proposed regulations become
final
►
Reserved on treatment of interests issued to employees of uppertier (i.e., management) entity
44
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Profits Interests and Proposed Legislation
●
Proposed Legislation in 2008:
►
►
A carried interest is received for services, so it should be treated
as compensation income.
−
Taxed as ordinary income
−
Subject to self-employment tax
Applies to investment services partnerships, which includes real
estate – and thus oil and gas?
45
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Profits Interests and Section 409A
●
IRC § 409A accelerates the recognition of income on deferred
compensation and imposes penalty interest plus a 20% excise tax on
the employee.
●
Profits Interest:
►
●
Receipt is a nontaxable event, so IRC § 409A does not apply.
Capital Interest:
►
If unrestricted, receipt is a taxable event and compensation income is
taxed in the year of receipt.
►
Thus, there is no deferred compensation, and IRC § 409A does not apply.
46
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Partners as Employees
●
IRS Position: A partner cannot be an employee of his partnership.
(There is contrary analogous caselaw.)
●
Payments to a partner should not be treated as wages subject to
withholding or employment taxes.
●
Routinely violated
►
IRS should receive same amount of taxes and not be harmed.
►
But risk that cafeteria plans would be invalidated, which would
harm other employees.
►
Also, reporting issue now raised by return preparers.
47
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Self-Employment Tax
●
2008: 15.3% on amounts up to $102,000 and 2.9% on additional
amounts
●
2009: ++?
●
General Partner
►
●
Distributive share and guaranteed payments are both subject to
self-employment taxes.
Limited Partner
►
►
Only guaranteed payments are subject to self-employment taxes.
Distributive share is exempt by IRC § 1402(a)(13).
48
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
Partners as Employees
●
Who is a Limited Partner?
►
Clear for a limited partnership
►
But for an LLC?
−
1997 Proposed Regulations – Not a limited partner if:
■ Personal Liability for LLC’s Debts?
■ Authority to Contract on Behalf of the LLC?
■ Participate in the LLC’s Business More than 500 Hours?
−
Common Practice: Non-managers
49
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
J. FORM PARTNERSHIP AGREEMENT PROVISIONS
●
DEFINITIONS:
●
“Capital Account” means, with respect to any Member of the Company, the Capital
Account maintained for such Member in accordance with the following provisions:
●
(i) To each Member's Capital Account there shall be credited (A) such Member's
Capital Contributions, (B) such Member's distributive share of Profits and any items in
the nature of income or gain which are specially allocated to such Interest pursuant to
Section 3.3 or Section 3.4, (C) such Member's distributive share of Simulated Gain,
and (D) the amount of any Company liabilities assumed by such Member or that are
secured by any Property distributed to such Member;
●
(ii) To each Member's Capital Account there shall be debited (A) the amount of
money and the Gross Asset Value of any Property distributed to such Member
pursuant to any provision of this Agreement, (B) such Member's distributive share of
Losses and any items in the nature of expenses or losses which are specially
allocated to such Interest pursuant to Section 3.3 or Section 3.4, (C) such Member's
distribution share of Simulated Depletion and Simulated Loss, and (D) the amount of
any liabilities of such Member assumed by the Company or that are secured by any
Property contributed by such Member to the Company;
50
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
●
(iii) In the event an Interest is Transferred in accordance with the terms of this
Agreement, the transferee shall succeed to the Capital Account of the transferor to
the extent it relates to the Transferred Interest;
●
(iv) In determining the amount of any liability for purposes of subparagraphs (i) and
(ii) above, there shall be taken into account Code Section 752(c) and any other
applicable provisions of the Code and Regulations; and
●
(v) For purposes of computing the Members' Capital Accounts, the Simulated Basis
of each oil and gas property of the Company will be allocated 50% to the Managing
Member and 50% to the Class A Member.
●
The foregoing provisions and the other provisions of this Agreement relating to the
maintenance of Capital Accounts are intended to comply with Regulations Section
1.704-1(b) , and shall be interpreted and applied in a manner consistent with such
Regulations. In the event the Tax Matters Member shall determine that it is prudent to
modify the manner in which the Capital Accounts, or any debits or credits thereto are
computed in order to comply with such Regulations, the Tax Matters Member may
make such modification. The Tax Matters Member also shall (i) make any
adjustments that are necessary or appropriate to maintain equality between the
Capital Accounts of the Members and the amount of capital reflected on the
Company's balance sheet, as computed for book purposes, in accordance with
Regulations Section 1.704-1(b)(2)(iv)(q) , and (ii) make any appropriate modifications
in the event unanticipated events might otherwise cause this Agreement not to
comply with Regulations Section 1.704-1(b) . The Tax Matters Member shall provide51
the Managing Member and the Class A Member with written notice of any such
adjustments or modifications.
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
●
“Simulated Basis” means the Gross Asset Value of any oil and gas property (as
defined in Code Section 614 ).
●
“Simulated Depletion Deductions” means the simulated depletion allowance
computed by the Company with respect to its oil and gas properties pursuant to
Regulations Section 1.704-1(b)(2)(iv)(k)(2) . For purposes of computing Simulated
Depletion, the Company will apply the simulated cost depletion method under
Regulations Section 1.704-1(b)(2)(iv)(k)(2) .
●
“Simulated Gain” or “Simulated Loss” means the simulated gain or simulated loss
computed by the Company with respect to its oil and gas properties pursuant to
Regulations Section 1.704-1(b)(2)(iv)(k)(2) .
52
ALGIERS
AUSTIN
MONTERREY
DALLAS
NEW YORK
FORT WORTH
PARIS
HOUSTON
RIO DE JANEIRO
LONDON
SAN ANTONIO
MEXICO CITY
SÃO PAULO VITÓRIA
●
ALLOCTIONS:
●
(h) Simulated Depletion, Simulated Loss, and IDCs. Simulated Depletion,
Simulated Loss, and IDCs with respect to each oil and gas property of the Company
will be allocated in proportion to the manner in which the Simulated Basis of such
property is allocated among the Members pursuant to subparagraph (v) of the
definition of “Capital Account” in Section 1.10.
●
(i) Simulated Gains. Simulated Gain with respect to any Company oil and gas
property will be allocated 50% to the Managing Member and 50% to the Class A
Member.
●
(j) Amount Realized. For purposes of Regulations Sections 1.704-1(b)(2)(iv) (k )(2)
and 1.704-1(b)(4)(iii), the amount realized on the disposition of any oil and gas
property of the Company shall be allocated (i) first to the Members in an amount
equal to the remaining Simulated Basis of such property in the same proportions as
the Simulated Basis of such property was allocated to the Members pursuant to
subparagraph (v) of the definition of “Capital Account” in Section 1.10, and (ii) any
remaining amount realized shall be allocated to the Members in the same ratio as
Simulated Gain is allocated pursuant to Section 3.3(i).
●
(from Whitmire, Nelson, McKee, Kuller, Hallmark & Garcia: Structuring & Drafting Partnership
Agreements: Including LLC Agreements (WG&L))
53
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