PHANTOM GAIN – IT’S MAGIC

Derek P. Usman, The Usman Law Firm, P.A.

 
“MINIMUM” GAIN ARISING FROM PARTNERSHIP NONRECOURSE DEBT

Section 702(a) provides a list of items arising from partnership operations that are to be separately distributed to each partner. Subsequently, the partner takes into account his distributive share of the partnership items in determining his income tax.

 

Unlike a corporation, where profits must be distributed based on a stock ownership percentage, a partnership agreement may allow custom allocations of income and expenses to flow through to the partners. These customized distributions do not have to be proportional to a partner’s interest in the partnership. Furthermore, since liquidating distributions to the partners are made in accordance to the partners’ capital accounts, legitimate economic allocations are necessary under the Code. As an ongoing matter, a partnership usually maintains capital accounts for each partner to properly reflect the economic allocations among the partners.

 

While a partner’s distributive share of partnership items is determined by the partnership agreement, Section 704(b) is the starting point to determine the validity of allocations to the partners. The allocations are respected under 704(b) if the allocations conform to one of the three criteria under the Regulations:

  1. the allocation is in accordance with the partner’s interest in the partnership,
  2. the allocation has substantial economic effect or,
  3. the allocation is deemed to be in accordance with the partner’s interest in the partnership (a facts and circumstances test)

 

Of the three provisions to validate an allocation, the primary method provided by the Regulations under 704(b) is the substantial economic effect test. The substantial economic effect test consists of a two-part test made at the end of the taxable year of the allocation. The two-part test requires that the tax allocation have economic effect and that the economic effect be substantial. The Regulations further state various requirements for meeting the economic effect test and the substantiality test.

 

Additionally, Treasury Regulation 1.704-2 contains rules to allocate deductions and losses attributable to non-recourse debt. Since partners aren’t liable for nonrecourse debt, deductions and losses from nonrecourse debt do not create any economic effect. Specifically, an economic effect is established when a tax burden results from an allocation of income or gain or a tax benefit arises from a loss allocation. Since a creditor alone bears any economic burden from the nonrecourse debt, any deduction allocations do not result in an economic effect. Therefore, the taxpayer must then attempt to allocate nonrecourse deductions in accordance with the partner’s interest in the partnership.

 

While determining the allocation of non-recourse deductions, the proper amount of minimum gain must also be calculated. Minimum gain provides tax responsibility for allocations of nonrecourse deductions. When a partner receives a non-recourse deduction, a proper share of minimum gain should also be provided to that partner. The amount of partnership minimum gain is determined by first computing for each partnership nonrecourse liability any gain the partnership would realize if it disposed of the property subject to that liability for no consideration other than full satisfaction of the liability. Simply put, minimum gain is the excess of nonrecourse debt over the basis of property subject to debt.

 

Minimum gain arises when depreciation deductions decrease the partnership’s basis below the balance of the nonrecourse debt. For example, if a building is purchased through nonrecourse financing for $800,000 and year 1 depreciation is $200,000, the basis would equal $600,000. Following Commissioner v. Tufts, nonrecourse debt, not the fair market value of the property, is used to determine the taxable gain upon disposition of the property. Consequently, a hypothetical sale of the property would result in a minimum gain of $200,000. This phantom or minimum gain must be allocated along with the corresponding nonrecourse deduction of $200,000.

 

However, often the potential taxable gain realized upon disposition of the property is not the gain used to determine the partnership minimum gain. If any of the partnership properties has a book basis that is different than its tax basis, then the book basis (capital account value) is used to determine minimum gain. Simply, the book gain is difference between the nonrecourse liability and the book value of the property. As an example, after a partner contributes property with a FMV of $10,000 and a tax basis of $6,000 to the partnership, the partnership uses the property as collateral to acquire a $10,000 nonrecourse debt. Under this example, there is no minimum gain because the book basis of $10,000 equals the amount of the nonrecourse debt.

 

Minimum gain attributable to a property may also decrease. A decrease results when there are reductions in the amount by which the nonrecourse liability exceeds the basis of the property. Such a decrease would occur when the basis of the property increases or upon the decrease of the nonrecourse debt upon repayment.

 

After the amount of minimum gain is computed separately for each property subject to a nonrecourse debt, the gains are aggregated to determine the partnership minimum gain. Next, the partnership minimum gain on the last day of the current taxable year is compared to the partnership minimum gain on the last day of the prior taxable year. Any net increase in the partnership minimum gain for the year will equal the amount of partnership nonrecourse deductions for a taxable year. In contrast, a net decrease from the prior year will result in a partnership minimum gain chargeback for the taxable year. Consequently, each partner must be allocated items of partnership income and gain for that year equal to the partner’s share of the net decrease in partnership minimum gain. It should be noted that any decreases in minimum gain due to revaluations of property are added back.

 

Since the minimum gain is a phantom gain, the allocation of the nonrecourse deduction still does not have an economic effect. Consequently, the nonrecourse deduction must be allocated according to the partner’s interest in the partnership. Regulation 1-704-2(e) provides a test that deems allocations of nonrecourse deductions to be in accordance with the partner’s interests in the partnership.

 

If that test is not satisfied, Treasury Regulation 1.704-1(b)(3) should then be utilized to determine the validity of a nonrecourse debt allocation. Section 1.704-1(b)(3) provides a facts-and-circumstances test that provides guidelines for a nonrecourse deduction to be allocated according to the partner’s interest in the partnership. Additionally, the Regulations also provide a safe harbor for a proper allocation in lieu of utilizing the facts-and circumstances test.

 

After nonrecourse deductions and minimum gain are calculated, it should be quite evident that minimum gain is just as real as Santa Claus.

MINORITY SHAREHOLDERS RECEIVE A CHRISTMAS GIFT FROM THE GOVERNOR

Derek P. Usman, The Usman Law Firm, P.A.

 

Effective January 1, 2007, amendments to the Illinois Business Corporation Act now provide a more precise definition of the fair value of minority interests. The new Illinois legislation is quite similar to the 1999 amendments to the Model Business Corporation Act. The Illinois Business Corporation Act now explicitly states that “fair value…means the proportionate interest of the shareholder in the corporation, without any discount for minority status or, absent extraordinary circumstances, lack of marketability.”

 

Prior to 2007, “fair value” proceedings in Illinois courts have often resulted in the application of minority and marketability (liquidity) discounts. Even though the Illinois Supreme Court repeatedly discouraged the use of discounts, the position of trial courts remained inconsistent with the majority of courts throughout the country that disallowed discounts. Also, while other states considered discounts to be a question of law, Illinois considered the appropriateness of discounts as one of fact. During “fair value” proceedings, Illinois trial courts left the calculation of fair value to valuation experts and subsequently, the appellate courts deferred to the trial courts. Nevertheless, the newly enacted legislation explicitly prohibits the application of discounts in calculating the fair value of minority shares.

 

“Fair value” proceedings arise to resolve conflicts between the majority and minority shareholders where the controlling shareholders would benefit at the expenses of the minority shareholders. For example, a conflict is present when a minority interest is discounted in a merger or stock restructuring but the majority interest ends up retaining the discounted value after the reorganization. As a potential remedy, Section 8.60 of the Illinois Business Corporation Act requires the majority shareholders to demonstrate that a fair value was provided for the minority interests.

 

Sections 11.65 and 11.70 of the Illinois Business Corporation Act provide for dissenter’s rights to a shareholder of a corporation by allowing the shareholder to obtain payment for his shares in the event of certain corporate actions. Alternatively, the presence of oppressive conditions also avails remedies to an injured shareholder. Upon satisfying any of the conditions listed under Section 12.56(a)(1)(4), a petitioning shareholder of a private corporation may request judicial intervention. Subsequently, a possible remedy for the statutorily defined oppressive situations includes a court ordered share purchase after a determination of the fair value of shares.

 

As a starting point, the “fair value” standard must be distinguished from the “fair market value” standard in analyzing the reasoning behind prohibition of minority discounts in “fair value” proceedings. Illinois courts have stated that fair market value is “based on the price that would be agreed upon in an arms length transaction between a willing buyer and willing seller on the open market, neither under a compulsion to act, and both parties possessed of all relevant facts”. Furthermore, the fair market value standard is used in gift and estate tax valuations where minority and liquidity discounts are routine. On the other hand, fair value is often calculated for interests purchased by the remaining shareholders of an entity and the fair market value is inapplicable. The two standards are not analogous; nor are they utilized under similar circumstances. Therefore, the application of discounts is not necessarily appropriate under the “fair value” standard.

 

Still yet, a minority discount adjustment is based on the theory that non-controlling shares are not worth their proportionate share of the company’s value because they lack voting power to control corporate actions. On the other hand, a marketability discount is an adjustment for a lack of liquidity. Here the theory is that there are a limited number of potential buyers for the stock of a closely-held corporation. However, minority and marketability discounts are inappropriate when the purchaser of the stock is either the majority shareholder or the corporation itself. The application of a minority discount is not appropriate because different interests are present when a there is a sale to an outside third party. Upon a sale to a third party, the value of the shares remains constant or drop in value because the third party does not gain a right to control or manage the corporation. On the other hand, a sale to a majority shareholder or to the corporation increases the interests of those already in control. Consequently, the application of a minority discount in a sale to “insiders” would result in a windfall to the buyer.

 

Nevertheless, litigation is still inevitable because there is a lack of legislative history that discusses exactly when the statutory exception for “extraordinary circumstances” warranting a discount for lack of marketability arises. So, just what will these extraordinary circumstances entail? Even though the amended statutes are void of any guidance, the American Law Institutes’ Section 7.22 of the Principles on Corporate Governance is a good starting point. Illinois’ newly adopted definition of fair value mirrors the American Law Institute’s definition of fair value. The ALI endorses the national trend of interpreting fair value as the proportionate share of a going concern “without any discount for minority status or, absent extraordinary circumstances, lack of marketability.” The ALI has further recommended that to determine fair value, the trial court must determine the aggregate value for the firm as an entity, and then simply allocate that value pro rata in accordance with the shareholders’ percentage ownership.

 

Similar to Illinois, the ALI’s definition of fair value also includes the exception for “extraordinary circumstances”. Unlike the Illinois statute, the ALI provides guidance as to just when extraordinary circumstances might arise. Comment e to Section 7.22 clarifies that extraordinary circumstances must consist of more than an absence of a trading market in the shares. Furthermore, an ALI comment states that the extraordinary circumstances exception is “very limited” and is intended to apply only when the trial court “finds that the dissenting shareholder has held out in order to exploit the transaction giving rise to appraisal so as to divert value to itself that could not be made available proportionately to other shareholders.”

 

The comment also provides an example of “extraordinary circumstances”. In the example, a financially strained corporation lacking liquid assets makes relatively minor changes in its governance and structure which trigger appraisal rights. Since the corporation is financially troubled and only has illiquid assets, a fair value appraisal proceeding would likely result in a higher price per share than a market transaction for the shareholder’s shares. Furthermore, a shareholder dissents because he had been unsuccessfully attempting to persuade the other shareholders to purchase his shares. Therefore, the dissenting shareholder now has the opportunity to obtain a much higher price for his share by exploiting a relatively minor change. A marketability discount would be proper because the “fair value” proceeding is likely to produce an appraisal higher than the remaining shareholders could receive upon a sale of the corporation or its assets and the dissenter is taking advantage of a minor corporate change. Therefore, if a dissenting shareholder does not have a valid objection to the transaction, the shareholder is deemed to be exploiting a minor change in the charter. Consequently, a marketability discount should be applied to prevent an unfair wealth transfer to the dissenting shareholder. The comment does indicate that under identical facts, if the shareholder dissented to a fundamental corporate change, such as a merge, a marketability discount would be inappropriate.

 

In 2003, the Colorado Supreme Court analyzed the ALI’s definition and interpretation of “fair value” and “extraordinary circumstances” and asserted that that the “extraordinary circumstance” exception is intended to enable trial courts to utilize their equitable powers and provide a fair result when extraordinary circumstances are present. (For brevity’s sake I’m excluding a discussion of cases that analyze the applicability of the “extraordinary circumstance” exception. Nevertheless, all of those cases emphasize the limited nature of the exception.)

 

In addition to the strict statutory limitations on discounting minority shares, courts across the nation have recognized that discounts unjustly benefit the majority shareholders. As the Delaware Supreme Court stated in the leading “fair value” case in Cavalier Oil Corp. v. Harnett, “…to fail to accord to a minority shareholder the full proportionate value of his shares imposes a penalty for lack of control, and enriches the majority shareholders who may reap a windfall from the appraisal process by chasing out a dissenting shareholder, a clearly undesirable result.”
 

A Matter of Trust: Closely-held derivative lawsuits

Derek P. Usman, The Usman Law Firm, P.A.

 

A shareholder may initiate a direct action lawsuit against a corporation to redress an injury inflicted by the corporation upon the shareholder. However, a shareholder may also assert a cause of action on behalf of the corporation. Such a suit, a derivative lawsuit, arises against officers or shareholders when the corporation has failed to commence suit for injuries to the corporation itself. The Illinois Business Corporations Act creates a statutory cause of action for such an event. Nevertheless, distinctive characteristics and needs of close corporations have resulted in these companies receiving disparate treatment upon litigation.

 

Foremost, derivative lawsuits must be distinguished for close corporations (and other closely-held firms) and widely-held and/or publicly held corporations. For the former, derivative lawsuits are categorized as “Closely-Held”. While public or widely-held corporation derivative lawsuits are designated either as “Corporate Impropriety” or “Exploitation of Control” derivative lawsuits. “Corporate Impropriety” includes derivative suits seeking to impose personal liability on the board for a discrete act of corporate wrongdoing (typically a violation of law or a regulatory requirement). Corporations in this category tend to be larger and shareholdings more widely dispersed. “Exploitation of Control” suits are limited to challenging transactions between the corporation and those who control it. The Exploitation of Control category involves corporate transactions with or on behalf of the persons who control it. For cases in this category, the corporations tend to be smaller, the plaintiffs tend to hold significant blocks of stock, and that stock tends to be thinly traded, especially compared to that of the corporations in the Corporate Impropriety category.

 

While public corporations tend to incorporate in Delaware, close corporations are incorporated in the state of their principal state of business. The unique treatment afforded close corporations is further evident in the adoption of special code sections governing close corporations. In Illinois, a corporation’s failure to elect close corporation status will not prevent the corporation to be treated as a close corporation if under common law principles it would qualify as a close corporation.

 

The most extreme statutory provision that impacts shareholders in close corporations is involuntary dissolution. The remedy of involuntary dissolution will be administered in derivative lawsuits if the defendant acts “oppressively”. While the Illinois statutes do not define oppression, the courts have supplied definitions of oppressive conduct in closely-held cases. In Illinois, there is an enhanced fiduciary duty to shareholders of a close corporation that is similar to that of partners in a partnership. The emphasis placed on fiduciary duties in closely-held cases negates a requirement of finding fraud or illegal conduct.

 

Close and public corporations differ in ways that make general corporate law ill suited to close corporations. A major distinction for close corporations is that shareholders of a close corporation often serve as the directors or officers. Corporate law gives controlling insiders considerable latitude to run the corporation as they see fit. Understandably, they will generally favor their own priorities and objectives over those of the minority. Aside from their investments, these shareholders are also actively managing the company. Unlike public corporation shareholders, most close corporation shareholders’ income derives solely from distributions from the corporations. Consequently, a minority shareholder is particularly vulnerable to the whims of the majority. A minority shareholder’s dependence on the corporation, lack of control and a lack of market for shares all create unique circumstances for the minority shareholder.

 

There are several recurring scenarios that lead to derivative litigation in the close-corporation context. For example, a “freeze-out” or exclusion of a minority shareholder from management of the corporation prompts litigation. Also, disparate treatment of different shareholders, e.g., purchase of one shareholder’s share for fair value and not the others. Another common scenario involves the frustration of “reasonable expectations” of a shareholder; often the minority shareholder is deprived of a prominent position (director, officer or employee). Still yet, a shareholder’s attempt at competing with the corporation in another business leads to litigation.

 

It should be noted that situations arise where majority shareholders are the ones with the scales tipping against them. Minority shareholders may have the capacity to overpower a controlling shareholder (especially where corporate actions require supermajority approval). Of course the share liquidity issue is just as relevant for majority shareholders. Also, it might very well be that the minority shareholder brings all the expertise to the table.

 

Generally, cases in the Exploitation of Control and Closely-Held categories involve applications of the duty owed to minority shareholders by the majority. Derivative litigation performs the task of translating the abstract concepts of fiduciary obligation, good faith and fairness into the specific limits on the insiders’ ability to favor themselves. To this end, Illinois courts have embraced the “enhanced fiduciary duty” as a solution. The expansion of the duties makes more sense since closely-held shareholders often neglect to have a shareholders’ agreement in place. Thus, the old adage, “an ounce of prevention is worth a pound of cure”, is quite relevant in the avoidance of derivative litigation. The presence of a shareholders’ agreement significantly reduces the likelihood of a corporate breakdown. Additionally, under a longstanding history of allowing the freedom to contract, courts traditionally uphold shareholder agreements. The trick is to balance the interests of the majority and the minority. A shareholders’ agreement requiring unanimous approval for corporate actions might curb arbitrary actions by the majority. Nevertheless, such a provision providing the minority with carte blanche veto power might result in the minority shareholders holding the majority shareholders hostage. Similarly, the emergence of venture capitalists as minority shareholders further necessitates the need for a well-drafted shareholders’ agreement to avoid litigation scenarios.

 

Shareholders would be wise to employ a competent legal draftsman to produce an explicit agreement that reflects acceptable conduct by close corporation shareholders. Practitioners must communicate to their clients that the presence of a shareholders’ agreement would reduce the risk of litigation. While courts navigate around the contours of fiduciary duties, a shareholders’ agreement goes a long way towards preventing inequitable treatment.

COMING THIS SUMMER: THE NEW ILLINOIS POWER OF ATTORNEY ACT

Effective July 1, 2011, changes in the Act create new statutory Power of Attorney (POA) forms for property and healthcare.  A Power of Attorney is a legal document that gives another person (your agent) the authority to make financial and other legal decisions on your behalf.

The revised act provides more guidance to the agent in the performance of his duties.  For example, the agent will now receive a notice describing his responsibilities.  As before, you, the principal, must decide whether the agent is granted the power immediately or at a later time.

The property and healthcare POA forms are essential estate planning tools for adults.  The forms allow your wishes for medical and financial decisions to be carried out by someone trustworthy if you were to become incapacitated.

THE CONTRACT – HAVE IT IN WRITING

A written document to memorialize terms of an agreement between two or more persons minimizes confusion and possibility of litigation. Even though an oral agreement is usually sufficient to form a legal binding contract, a written contract provides proof of the intentions of the parties.

To demonstrate a breach of contract, the aggrieved party must first show that a contract exists.  An offer and acceptance is the starting point for a contract to exist.   Since a written contract explicitly spells out the obligations of all the parties to the contract, a breach by one of the parties is easier to establish.  Then under the terms of the contract, the aggrieved party must have performed its obligations while the other party did not.  Finally, there must be damages resulting from the breach.  A written contract also allows the parties to stipulate specific damages upon the occurrence of a breach of the contract.

A START-UP BUSINESS MIGHT BE WISE TO CHOOSE THE LLC AS ITS ENTITY FORM

Since tax considerations are of utmost importance in choosing an entity form, entrepreneurs should determine the advantages of beginning their business as a LLC. In particular, the applicability of the LLC structure must be examined when the entity plans to go public or merge with a public corporation.

While enjoying the benefits of a LLC prior to “going public”, the conversion of a LLC to a corporation is quite seamless.

An incorporation of an LLC can follow three forms:
1. the LLC can transfer its assets to the corporation in exchange for stock;
2. the LLC can distribute its assets to its members who then contribute those assets to the corporation in exchange for stock and;
3. the members can contribute their interests to the corporation in exchange for stock.

Of course, the incorporation of the LLC can also take place as part of the initial public offering under Section 351.

Also, the LLC’s conversion to a corporation should not prevent a subsequent tax-free reorganization under Section 368 when the corporation is acquired by a public company.

AMENDING PLEADINGS IN ILLINOIS COURTS

Section 2-616 of the Illinois Civil Practice Law provides for amendments to pleadings on just and reasonable terms before final judgment.

Loyola Academy v. S & S Roof Maintenance, 146 Ill.2d 263 provides the standard for amending pleadings in Illinois. The Loyola Academy court looked to four factors in determining the appropriateness of allowing leave to file an amended pleading:

The four factors are the following:

  1. Whether the proposed amendment would cure the defective pleading;
  2. Whether other parties would sustain prejudice or surprise by virtue of the proposed amendment;
  3. Whether the proposed amendment is timely; and
  4. Whether previous opportunities to amend the pleadings could be identified.