The question of whether a momentary or “flash” ownership by private equity funds of operating assets has adverse tax consequences arises with increasing frequency. As private equity funds continue to deploy complex acquisition structures involving partnership holding companies, the tax treatment of transitory ownership of assets or pass-through interests has become a critical but unsettled issue.
Typical PE Structure
Private equity funds raise capital from a broad range of investors, including many who are sensitive to the tax consequences of fund investments. These tax-sensitive investors generally fall into three categories:
- Sovereign wealth funds, which are foreign governments or instrumentalities that enjoy a broad exemption from US taxation under §892, but lose that exemption to the extent they derive income from “commercial activities,” or CAI;
- Foreign persons, including individuals, corporations, and other entities, which are generally subject to US federal net income tax only on income that is “effectively connected” with the conduct of a US trade or business under §864, or ECI; or
- Certain tax-exempt organizations, including pension funds, university endowments, and charitable foundations, which are generally exempt from US federal income tax on exempt activities but remain subject to tax on “unrelated business taxable income,” or UBTI, under §512.
To protect tax-sensitive investors, private equity funds often negotiate tax covenants in their fund agreements or side letters to obligate the funds to some level of efforts to avoid generating CAI, ECI, or UBTI and provide timely notice to affected investors of any CAI, ECI, or UBTI allocable to them.
CAI, ECI, and UBTI need not be generated directly by the fund to be a problem for tax-sensitive investors. Because private equity funds are typically structured as partnerships, activities and investments held by the funds are passed through to its investors. Activities and investments made by pass-through entities (such as partnerships or disregarded entities) held by the funds can also be passed through to the funds (and then passed through by the funds to its investors).
Despite the CAI, ECI, and UBTI exposure inherent in partnerships, the partnership-above-corporation structure, where the partnership is a holding company and the corporation operates a business, is the typical approach for platform investments made by private equity funds. This structure permits tax-free rollover for add-on investments made by the portfolio company, provides a tax-efficient vehicle for the issuance of profits interests to management, and simplifies the exit by allowing one fund-controlled seller to dispose of stock in the corporation on behalf of all owners. However, in an add-on transaction where the seller is contributing assets, or equity in a pass-through target business (such as a partnership or LLC interest), the assets or pass-through equity interest may be momentarily held by the partnership holding company before it’s immediately contributed down to the operating corporation.
Flash, Momentary Ownership
Current treatment. Accounting firms for private equity funds utilizing this partnership-above-corporation structure generally do not report any income to the holding partnership in its capacity as an interim owner of assets or pass-through equity based on momentary ownership. This practice avoids any allocation of CAI, ECI, or UBTI to the funds. Even assuming this practice is correct, tax-sensitive foreign investors and sovereign wealth funds may still be harmed beyond income recognition. IRC §875 attributes any US trade or business activity (not just income) conducted by a partnership to its partners. With respect to foreign persons, there is an obligation for a partner in a partnership that is engaged in a US trade or business to file a US tax return. Treas. Reg. §1.6012-1(b). With respect to sovereign wealth funds, Treas. Reg. §1.892-5T(d)(8) generally attributes commercial activities of a partnership to its partners (with several exceptions). Should momentary ownership be disregarded not only for the generation of income but also for the attribution of commercial activity or trade or business activity?
Partnership equity interest. When momentary ownership involves an equity interest in a target partnership, §706 provides instructive guidance for purposes of allocating income between a buyer and seller upon a complete transfer of a partnership interest. The partnership year is deemed to end with respect to the seller on the date of disposition, and for purposes of determining the distributive shares of each item of income between buyer and seller, there are three permissible conventions: calendar day convention, semi-monthly convention, and monthly convention. Under the calendar day convention, the change is deemed to occur at the end of the sale date, and there is no splitting of the closing date. Under that approach, the partnership’s income (and, arguably, its trade or business activities) for the entire day of sale would presumably be allocated exclusively to the seller and not attributed to anyone else.
Business assets. When momentary ownership involves actual business assets, rather than a partnership interest, there is a possibility of splitting the closing date. An asset transfer is effective upon the transfer of the benefits and burdens of ownership, which can occur at any point during the closing date, rather than either at the beginning or end of the day. The relevant factors used in determining the benefits and burdens of ownership include the right of possession, the right to receive income from the property, liability for expenses, risk of loss, payment of property taxes and utility bills, and the exercise of managerial authority.
Consider the example where A sells a delivery business to B and the benefits and burdens of ownership shift at noon on the closing date. The net income from operations before noon would properly be attributed to A, and the net income from operations after noon would be attributed to B. The parties could contractually move the point at which benefits and burdens of ownership are transferred by making the elements of ownership become effective only at, say 11:59 p.m., on the closing date.
Therefore, even with a rollover of assets, the likelihood of income (and, arguably, trade or business activities) being attributed to an interim owner can be minimized with some tweaks to the timing of elements of ownership in the purchase agreement.
General authority. There is broad authority under both Treasury regulations and IRS rulings that supports disregarding transitory ownership. For example, transitory ownership by underwriters in connection with a public offering is ignored for the purposes of both §351 and §382. See Treas. Reg. §1.351-1, §1.382-3. Similarly, under the partnership merger and division regulations, the transitory ownership of a partnership’s assets by its partners is disregarded where a terminating partnership makes an interim liquidating distribution of its assets to its partners who then immediately recontribute those assets to a new continuing partnership. See Treas. Reg. §1.708-1(c)(3) and §1.708-1(d)(3). Several IRS rulings in the context of Sub S corporation disqualification also similarly disregard transitory ownership by impermissible shareholders. See Rev. Rul. 72-320, Rev. Rul. 73-496; PLR 8934020. While none of these authorities directly address the momentary ownership question in the private equity context, they reflect a consistent underlying principle that transitory ownership should generally not be given tax significance.
Private Equity Context
The flash ownership question in the private equity context presents a unique complication due to inconsistency. The rollover parties would like the transitory ownership of the holding partnership to be legally respected in order to qualify the rollover equity as a tax-free contribution under §721 and §351. However, the fund would like the same transitory ownership to be disregarded to protect its tax-sensitive investors from CAI, ECI, and UBTI attribution.
In many cases, a direct contribution by the rollover seller to the corporation would fail as a tax-free contribution under §351 due to the requirement that the contributing persons must control the corporation (defined as ownership of at least 80% of the corporation’s stock) immediately after the contribution. If the rollover seller is the only contributing person to an existing platform corporation with material value, §351 treatment would be unavailable for a direct contribution to the corporation. It’s only the existence of the partnership that permits the tax-free contribution under both §721 and §351. Section 721 has no control requirement so the rollover seller may make a tax-free contribution to the partnership holding company and, afterwards, the partnership may make a tax-free contribution to the operating corporation under §351 because the partnership controls 100% of the operating corporation. If the transitory ownership is disregarded, the partnership is out of the picture.
It isn’t rare for taxpayers to take inconsistent positions (particularly on valuation) for estate (or property) tax purposes versus income tax purposes. However, it’s trickier for a taxpayer to take inconsistent positions regarding the same transaction for income tax purposes. Of course, in the partnership context, a partner may take a position that is inconsistent with the partnership under certain circumstances. See IRC §6222. A foreign partner might take the position that the transitory ownership of a rollover asset or partnership interest is disregarded, despite the partnership reporting that transfer as tax free to benefit the rollover seller. Practically speaking, most private equity funds flatly prohibit any inconsistent reporting by partners.
Alternatives
Many private equity sponsors prefer to simply avoid the flash CAI, ECI, and UBTI issue by structuring the rollovers for add-on acquisitions through a two-step transaction, requiring a seller to transfer its rollover equity or assets to a newly formed corporation and then to immediately retransfer the equity it receives in the corporation to the holding partnership. The tax consequences of a contribution to a partnership of stock received by a rollover seller in a tax-free §351 transaction isn’t crystal clear. See Rev. Rul. 2003-51; PLR 201133006, PLR 201506008. Depending on the particular facts, these alternatives can present a seller with some unwanted tax risk. In such a case, the private equity buyer may simply be substituting its own CAI, ECI, and UBTI tax risk for a seller tax risk on the viability of the tax-free rollover.
Takeaways
The issue of transitory ownership for private equity add-on acquisitions is clouded by inconsistent tax positions. Ultimately, there is a tax risk buried in the transaction and the substantive question is whether the private equity buyer or the rollover seller will suffer that tax risk.
This article does not necessarily reflect the opinion of Bloomberg Industry Group Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.
Author Information
Isaac P. Grossman is a partner and chair of the tax department at Morrison Cohen LLP, in New York. He is a graduate of Harvard Law School, has an LL.M. from NYU School of Law, and has been in practice for more than forty years.
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