Buyout firms almost invariably structure their own funds as limited partnerships. But ironically they often avoid investing in operating entities that are taxed as partnerships for U.S. Federal income tax purposes because of the complexity associated with partnership tax.
That is a shame. Investing in operating partnerships can increase returns substantially by removing all entity level Federal income tax, which often is the largest single expense of an operating business. This article attempts to demystify partnership tax, hopefully enabling more buyout professionals to understand, and therefore invest in, operating partnerships.
What Is a Partnership?
For Federal income tax purposes, a partnership is any entity, venture, agreement, arrangement or other unincorporated organization through which any business, financial operation or venture is carried on, and which is not a trust or corporation. A “domestic corporation” generally is an entity formed as a corporation under state law. A “foreign corporation” is either (i) a specific type of entity listed in the Treasury Regulations as a “per se” corporation or (ii) an entity that either (A) has two or more members and at least one does not have limited liability, or (B) elects to be taxed as a corporation for Federal income tax purposes.
“Per se” corporations tend to be entities incorporated in foreign jurisdictions that are similar to U.S. corporations. For example, in the United Kingdom a public limited company is a “per se” corporation, and in Mexico a Sociedad Anonima is a “per se” corporation. For a business venture to be taxed as a partnership, a legal entity need not exist. The tax law can treat any combined business venture as a partnership if the underlying intent of the parties is to operate the business venture together, essentially as partners. A domestic partnership can elect to be taxed as a corporation for Federal income tax purposes. Therefore, one should never assume that a domestic partnership is taxed as a partnership, but must inquire into how the entity is taxed. It is also important when acquiring a non-corporate entity to have a representation confirming how the entity is taxed for Federal income tax purposes. Generally, states follow the Federal tax treatment of entities and other business ventures for state income tax purposes.
Benefit of Partnership Form
A partnership is not subject to Federal income tax. Rather, the partners of the partnership include in their income their respective shares of the net profit or loss earned or incurred by the partnership in each tax year. Therefore, a partnership generally is the most desirable entity through which to run either a profitable business, because the profits are only taxed once, or an unprofitable business, because losses may be able to be currently used by the partners to reduce tax on unrelated income. By contrast, corporate profits are always taxed twice, at the corporate level and again at the shareholder level. This disparity between corporate and partnership taxation is demonstrated by the following example.Assume a business is capitalized with $100, which is used to buy property, plant and equipment (“PP&E”). In each of years one through three, the business earns $10. In years one and two that $10 is reinvested in the business to buy more PP&E. The year-three profit is distributed to the business owners, and later in year three the business is sold. If the business is a corporation, the tax payments and balance sheet would be like the first table in the links to the right.
Sale of the business for book value will be for $113. Accordingly, the shareholder will receive a $6.50 dividend, will pay tax of $1.30 (assuming a 20 percent tax rate), and will have a gain on the sale of $13, paying tax of $2.60. Therefore, for the three year ownership of the business in corporate form, the shareholder will have net, after-tax investment returns of $15.60. Contrast this with running the business through a partnership entity, as shown in the second table in the links to the right.
In this case, profits flow through to the owner, and the owner’s tax basis in the partnership will be increased by any income allocated to it and decreased by cash distributions. Assume (i) that the partnership will make taxable distributions to its owners, and (ii) that the owner’s tax rate is the same as the corporate tax rate of 35 percent (currently the highest tax rate for individuals).For the three year ownership of the business in partnership form, the owner will have net, after-tax investment returns of $19.50. Notice that in the partnership form, the investor has increased after-tax returns by $3.90. This reflects that the corporate level of tax has been avoided, i.e., the $3.90 increase in after-tax returns equals the second level of tax paid in the corporate structure. Distributions from a partnership are generally not taxed unless they exceed the partner’s tax basis in its interest. Therefore, the $6.50 distribution is tax-free. Accordingly, as a pure cash-flow matter, given the choice between partnership or corporate form, investors will prefer partnership form.
Limitations Of Partnership Form
Notwithstanding the cash-flow benefits described above, not all entities are formed as tax partnerships, for several reasons.
First, when acquiring a corporate entity an investor generally is stuck with the corporate form. This is because liquidating a corporation, or otherwise converting it to a partnership entity, is a taxable event to the corporation. The corporation will pay tax on the differences between the adjusted tax basis it has in its assets, and the fair market value of those assets. In most cases this will have a prohibitive tax cost. This is also the reason why corporations generally will not sell all of their assets to a partnership entity newly formed by an investor for purposes of the acquisition. However, there are a couple of exceptions to this.
Specifically, if the corporation has a net unrealized built-in loss in its assets, or if the corporation has net operating losses that may offset potential gains, conversion is possible, although each of these situations is complicated, and must be analyzed on a case-by-case basis. However, when acquiring a corporation taxed pursuant to Subchapter S of the Internal Revenue Code (an “S Corp”), it is often possible to restructure the business’s operating assets so that a new investment (or acquisition) may be made through an operating partnership.Publicly traded operating companies are not eligible to be taxed as partnerships. If an entity that is otherwise eligible to be taxed as a partnership in publicly traded, it will be taxed as a corporation unless at least 90% of its income in each tax year is passive income, (e.g., dividends, interests, rents from real property, etc.) Therefore, most public companies tend to be formed as corporations.Private equity funds may not want to invest through partnership structures because their limited partners may be sensitive to incurring tax on the operating income of partnerships (for tax-exempt entities, this is called unrelated business taxable income, or “UBTI,” and for non-U.S. investors this is income effectively connected to a U.S. trade or business, or “ECI”). When a partnership earns UBTI or ECI, its otherwise tax-exempt and non-U.S. partners, respectively, are required to pay Federal income tax at regular tax rates on such income. This can be avoided by forming corporate entities through which these limited partners run their investments. However, some private equity fund sponsors prefer to avoid such complexities and invest only in corporate entities. Moreover, some funds simply prohibit investments that could generate UBTI or ECI, although such prohibitions are increasingly rare. Note, however, that only operating partnerships generate UBTI and ECI. Where a partnership is a holding company for corporate entities, UBTI and ECI are not an issue.There are other significant issues that present themselves when using partnerships as operating entities: treatment of such entities is often either unclear or burdensome in foreign jurisdictions and under foreign tax treaties; employees who own equity interests are not treated as employees for payroll tax and employee benefit purposes, and this treatment can impose significant costs and compliance burdens on those employees; there may be corporate law issues depending on the choice of entity; if the investor plans to offer equity in the entity in an IPO, converting to corporate form may be required by the underwriter; in the international context, the choice of entity will involve significant analysis to determine how tax losses and tax credits will be treated for Federal tax purposes.
Accordingly, while choosing the partnership form may seem like the best approach in many cases, thorough analysis is required to determine whether that form meets all the business goals.
Russell J. Pinilis is a partner in the tax and corporate departments in Kramer Levin Naftalis & Frankel LLP’s New York office. He has worked extensively with structuring and forming private equity investment funds and advising them on the tax aspects of investing capital.