Tax traps to avoid when holding a corporation through a partnership
Beware of phantom income: Partnership-owned C Corporations
INSIGHT ARTICLE |
Private equity funds and venture capital investors often create partnership entities1 to hold their investments. A partnership holding company may accommodate co-investment, rollover investment by target company owners, carried interests, or equity compensation to management of the portfolio company. The partnership holding company owns an operating company treated as a C corporation2 for U.S. federal income tax purposes. This company structure gives rise to potential tax traps in situations where assets or equity of one company is used to make payment for costs of the other company. Falling into these traps may result in unintended dividends to the partnership if assets of the corporation are used for the partnership’s benefit, or taxable gain to the corporation if equity of the partnership is used for the corporation’s benefit.
To avoid falling into these tax traps, companies should bear in mind that the partnership and the corporation are viewed as separate entities for U.S. federal income tax purposes, even though they may be viewed as one company economically and operationally for financial statement purposes. Each entity files its own separate tax return and is subject to a different set of tax rules.
The following examples show how a holding company partnership and its wholly owned corporate subsidiary may unwittingly create a taxable event.
The corporation pays costs of its partnership shareholder
Where a partnership’s sole asset is the stock of a corporation and the partnership needs cash, one solution to consider is a transfer of cash (or other assets) from the corporation for the partnership’s benefit. This ‘solution,’ however, may result in taxable dividend income for the partnership.
Consider this example:
Partnership (Holdco) owns 100% of the stock of a corporation (Opco). Opco operates a profitable business. Holdco has four partners and redeems one of the four partners with a Promissory Note. The Note is payable in annual installments. Opco makes the annual Note payments to the redeemed partner.
In this situation, Opco is paying cash to a creditor of Holdco. Opco’s payment of Holdco’s liability would generally represent a distribution to Holdco that is taxable as a dividend to the extent of Opco’s current and accumulated earnings and profits (E&P). The dividend would represent taxable income allocated to the partners of the partnership in accordance with the partnership agreement, rather than income solely to the partner receiving cash. Partners typically would have ‘phantom income’ to report with no accompanying cash to pay the tax.
Other unintended consequences of this transaction may include triggering additional distributions from the corporation to the partnership to make necessary tax distributions under the partnership agreement, withholding obligations with respect to foreign investors, and potential gain recognition if distributions exceed both E&P and the partnership’s basis in shares on which the distribution is made. Because of the combined financial reporting Holdco and Opco may apply combined financial reporting and may be viewed as an economic unit, the dividend in this situation may be easy to miss unless the separate tax return filings of Holdco and Opco are considered.
Alternative transaction structures may permit redeeming a Holdco partner, without triggering unwanted dividends from Opco. Before entering into any transfer of value from a corporation for the benefit of the partnership that owns it, the corporation and its owner should consider alternative transactions and their potential tax results. What transaction structure is advantageous from a tax perspective will depend on the parties’ situation.
Partnership issues equity to pay costs of the corporation
Where the partnership shareholder pays costs of the corporate subsidiary with cash, the payment generally results in a deemed capital contribution to the corporation and a deemed payment of the costs by the corporate subsidiary.3 The corporation then determines the appropriate treatment of the cost (i.e., expense or capital costs).
The corporation may fall into a tax trap if the partnership pays the corporation’s costs with equity of the partnership.
Consider this example:
Holdco Partnership owns 100% of the stock Opco Corporation. Opco operates a business, which is in need of additional capital. Opco accordingly borrows money from a lender. The lender loans $10 million to Opco, and receives an “equity kicker” in the deal. In exchange for the $10 million, the lender receives (a) a Promissory Note issued by Opco Corporation with a $10 million principal amount, and (b) equity of Holdco Partnership with a fair market value (FMV) of $1 million. Opco does not pay Holdco for the Holdco equity that Holdco transferred to the lender on Opco’s behalf.
In this situation, Holdco is transferring Holdco equity to a creditor of Opco. Holdco’s transfer on Opco’s behalf likely would be treated as a contribution by Holdco of its equity to Opco. Opco’s transfer of the Holdco equity to the lender generally would result in a taxable transfer. Opco Corporation would have a tax basis of zero in the equity of Holdco.4 Opco Corporation accordingly would recognize gain of $1 million, i.e., gain equal to the FMV of the Holdco Partnership equity transferred on its behalf. The taxable gain result here differs from the result that would obtain if Holdco was a corporation.5
This example illustrates a partnership’s transfer of equity for the benefit of the corporation it controls. A similar situation may arise if Holdco Partnership equity were used to compensate employees of Opco Corporation.
Before entering into a transaction designed to transfer value in this way, the partnership and the corporation it owns should consider alternative transactions and their potential tax results. Again, what transaction structure is advantageous from a tax perspective will depend on the parties’ situation.
Partnerships and the corporations they control may trigger unexpected tax liabilities by transferring value from one entity to pay costs of the other. The parties should consult with their advisors regarding the potential tax consequences when planning to transfer equity or assets of one to benefit the other. An ounce of prevention may be worth a pound of cure.
1 An entity treated as a partnership for U.S. federal income tax purposes could be organized, for example, as a limited partnership or as a limited liability company.
2 A C corporation is corporation that is not an S corporation. C corporations generally are subject to federal income tax, while the taxable income (or loss) of an S corporation generally is taxable to its owners. A corporation with a partnership shareholder cannot be an S corporation.
3 See Specialty Restaurants Corp. v. Comm’r, T.C. Memo 1992-221. See generally Interstate Transit Lines v. Comm’r, 319 U.S. 590 (1943).
4 If Holdco were a corporation instead of a partnership, Holdco would likely avoid the zero basis problem through application of section 1032. However, the section 1032 protection against the zero basis problem does not reach the situation described here, where Holdco is a partnership.
5 See note 4 above.