January 2020
Partnership Dilution And Concentration.

It is well understood that when interests in a partnership are sold the sellers recognize income. Other partnership transactions can have the effect of making partners wealthier or less wealthy, whether inadvertently or through intentional manipulation, even if those partners are not directly parties to the transactions. Since ownership adjustments are often made in preparation for business acquisitions, those results can affect business acquirors.

  What Is Dilution Or Concentration?

Concentration or dilution occurs when a partner's share of the partnership's value changes in a transaction in which the partnership's total value does not change commensurately.

Example 1: assume a two-member partnership, AB, in which each partner owns 50 partnership units (100 units in total), each of which currently has a value of $10, making the partnership worth $1,000. The partnership decides to redeem half of A's interest. The partnership therefore purchases 25 units from A for $250, following which A holds 25 units and B still holds 50 units. The partnership is now worth $750, as it just spent $250. That means A's interest is now worth $250 (that is, 25/75*$750) and B's remains worth $500 (that is, 50/75*$750). No partner has gained or lost value. Thus, there has been no taxable event.

Example 2: assume the same facts, but for some reason (discussed below) A consents to sell its 25 units to the partnership for $100. Following that redemption, A holds 25 units and B holds 50 units, but the partnership has spent only $100 and therefore is worth $900. That means A's interest is now worth $300 (that is, 25/75*$900) and B's is now worth $600 (that is, 50/75*$900). A has lost $100 of value (dilution), and B has gained $100 of value (concentration). There probably has been a taxable event.

The above examples relate to ongoing partnerships. A special case can arise in a newly-formed partnership: when a partnership is formed with one partner contributing money and the other receiving an interest in exchange for services, the service partner can be immediately enriched by receiving an indirect interest in the money contributed by the money contributor.

  • Normally this problem is avoided by a provision in the partnership agreement that causes the money contributor to receive a preferred return of its capital before the service partner receives any return.
  • However, a surprising number of partnerships are "straight" (or simply undocumented "de facto partnership") arrangements in which there is no preferred return and therefore the service partner can be enriched unexpectedly.
  Situations Creating Dilution or Concentration.

In Example 2 above, why would A consent to receiving such a bad deal? There are three likely scenarios: (1) making a gift; (2) making the partnership interests "the way they should have been;" or (3) paying compensation. Those scenarios often arise in the process of planning for a business disposition.

  • Consequences of different types of dilution or concentration.

The gift scenario is simple: if B is A's favorite niece, A may be happy to make B wealthier. That is a simple gift, and gift tax should be reported and paid on the transaction.

The "way they should have been" is a bit more involved. Perhaps the parties had an informal understanding about interests in the partnership but did not formalize it, or perhaps they agree that for some other reason the interests should be adjusted. In that case, the concentration/dilution transaction is not a gift, but a transfer in consideration of value or a prior commitment. It will have tax consequences in accordance with the facts, probably most typically being taxation as a sale or exchange.

  • Comment: if the parties can substantiate that they are documenting an existing binding agreement, as opposed to executing a new transaction, the transaction may be treated as not being an actual transaction for tax purposes.

Compensation raises additional issues because it requires the partnership itself to become involved in reporting the transaction. If B has been doing valuable work for the partnership and A agrees to give up wealth in order to help pay compensation to B in the form of a partnership interest, the transaction can be viewed as a simple contribution to capital by A and a simple payment of compensation to B.

  • Since B is a partner, AB must report the compensation as a "guaranteed payment" when issuing its reporting forms to B and the government and must also correctly claim and allocate a deduction for the compensation payment.
  • Worse, if B is not legally a partner (perhaps because B's interest is actually held through a trust or other beneficial ownership arrangement), the compensation to B is wages, the AB is responsible for wage withholding and employment taxes. That makes AB responsible for the potential tax cost of the wealth transfer.
  • Dilution and concentration in preparation for disposition.

As it happens, partners most typically rearrange their economic arrangements when it looks as if money may be coming in, that is, when there is reason to anticipate a disposition of the partnership's business to an outside party in the near term. That is also the most risky time for rearrangement, as the terms of the transaction with the outside party may throw any non-market pricing into sharp relief. Also, the buyer will view any issue such as a potential compensation reporting or withholding obligation (see above) as a potential liability of the business.

That being said, if the anticipated transaction actually closes the risk may be tolerable: there may be tax to pay, but the taxpayer who owes the tax should be able to pay it out of cash on hand from the purchase price. The gift scenario would be an exception, as in that case the donor will have given up value and will also be responsible for any gift tax. Similarly, in the employee compensation scenario, the partnership may have a withholding liability even though it is the partners that actually receive the cash.

  Doubt As To Value In Concentration And Dilution Transactions.

The value transfer issue can arise in a business acquisition when the buyer's tax due diligence advisers discover recent partnership interest transfers based on valuations very different from the valuation in the planned acquisition. In some cases there is real doubt as to the value of a partnership interest, so the partners can argue that the transfers were made on arm's-length terms. However, the less time there is between a transfer and the ultimate sale of the business, the harder it is to disassociate the two (absent a change of circumstances that supports a value change).

Accordingly, if partnership interests need adjustment, the partners should make the adjustment as soon as possible, and specifically before the partnership's business increases in value or nears sale. It is also advisable to obtain an independent appraisal to help establish and support the terms of the adjustment.

If you have questions about these issues or their effect on you or your business, please feel free to contact TaxGroup Partners at (213)873-1200 or e-mail us at info@TaxGroupPartners.com or visit our website at TaxGroupPartners.com.
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