LSI 2010 Real Estate Joint Ventures conference materials.pdf

Brian Todd of Davis Wright Tremaine LLP
Andrew H. Zuccotti of K&L Gates LLP
its (some would say “illusion of” 3 ) simplicity. A draftsman can insert the target
allocation provision into any operating agreement he drafts. He can exclude tax lawyers
completely from the drafting process. He can save the client money and (some would
say) headaches. The liquidation-by-tiers-with-target-allocations method is, in our view,
more likely than the liquidation-by-capital-account method to give rise to capital shifts
among the members of an LLC or the partners of a partnership, particularly in situations
involving preferred returns. By its nature the liquidation-by-tiers method directs
available cash be distributed in tiers. This may move one member’s capital contribution
to another, senior member. (The federal income tax consequences of internal capital
shifts in an LLC are not well understood by practitioners.)
But this (apparent) simplicity comes at a cost, i.e., it is difficult to predict how
profit and losses will be allocated. This may be a reason why accountants typically prefer
the liquidation-by-capital-accounts method. And, given new Code Section 6694, which
imposes penalties on “return preparers” who take a position on a return and do not have
“a reasonable belief that the position would more likely than not be sustained on the
merits,” it seems likely that the accountants’ preference for greater predictability will
only increase. Furthermore, this lack of predictability probably makes it even more
appropriate to include in the operating agreement a provision for distributions to pay tax
on allocations of income.
The best answer we can give to the question of which method to use in drafting
LLC and partnership agreements is that it depends on the circumstances. If one of the
members is a tax exempt plan or a charity, the liquidation-by-capital-accounts method
seems clearly preferable because of Sections 168(h) and 514(c)(9)(E). If the business
deal includes a flip-flop as a function of an internal rate of return calculation, the
liquidation-by-tiers-with-target-allocations method is preferable because it is difficult to
draft a flip-flop which is a function of an IRR – a cash return concept – using the
liquidation-by-capital-accounts method.
C. Potential Pitfalls: Drafting Issues to Watch For.
Two recent cases illustrate the dangers of trying to draft an LLC agreement
without input from tax counsel.
1. Imprimis Investors, LLC. v. U.S., ___F.3d___ (Cl. Ct. 2008); 102
AFTR2d 2008 5727.
The LLC Agreement provided for a “waterfall” of allocations of net profits and
net losses and then, after such waterfall, 20% of net profits and net losses would be
allocated to one member, Insight. If the net profits consisted of “items of ordinary
income,” then Insight was to receive a special gross income allocation of such “ordinary
income” items equal to the amount Insight would otherwise receive with the remainder to
be allocated to the other members. If the amount of ordinary income allocated to Insight
Speaker 11: 7
Speaker 12: 7
3 Cuff, “Working with Target Allocation Provisions: Idiot-Proof or Drafting for Idiots?” (Pre-publication
draft) (2008). Mr. Cuff sets forth a series of examples arguing that “the perceived simplicity of the target
allocation provision is considerably overstated.
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Law Seminars International | Real Estate Joint Ventures and Funds | 02/08/10 in Seattle, WA