1973, March, Pg. 15. Sected Tax and SEC Implications of Real Estate Limited Partnerships.

• Author: by Barry J. Goldstein

2 Colo.Law. 15

The Colorado Lawyer

1973.

1973, March, Pg. 15.

Sected Tax and SEC Implications of Real Estate Limited Partnerships

15Vol. 2, No. 5, Pg. 15Sected Tax and SEC Implications of Real Estate Limited Partnershipsby Barry J. GoldsteinBarry J. Goldstein, Denver, is a member of the firm of Isaacson, Rosenbaum, Spiegleman & Friedman, P.C. His article was originally presented as a speech before the Greater Denver Tax Council in January 1973.SECURITIES ASPECTS

Over the past few years, real estate limited partnerships have increasingly been used to raise capital to buy real estate investments, provide limited liability for the non-active investors and allow tax shelter to be passed through to these investors while they are receiving cash distributions. While the advantages of this type of organization are numerous, certain problems exist.

The question of whether an interest in a limited partnership which deals in real estate is a "security" subject to federal and state securities laws has been answered in the affirmative. The Colorado Securities Commissioner dealt with this question in a release issued November 6, 1970. A security exists when an investor provides capital and shares in the risks and the profits, and the promoter or a third party manages, operates and controls the enterprise, usually without active participation on the part of the investor. The Securities and Exchange Commission noted in Release No. 33-4491 (May 22, 1962) that: "... transactions which in form appear to involve nothing more than the sale of real estate, chattels, or services have been held to be investment contracts where in substance they involve the laying out of money by the investor on the assumption and expectation that the investment will return profit without any active effort on his part, but rather as a result of the efforts of someone else."

In Securities Act Release No. 33-4877 (August 8, 1967) the SEC noted that: "Under the Federal Securities Laws, an offering of limited partnership interests and interests in joint and profit sharing real estate ventures generally constitute an offering of a 'profit sharing agreement' or an 'investment contract" which is a 'security' within the meaning of Section 2(1) of the Securities Act of 1933. The Supreme Court has said that an 'investment contract' is a contract, transaction or scheme whereby a person invests money in a common enterprise and is lead to expect profits from the efforts of the promoter or a third party. (SEC vs. W. J. Howey Co., 328 U.S. 293, (1946). In other words, the investor provides the capital and shares in the risk and the profits; the promoter or the third party manages, operates and controls the enterprise usually without active participation on the part of the investor."

Thus, a syndicator who wishes to form a real estate limited partnership must comply with all the rules and regulations promulgated under the Securities Act of 1933

16("the 1933 Act") and the Securities Exchange Act of 1934 ("the 1934 Act"). This can include registering, the anti-fraud provisions of Section 17 of the 1933 Act, Section 10(b) of the 1934 Act and the civil liability provisions of Section (12)(2) of the 1933 Act. However, the proposed transaction might be exempt from registeration under the securities laws.

The two most common exemptions from registering under the federal securities laws are known as the private offering (Section 4(2) of the 1933 Act) and the intrastate exemption (Section 3(a)(11) of the 1933 Act). These two exemptions have been codified in the past few months by SEC proposed Rules 146 and 147.

Private Offering ExemptionThe first exemption which real estate syndicators look to is the private offering exemption. This exemption, set forth in Section 4(2) of the 1933 Act, was created for situations in which a limited number of people deemed to be sophisticated investors would not need the protection of the Act.

Formerly the general rule was that if not more than 25 persons were approached to invest a private offering would exist. However, the Supreme Court in SEC v. Ralston Purina Co., 346 U.S. 119 (1953), established the basic criteria to be considered in determining the availability of the private offering exemption. The test is whether the offerees need the protection afforded by the 1933 Act as evidenced by whether the offerees have "access" to the kind of information that registration would make available and whether they are able to fend for themselves. This in effect eliminated the 25-person test as the Supreme Court did not limit the test to any number of people.

This left as the key test the determination of the identity and type of person to whom the securities are offered, the dollar amount of the offering, the number of investors and the restriction on transferability of the initial investors. In addition, the SEC has taken the position that the exemption only applies in cases where there have been negotiated transactions and where the transactions are not part of a series or "integrated" pursuant to SEC Release No. 33-4552.

The SEC is attempting to codify the rules through proposed Rule 146, contained in Securities Act Release No. 33-5336 (Nov. 28, 1972). If a party can comply with all of Rule 146 he should be safe. However, if an issuer feels that he would be able to meet the criteria as set forth in the relevant judicial and administrative interpretations of Section 4(2) in effect at the time of the proposed transaction, he may take his chances and offer to sell without complying with Rule 146.

The key parts to Rule 146 are as follows:

1. The manner of the offering is limited and the issuer or any person acting on his behalf is prohibited from offering the securities through any form of general advertising.

2. The offeror or his representative must have reasonable grounds to believe that each offeree is able to fend for himself in the transaction and able to bear the economic risks of the investment.

3. The same kind of information that the 1933 Act would make available in the form of a registration statement shall be provided to the offeree or his investment representative during the course of the negotiated transaction, as well as access during this time to verify the accuracy of the information supplied.

4. In any consecutive 12-month period there shall be no more than 35 purchasers of the issuer's securities (excluding cash purchasers of $250,000 or more).

5. The issuer of the security must limit disposition by doing at least the following: (a) placing a legend on the certificate or other documents evidencing the securities indicating that they were not registered and cannot be transferred without registration or an available exemption; (b) issuing stop-transfer instructions to the transfer agent, if any, or making an appropriate notation in the issuer's records, if the issuer transfers its own securities; and (c) obtaining

   17a written agreement from the purchaser that the securities will not be resold without registration or other compliance with the 1933 Act. It seems only (c) would apply to real estate limited partnerships.

6. If the issuer has sold securities in reliance on this exemption in an amount exceeding $50,000 in the 12 months preceding the first sale, he must file a report of sales within 45 days after the end of any quarter of the issuer's fiscal year during which sales are effected pursuant to the rule.

   Proposed Rule 146, if adopted, would operate prospectively only. However, the syndicator seeking the private offering exemption bears the burden of proof of his exemption. In addition, he must prove that he met the tests as to all offerees pursuant to Lively v. Hirschfeld, 440 F.2d 631 (1971).

   Section 125-1-1 et seq. of Colorado Revised Statutes Annotated (1963) sets forth the Blue Sky Laws, and Section 125-1-13(2)(j) defines a transaction not involving a public offering. This definition in general follows Ralston Purina, supra, and the cases thereafter, so that an exemption under the federal securities laws should act as an exemption under the state Blue Sky Laws. Most likely Colorado would also follow Rule 146, if adopted.

   Intrastate ExemptionThe next major exemption under the federal laws involving registration is the intrastate exemption, contained in Section 3(a)(11) of the 1933 Act. Intrastate offerings have certain advantages in that the time and cost of bringing an issue to market is generally much less than registering an issue with the SEC. However, the issuer is still subject to the anti-fraud provisions of the 1933 and 1934 Acts.

   Through Securities Act Release No. 33-4434, SEC v. Truckee Showboat, Inc., 157 F. Supp. 824 (1957), and various other cases and releases, the SEC has developed guidelines and standards for qualification for the...