CHAPTER 3 A PRIMER ON SELECTED ACQUISITION INCOME TAX ISSUES FOR THE NON-TAX LAWYER
| Jurisdiction | United States |
(Nov 1995)
A PRIMER ON SELECTED ACQUISITION INCOME TAX ISSUES FOR THE NON-TAX LAWYER
Holland & Hart
Denver, Colorado
INTRODUCTION
The acquisition of oil and gas properties involves income tax issues germane for both the purchaser and the seller. Many times, income tax issues are a minor part of the calculus of acquiring or transferring a property; other times they are the central feature of the planning involved. In all cases, however, income tax issues will play a role in the acquisition or dispostion of the property.
This Paper briefly outlines some of the important income tax issues that arise in connection with the transfer of oil and gas properties. This Paper does not attempt to discuss all of the income tax issues that may arise on the transfer of oil and gas properties.
CHOICE OF ENTITY ISSUES
General
The purchaser must determine what type of entity it wishes to employ whenever an acquisition is made. In many, if not most, cases, the purchaser may itself be an entity that is already organized, and there may be no flexibility in terms of organizing a separate acquisition vehicle. Even in circumstances in which the acquiror is an entity, it may be wise to organize a separate acquisition vehicle, if for no other reason, to isolate the
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purchaser's current activities from the potential liabilities associated with the ownership of the acquired properties.
C Corporations
The use of so-called "C corporations" is advantageous because it is relatively easy to organize a corporation, and the law governing corporate enterprises is relatively certain. Because of this certainty, and the relative lack of flexibility accorded the corporate form of doing business, it is simple to organize a corporation, and the documents governing corporate formation are always standard form.
Unfortunately, the tax consequences associated with using a C corporation in circumstances in which the corporation owns significant assets are generally adverse. This arises because a corporation is a separate taxable entity that is subject to income tax relative to its own earnings, and because the distribution of those earnings to shareholders is generally taxable. Although a single-level tax regime can be achieved in the C corporation context by paying the corporation's earnings out to its shareholders through deductible payments (such as payments for the services rendered by shareholders), there will generally be a double tax to pay on the sale of substantial corporate assets and, the distribution of the proceeds of the sale.
As noted above, the corporate form is typically an inflexible means of conducting business. For example, if there are two or more independent persons that wish to conduct business
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and they have differing tax objectives, or a differing economic sharing arrangement relative to the activities of the corporate enterprise, it is difficult to employ the corporate forum to achieve these objectives. From a tax perspective, the failure to flow through tax attributes attributable to the operations can adversely affect a particular investor because of the investor's particular tax situation. Furthermore, if one of the investors is contributing capital and the other investor is contributing past, present or future services, the receipt of shares will be taxable to the service provider and, absent the use of some sort of debt or preferred shares, there is no means of returning capital preferentially to investors contributing capital.
General Partnerships
A general partnership or joint venture arrangement can afford significant operational flexibility to partners having varying economic or tax interests. From a tax perspective, the general partnership is often preferable to a corporation because a general partnership will be treated as a pass-through tax entity for tax purposes,1 because tax items can be disproportionately allocated among the partners2 and because the
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partnership agreement is generally flexible enough to permit the partners to organize their affairs in virtually any manner they wish.
The very flexibility of partnership structure, however, is also its most unappealing characteristic—it is virtually never inexpensive to draft a partnership or joint venture agreement used to operate a commercial venture by parties with potentially adverse interests. A general partnership can also be unappealing because of its joint and several liability feature. Moreover, many investors have concerns using general partnerships because of the inherent agency power of each partner to bind the partnership.
Partnerships also possess some undesireable tax characteristics. For example, under Section 704(c)3 a partner contributing property having a value that exceeds its basis may discover that tax allocations relative to depletion or depreciation attributable to the contributed property must be disproportionately allocated to another partner contributing money. Moreover, distributions of contributed property made
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within five years of the date on which the property was contributed can result in taxable gain.
Limited Partnerships
The use of a limited partnership preserves all of the flexibility of a general partnership, but permits investors to have limited liability. This limited liability does, however, come at a price. Investors often desire to participate in management, or, if they believe that management decisions are improperly made, the investors may desire to assume control over operations. Under the Uniform Limited Partnership Act and many versions of the Revised Uniform Limited Partnership Act, limited partners actively directing or managing the partnership's business will lose their limited liability.4 Accordingly, in a limited partnership context, investors must often choose between limited liability and effective day-to-day control of the investment enterprise.
A clear advantage associated with the use of the limited partnership is the ability of a limited partner to treat income allocated to him as income that is not subject to the self employment tax. Given that the self employment tax is no longer
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subject to a cap, receiving income not subject to the self employment tax (currently 2.9% in excess of approximately $60,000) can be important to individuals.
Although a general partnership will virtually always be classified as a partnership for tax purposes, a limited partnership can be classified as an association taxable as a corporation. The following corporate characteristics must be examined to determine whether a partnership is an association taxable as a corporation:
(1) Centralization of management;
(2) Free transferability of interest;
(3) Continuity of life; and
(4) Limited liability.5
The partnership will not be classified as an association taxable as a corporation unless it possesses at least three of these four corporate characteristics.6
The determination of whether the corporate characteristic of centralization of management exists with respect to a limited partnership is usually dependent upon whether the general partner has a substantial proprietary interest in the partnership.7 The Service's ruling position is that an interest of 20% or more constitutes a substantial interest for this purpose.8 However,
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the regulations imply that even if a general partner holds a substantial interest in the limited partnership, the limited partnership may nevertheless possess the corporate characteristic of centralized management if the limited partners have an unrestricted right to remove the general partner.9 Furthermore, if the limited partners control the general partner, the corporate characteristic of centralized management may exist.10
The corporate characteristic of free transferability of interest exists if each partner in the partnership or partners holding substantially all of the interest in the partnership may, without the consent of other partners, substitute for themselves in the partnership a person who is not a member of the partnership.11 For this purposes, the Service has announced that it will rule that free transferability does not exist if the partnership agreement restricts the transferability of more than 20% of all of the interests in partnership capital, income, gain, loss, deduction and credits.12 The common means of avoiding free transferability of interest is to give the general partner
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the right to refuse to admit the transfer of a limited partner to the partnership.13
A limited partnership lacks the corporate characteristic of continuity of life if the partnership dissolves on the death, disability, bankruptcy, withdrawal, or dissolution of the general partner.14
Finally, a limited partnership possesses the corporate characteristic of limited liability only if the general partner has no substantial assets (other than its interest in the partnership) that could be reached by a creditor of the partnership, and the general partner is merely a "dummy" acting as an agent of the limited partners.15 According to applicable case law, this portion of the regulations prescribes a two-part test: The corporate characteristic of limited liability will exist only if the general partner both lacks substantial assets and is controlled by the limited partners.16
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Limited Liability Companies
Limited liability companies ("LLCs") generally constitute an ideal compromise between the limited-liability-but-no-participation-in-management approach of the limited partnership and the unlimited joint and several liability of general partnerships. In the LLC, members generally retain their limited liability qua members. Nevertheless, they may participate in management either by being designated a manager of the LLC or by acting as a member in a member-managed LLC. From a tax perspective, however, there are some...
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