Cost reimbursements to partners are getting attention at the IRS.
The IRS is concerned about double dipping in partnerships as follows. A developer borrows to pay its costs to develop or build a project. The developer contributes the development rights or project to a partnership and a money partner is brought in as the other partner. The partnership assumes the debt. The money partner will be allocated most of the economics, leaving the developer with only a carried interest.
The developer is distributed cash to reimburse it for its spending on the project in the two years before the partnership was formed.
Under the US tax rules, the money partner gets to include the debt the partnership assumed in its “outside basis.” Its outside basis is a way of measuring what the partner contributed to the partnership and what it is allowed to take out. The additional outside basis gives the money partner more room to claim depreciation and other tax losses and be distributed cash without having to pay taxes on the cash.
Meanwhile, the developer may be able to receive the cash distribution to reimburse it for its spending on the project before the partnership was formed tax free under something called a “pre-formation expense safe harbor.”
The IRS believes it is double dipping to let the developer receive this cash tax free and set up the money partner also to receive the same amount of cash tax free because the debt that funded the spending has now been moved to its outside basis.
The IRS is expected to deny use of the pre-formation expense safe harbor in such cases to the developer. The cost reimbursement to the developer would not be tax free. Instead, the developer would be treated as having made a “disguised sale” of the development rights or project to the partnership for the money it was distributed. This is expected to be addressed in regulations on disguised sales that the IRS hopes to release later this year.