This post follows-up on Sponsors may Claim a Bonus Depreciation from Buyouts of Tax Equity Investors. For property placed in service after January 1, 2021, the final bonus depreciation regulations create a potential obstacle to claiming bonus depreciation for many sponsors upon buying out a tax equity investor interest in a partnership. With some advance planning, this obstacle can be avoided by ensuring the tax equity partnership does not "terminate."
Prior to tax reform enacted in 2017, used property did not qualify for bonus deprecation Tax reform lifted that prohibition, but the rules required that the taxpayer to not have previously owned the property. That raised interesting questions regarding the application of the prior ownership prohibition to partners and property owned by their partnership. The proposed bonus depreciation regulations allowed, in the context of a two partner partnership, for one partner to buyout the other and the purchasing partner to claim bonus depreciation to the extent its purchase price was allocated to bonus depreciation eligible property (i.e., property with a recovery period of 20 years or less that is not tax-exempt use property).
When a partnership consists of only two partners and one partner buys out the other, the tax law views that as the partnership terminating, even if as a matter of state law the "partnership" is a limited liability company that continues to exist and operate for state law purposes.
The ability of the sponsor partner to claim bonus depreciation with respect to the buyout amount paid the tax equity investor partner is premised on the fact that Revenue Ruling 99-6 treats such a transaction as (i) the partnership distributing, in complete liquidation, undivided interests in its assets to the sponsor and the tax equity investor, and (ii) the sponsor purchasing the tax equity investor's undivided interest in such assets. Accordingly, for purposes of the bonus depreciation eligibility the sponsor only needed to be unrelated to the tax equity investor as that is whom Revenue Ruling 99-6 deems the sponsor to have acquired an undivided interest in the assets of the former partnership from.
The Final Regulations: The Series of Related Transactions Standard
The final bonus depreciation regulations added an additional hurdle, which effectively means the sponsor must also be unrelated to the partnership:
each transferee in a series of related transactions tests its [relatedness] with the transferor from which the transferee [(i.e., the sponsor)] directly acquires the depreciable property (immediate transferor [(i.e., the tax equity investor)] and with the original transferor [(i.e., the partnership)] of the depreciable property in the series. The transferee is treated as related to the immediate transferor or the original transferor if the relationship exists either when the transferee acquires, or immediately before the first transfer of, the depreciable property in the series.
The construct of the sponsor acquiring property from the tax equity investor is a legal fiction created by Revenue Ruling 99-6 (i.e., what the sponsor really did was buy limited liability company units). Therefore, the deemed distribution in liquidation followed by an acquisition of the undivided interest in the asset is most likely "a series of related transactions" because the two distinct steps only exist for tax purposes due to the legal fiction created by Revenue Procedure 99-6. Thus, the sponsor must ask was it related to the partnership immediately prior to the buyout of the tax equity investor?
The Relatedness Standard
For the purpose of the bonus depreciation regulations, the test of relatedness between a partner and a partnership is whether the partner holds more than 50 percent of the profits or capital in the partnership.
The partnership tax law is less than crystal clear as to the definition of "capital" and "profits." "Capital interest" is generally what a partner would be entitled to in a hypothetical liquidation of the partnership with the assets sold for fair market value (not book value). A "profits interest" is any interest in a partnership other than a capital interest. These definitions were established by the IRS in the context of partnership interests issued in compensation for services; nonetheless, they are often used in other areas of the tax law.
An additional gloss is that in the context of determining the taxable year of a partnership based on the taxable year of certain thresholds of the partners holding capital and profits interests, Treasury Regulation section 1.706-1(b)(4)(ii) provides with respect to "profits":
(A) … a partner's interest in partnership profits is generally the partner's percentage share of partnership profits for the current partnership taxable year. If the partnership does not expect to have net income for the current partnership taxable year, then a partner's interest in partnership profits instead must be the partner's percentage share of partnership net income for the first taxable year in which the partnership expects to have net income.
(B) The partner's percentage share of partnership net income for a partnership taxable year is the ratio of: the partner's distributive share of partnership net income for the taxable year, to the partnership's net income for the year. If a partner's percentage share of partnership net income for the taxable year depends on the amount or nature of partnership income for that year (due to, for example, preferred returns or special allocations of specific partnership items), then the partnership must make a reasonable estimate of the amount and nature of its income for the taxable year.
With respect to "capital," Treasury Regulation section 1.706-1(b)(4)(iii) provides:
Generally, a partner's interest in partnership capital is determined by reference to the assets of the partnership that the partner would be entitled to upon withdrawal from the partnership or upon liquidation of the partnership. If the partnership maintains capital accounts …, then … the partnership may assume that a partner's interest in partnership capital is the ratio of the partner's capital account to all partners' capital accounts as of the first day of the partnership taxable year.
Accordingly, if section 706 regulations apply for purposes of the bonus depreciation "relatedness" standard, the flip in the tax equity partnership may have occurred such that the sponsor is being nominally allocated 95 percent of profit and loss and the tax equity investor nominally allocated 5 percent. However, if the tax equity investor has a negative capital, then it is typically specially allocated 99 percent of the profits to eliminate its negative capital account balance.
However, it is not enough to determine the profits interest of the sponsor is 50 percent or less; the sponsor's capital interest must also be 50 percent or less. One could apply the section 706 regulation quoted above; then, if sponsor has a zero (or negative balance) capital account as of the first day of the taxable year in which the buyout is exercised, the sponsor does not have more than 50 percent of the capital based on the section 706 definition.
Alternatively, if the sponsor at the start of the year has a positive capital account that exceeds the tax equity investor's capital account (i.e., the sponsor is over 50 percent of the capital under the section 706 definition), the sponsor could follow the liquidation waterfall (rather than the relative capital account balances as of the first day of the year) assuming a sale of the partnership's assets at fair market value as provided for in Revenue Procedure 93-27, as discussed above.
It is not unusual for such liquidation waterfalls to require the tax equity investor to be allocated gain from the sale of the partnership's assets in a liquidation scenario first to eliminate the tax equity investor's negative capital account balance, and then further gain to allow the tax equity investor, based on its relative capital account balance in a liquidation scenario, to be distributed cash from the sale of the partnership's assets sufficient for the tax equity investor to avoid recognizing a loss for financial statement purposes.
This manner of analysis to determine the sponsor is not related to the partnership requires a close reading of the allocation, special allocation and liquidation provisions in the partnership agreement; further, under some of the theories a careful determination of the fair market value of the partnership's assets is required. The tax law in this area is less than clear and different definitions exist that can favor the sponsor or the IRS, depending on the facts.
An Alternative Structure: Section 743(b) Adjustment
The buyout transaction could be re-structured to allow for a sponsor that was deemed "related" to the partnership, to claim bonus deprecation on the price paid to purchase a tax equity investor's interest. The restructuring requires that the partnership continue to exist for tax purposes. For instance, the buyout could be restructured for the tax equity investor to retain a one percent (or, possibly, less) of the partnership. Assuming the partnership has a "section 754" election in effect, which tax equity partnerships typically do, that purchase would benefit from a section 743(b) adjustment. The section 743(b) adjustment results in an increase in the tax basis of the partnership assets. That increase in basis qualifies for bonus deprecation as long as the sponsor and the tax equity investor are not "related" to each other.
The IRS went out of its way to confirm that relatedness is only tested between the partners in the section 743(b) adjustment scenario: "Relatedness tested at partner level. Solely for purposes of paragraph (b)(3)(iv)(D)(1)(ii) of this section, whether the parties are related or unrelated is determined by comparing the transferor and the transferee of the transferred partnership interest."
One issue with structuring to achieve a section 743 adjustment is that the arrangement leaves the tax equity investor a partner in the partnership, which may not be palatable to either it or the sponsor. To avoid that result, the tax equity investor could sell its small retained interest to another party (e.g., a hedge fund or even one of the executives of the sponsor).
Another alternative, would be prior to buying out the tax equity investor for the sponsor to sell a one percent interest to a friendly party that is willing to hold that interest long-term, and then for the sponsor to buyout all of the tax equity investor's interest. An edgier version of the transaction would be for the sponsor to form a separate but wholly owned corporation, and that corporation acquires a one percent interest from the sponsor and then the sponsor buys out the tax equity investor in full.
The ability to restructure the buyout and use a 743(b) adjustment suggests that the IRS may not have actually intended for the buyout in the Revenue Ruling 99-6 scenario to trigger the related party prohibition. If the result in the Revenue Ruling 99-6 buyout scenario was intended, there is little policy justification for the 743(b) adjustment transaction to escape the application of the related party rule but not the Revenue Ruling 99-6 transaction.
 See Treas. Reg. § 1.168(k)-2(h)(1)(i).
 See Treas. Reg. § 1.168(k)-2(b)(3)(iii)(C).
 See I.R.C. § 168(k)(2)(ii).
 1999-1 C.B. 432 ("the AB partnership is deemed to make a liquidating distribution of all of its assets to A and B, and following this distribution, B is treated as acquiring the assets deemed to have been distributed to A in liquidation of A's partnership interest.")
 Treas. Reg. § 1.168(k)-2(b)(3)(iii)(C) (emphasis added).
 See Treas. Reg. § 1.168(k)-2(b)(3)(iii)(A)(2) (referencing, inter alia, I.R.C. § 179(d)(2)(A) (referencing, inter alia, I.R.C. § 707(b))).
 Rev. Proc. 93-27, 1993-2 C.B. 343 ("A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership.).
 Rev. Proc. 2001-43, 2001-2 CB 191 (citing Rev. Proc. 93-27) ("a profits interest as a partnership interest other than a capital interest"). For an in depth discussion, see S. Banoff, "Identifying Partners' Interests in Profits and Capital: Uncertainties, Opportunities and Traps," 85 Taxes 197 (Mar. 2007); "How Do You Measure a 'Partner's Interest in the Partnership'?," J. of Tax'n (Sept. 2014).
 Treas. Reg. § 1.706-1
 I.R.C. § 707(b)(1)(A) ("a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership" (emphasis added)).
 See Treas. Reg. § 1.168(k)-2(b)(3)(iv)(D).
 Treas. Reg. § 1.168(k)-2(b)(3)(iv)(D)(2).