At the 2007 Fall Meeting of the LLCs, Partnerships and Unincorporated Entities Committee of the American Bar Association's Business Law Section, the Model Real Estate Limited Liability Company Operating Agreement (which is based on the Delaware Limited Liability Company Act) was presented for publication (the "Model Agreement"). During the course of drafting that agreement and its extensive commentary, the joint task force of the LLCs, Partnerships and Unincorporated Entities Committee and the Taxation Committee of the ABA Business Law Section responsible for the project (the "ABA Joint Task Force") discussed many common mistakes and oversights that frequently are encountered when negotiating and reviewing operating agreements. This article describes some of those miscues and oversights, all of which, and others, are discussed in more detail in the commentary to the Model Agreement.


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It is a common fact of life that businesses get sued from time to time by employees and former employees. It is critical that businesses understand the potential employment tax considerations associated with such litigation, whether involving a settlement or judgment. Businesses that fail to understand the potential tax implications can find themselves liable for substantial taxes, penalties and interest when the taxing authorities come calling. This article provides a brief primer on the major employment tax considerations businesses should understand.


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On May 8, 2008, the U.S. District Court for the Northern District of Alabama held that the tax accrual workpapers of Regions Financial Corporation ("Regions") were protected by the work product privilege and that the taxpayer's disclosure of such workpapers to Ernst & Young, its independent auditors, did not waive the privilege. Regions Financial Corp. v. U.S., No. 2:06-CV-00895-RDP (D. Ala. May 8, 2008).

During 2002 and 2003, Regions engaged in two "listed transactions." The IRS, as part of its examination of these transactions, served a summons on Ernst & Young ("E&Y"), requesting the tax opinions prepared by a law firm retained by Regions to analyze the transactions. The IRS also summoned certain other documents prepared by E&Y that examined the tax opinions and evaluated the tax consequences of the transactions. Regions instructed E&Y to withhold the documents on the grounds of work product privilege.


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I. The Tax Tail Should Never Wag the Deal Dog

But in private equity, tax structures can significantly affect deal price and portfolio company returns. This is especially true in "rollover" transactions, where the private equity fund (PEF) encourages the founders (Fs) to leave part of their target company (T) stock in the deal. Rollovers not only help align the Fs' interests with those of the PEF, they also bridge valuation and transaction financing gaps.

Fs often insist on a tax-deferred rollover - meaning they pay no tax on their retained equity until it is sold in the future. At the same time, PEFs generally favor transaction structures that permit them to increase (or step up) the basis in T's assets by the amount of the deal price.

This is because portfolio company cash flows and PEF returns can be enhanced by the ability to amortize and deduct purchase price against T's future profits. Unfortunately, deal structures that permit Fs to reinvest equity on a tax-deferred basis can limit the PEF's ability to step up the tax basis of T's assets.


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Summary

In Swallows Holding, Ltd. v. Comm'r (2008 U.S. App. LEXIS 3442 (3d Cir. 2008)), decided on February 15, 2008 ("Swallows Holding"), the U.S. Court of Appeals for the Third Circuit reversed the Tax Court and upheld the requirement of the regulations under Code Section 882 that a foreign corporation file a tax return within a prescribed deadline in order to be entitled to deductions and credits related to its U.S. business income (the "timely filing requirement"). The Tax Court, in Swallows Holding, Ltd. v. Comm’r (126 T.C. 96 (2006)), had invalidated the timely filing requirement under the six-factor standard governing the judicial review of interpretative Federal tax regulations set forth in Natl. Muffler Dealers Association v. United States (440 U.S. 472 (1979)) ("National Muffler"). The Court of Appeals reversed, holding that the timely filing requirement was a reasonable exercise of the Treasury’s authority and that the Tax Court had erred in analyzing the reasonableness of the requirement under National Muffler rather than under the standard of Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc. (467 U.S. 837 (1984)) ("Chevron"), which is generally more deferential to agency action.


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As uncertainty in the current economy continues to grow, corporations may have some opportunities to take worthless stock deductions in subsidiaries whose business have become worthless. The ability to claim the deduction as an ordinary loss on affiliates has been a challenge because the worthless company must meet certain requirements. Recent guidance, however, may give some relief and present some interesting planning opportunities for corporate taxpayers.


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Background

Treasury has issued final regulations under section 1446 that provide guidance on how a partnership may reduce its section 1446 withholding requirement by taking into account certain types of deductions and losses passed through to a foreign partner, and that provide rules on how a foreign partner may certify its allocable share of deductions and losses. Section 1446 generally requires a partnership with taxable income that is (1) effectively connected with the conduct of a U.S. trade or business (ECTI) and (2) allocable to a foreign partner under section 704 to withhold tax at the highest marginal rate applicable to corporations or individuals, as appropriate.

The withholding requirements apply to both U.S. partnerships and foreign partnerships. In response to taxpayers' comments, the final regulations have somewhat liberalized certain provisions in the previously issued temporary regulations regarding the circumstances in which a foreign partner will be eligible to certify deductions and losses to a partnership for reduced withholding. However, stricter rules regarding defective certificates now apply. Additionally, new certification rules for tiered partnerships are provided. The final regulations allow deductions for state and local taxes to reduce the partnership's withholding obligation and modify the rules governing how NOLs should be taken into account for this purpose.


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Background

Financially distressed businesses must not only navigate the minefields of potential foreclosure or debt restructuring, but may also be confronted with significant tax liabilities at the worst possible time. The problem arises because the foreclosure of property can trigger either taxable gain or cancellation of indebtedness income, and even a workout that avoids foreclosure or liquidation of the company may trigger cancellation of indebtedness income for the borrower. However, with planning, such tax consequences can often be minimized.


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Introduction

There are many hundreds of federal tax authorities potentially critical to tax accountants and lawyers in handling federal tax issues for their LLC clients. These authorities take the form of, among other things, Internal Revenue Code provisions; decisions by the Tax Court and other federal courts; U.S. Treasury Department temporary and final regulations; Internal Revenue Service proposed regulations; and IRS revenue procedures, revenue rulings and private letter rulings. And of course the list of these LLC federal tax authorities is constantly growing.

However, in my experience, the most important of these authorities are the 10 individual authorities and closely related pairs of authorities listed and briefly described below. In my view, every accountant and lawyer who handles LLC federal tax matters should have at least a general familiarity with each of these authorities.


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As we mentioned in a prior newsletter, the National Conference of Commissioners on Uniform State Laws (NCCUSL) has formed a committee to review and likely revise the Uniform Division of Income for Tax Purposes Act (UDITPA). This project has attracted considerable controversy thus far, with some parties arguing that uniformity in the state corporate income tax field is neither possible nor desirable, and other parties claiming the opposite: that greater uniformity is both possible, as evidenced by the many states that adopted UDITPA's basic framework in the 1960s, and also leads to lower administrative and compliance costs and a more equitable tax system.

As many of you know, UDITPA is a very important uniform act in the state income tax context, as it provides rules governing the sourcing of income of businesses operating in multiple states. Most states have generally followed the UDITPA sourcing rules, although a number of states have deviated from the UDITPA rules in various ways (some more significant than others). Any revision to UDITPA will likely be adopted by at least some states, and may be adopted by many states. Accordingly, the work of the drafting committee in reviewing and revising UDITPA may ultimately have a significant impact on the taxation of multi-state businesses.


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CHAIR:
L. Andrew Immerman
Alston & Bird LLP
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1201 W Peachtree St NW
Atlanta, GA 30309-3449
andy.immerman@alston.com



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