In a prior post (Beneficial Ownership Under the Corporate Transparent Act: The Capital Calculation Rules), I described how FinCEN’s Reporting Rule for preparing BOI reports required the reporting company to determine whether it was subject to the Partnership Capital Rule or the Corporate Capital Rule. In this post, I am going to de-construct the Partnership Capital Rule and outline how reporting companies should apply it.
Beneficial Ownership Under the Corporate Transparency Act: The Capital Calculation Rules
The CTA will require more than 35 million businesses to file a beneficial ownership information (BOI) report with FinCEN. The BOI report will need to provide specific items of personally identifiable information (PII) about each beneficial owner of the company.
Calculating Beneficial Ownership under the Partnership Capital Rule
FinCEN’s Reporting Rule distinguishes between the test for calculating percentage (1) for reporting companies “that issue capital or profit interests (including entities treated as partnerships for federal income tax purposes)” and (2) those that are “treated as corporations for federal income tax purposes, and other reporting companies that issues shares of stock.” See 31 CFR 1010.380(d)(2)(iii), subsections (B) though (C) (emphasis added).
This distinction can be confusing, and I wrote earlier that it sought to distinguish between (1) entities taxed as a partnership as well as other (non-partnership) entities that issue capital or profit interests, and (2) those taxed as a corporation, including those that issue shares of stock.
Reporting Companies Subject to the Partnership Capital Rule
If a reporting company falls into the first category (i.e. subsection (B) of 31 CFR 1010.380(d)(2)(iii)), the reporting company must follow the “Partnership Capital Rule” in subsection (B). The Partnership Capital Rule provides that an individual is a beneficial owner if the individual:
“owns or controls at least 25 percent of the ownership interests of a reporting company . . . directly or indirectly . . . calculated as a percentage of the total outstanding ownership interests” by calculating “the individual’s capital and profit interests in the entity, calculated as a percentage of the total outstanding capital and profit interests of the entity.”
The phrase “outstanding capital and profit interests of the entity” can be challenging to apply.
FinCEN’s discussion of the Reporting Rule so far has not focused on the meaning of this phrase and the terms “capital interest” and “profit interest” are not defined in the Reporting Rule.
In the context of tax law, the IRS defines “capital interest” as the amount a partner would expect to receive in a liquidation of the partnership in respect of the partner’s capital account. See Rev. Rul. 93-27, 1993-2 C.B. 343. For many partnerships (especially those that make an IRC Section 754 election) a partner’s outside tax basis is equal to the partner’s tax capital account (which often differs from the book capital account). The partner’s tax capital account can include his or her share of partnership liabilities and adjustments under IRC Section 743 as reported on IRS Schedule K-1. For many reporting companies, this can be a complex calculation and will require coordination with the accountants or other professionals who prepare the reporting company’s income tax returns and reports on Schedule K-1. In theory, however, the aggregate capital interest of all the partners in the partnership should be a determinable value, based on items calculated as of a specific date in time.
Elsewhere in the Reporting Rule, when FinCEN wanted to incorporate terms from other laws, the Reporting Rule cited those other laws specifically. (For example, in the large operating company exemption, when referring to the number of “employees,” the Reporting Rule takes pains to cite the Affordable Care Act regulation that defines that term.) In the Partnership Capital Rule, however, FinCEN simply uses the phrase “capital interest” without defining it, suggesting that FinCEN did not intend to incorporate any terms defined in the tax code.
The phrase “profit interest” also might describe a tax accounting concept or a more generic reference to the concept of the interest a partner has in deriving a profit.
Partnerships often issue a “profits interest” as a form of employee compensation under the provisions of Rev. Proc. 93-27 which defines the “profits interest” as a partnership interest “other than a capital interest.” At the same time, a partnership’s constituent document (the partnership agreement or LLC operating agreement) may distinguish between distributions of cash made in respect of each partner’s capital account and distributions to a partner made in respect of their percentage interest. This later percentage interest can termed a “profit interest” because it is an interest distinct from the capital interest.
When it wrote the Reporting Rule, FinCEN likely thought of the “profit interest” as this later type (rather than a “profits interest” under Rev. Proc 93-27) because (a) FinCEN did not refer to the IRS guidance that would have defined the term more specifically, and (b) the sum of a partnership’s capital interest and its profit interest only describes the aggregate liquidation proceeds of the partnership if the term “profit interest” describes every interest that is not a capital interest.
As a result, the Reporting Rule is ambiguous with respect to the definition for “profit interest.”
But, calculating a partnership’s “total outstanding . . . profit interests” is only feasible if either (a) profit interests are always distributed pursuant to a fixed percentage (i.e., to each partner based upon a percentage rate), or (b) the aggregate value that would be distributed (i.e., the aggregate liquidation value of the partnership) can be determined definitively.
If the reporting company can calculate (a) the aggregate capital interest of all the partners in the partnership, and (b) the aggregate profit interest of all the partners in the partnership, only then can the reporting company calculate each partner’s percentage share of that aggregate value.
When the Calculation is Not Reasonably Determinable
Subsection (D) of 31 CFR 1010.380(d)(2)(iii)) provides that “if the facts and circumstances do not permit the calculations described in [the Partnership Capital Rule, subsection (B)] to be performed with reasonable certainty, any individual who owns or controls 25 percent or more of any class or type of ownership interest of a reporting company shall be deemed to own or control 25 percent or more of the ownership interests of the reporting company (emphasis added).”
When would such calculations not be “reasonably certain”. Again, the Reporting Rule gives little guidance on this question. FinCEN’s Small Entity Compliance Guide provides only simple examples and devotes only a single line (on page 23) to the rule that applies “if none of these calculations apply to your company.”
The best example of a partnership structure that would render the Partnership Capital Rule incapable of being “performed with reasonable certainty” is when the partnership’s constituent documents require that its profit interests be distributed at a different percentage rate than the percentage rate applied to the distribution of capital interest.
In other words, if capital interests and profit interests are always distributed to the partners at a fixed percentage rate, then the partnership’s liquidation value doesn’t matter: each partner would always receive the same percentage. (And that percentage is the percentage that would apply for purposes of the Partnership Capital Rule.)
But, if capital interest and profit interests are distributed at different percentage rates then you cannot calculate the “ultimate” percentage interest of any partner unless you can calculate the liquidation value of the partnership and apply the several percentage rates to that total value. In such a circumstance, if the total liquidation value cannot be determined, then the applicable percentage interests also cannot reasonably be determined.
If the applicable percentage interests cannot reasonably be determined, then the reporting company must apply the “failsafe rule” in subsection (D), that asks the reporting company to identify as a beneficial owner any “individual who owns or controls 25 percent or more of any class or type of ownership interest of [the] reporting company.”
Examples that Apply the Partnership Capital Rule
Example #1. Alpha Partnership is an LLC that has elected to be taxed as a partnership. Alpha Partnership has five members: A, B, C, D and E. Each of the five members contributed the same amount of capital to the partnership. The Alpha Partnership operating agreement provides that all distributions should be made (a) to each partner until the capital account of each partner has been reduced to zero, and (b) thereafter, 20% to each of the five partners.
In Example #1, because each of the five members contributed the same amount and the percentage rate applicable to the profit interest is the same as the percentage applied to the capital interest, the ultimate liquidation value of the partnership doesn’t matter: each member will always receive 20% of any distribution. As a result, none of these five partners has 25% or more of the “total outstanding capital and profit interests of the entity.” In Example #1, the Partnership Capital Rule produces a reasonably certain outcome, so there is no need to apply the failsafe rule in subsection (D).
Example #2. If the facts are the same as Example #1, except that members A and B each contributed $1,000,000 to the partnership’s capital, while members C, D and E contributed only $100,000.
In Example #2, the reporting company cannot determine the “total outstanding capital and profit interests of the entity” because the rates of distribution will vary based upon the liquidation value of the partnership. For example, if the liquidation value of the partnership was $2,300,000, then A and B would each get $1,000,000 (a little more than 43%) while C, D and E would each get $100,000 (less than 5% each). But, if the liquidation value of the partnership was $100,000,000, the amount received by each of the five partners would be nearly equal. (Members A and B would each get $20,540,000 (20.54%) while members C, D and E would each get $19,640,000 (19.64%).
In Example #2, the Partnership Capital Rule does not produce a reasonably certain outcome (unless the precise liquidation value of the partnership can be determined). Consequently, the partnership in Example #2 would need to apply the failsafe rule in subsection (D) of Section 380(d)(2)(iii)
Conclusion
Reporting companies that must apply the Partnership Capital Rule will need to coordinate their analysis with counsel and with the tax and accounting professionals that prepare the reporting company’s tax returns and Schedule K-1. If the reporting company’s constituent documents provide that distributions must always be made at the same percentage rate, the reporting company will probably be able to apply the Partnership Capital Rule with reasonable certainty. But, if the constituent documents provide for varying distribution rates, the reporting company will probably not be able to complete the calculations under the Partnership Capital Rule with reasonable certainty. In that event, the reporting company will need to apply the failsafe rule in subsection (D) of 31 CFR 1010.380(d)(2)(iii).
