| EXECUTIVE SUMMARY | |  CPAs can use their expertise to structure partnerships between long-term community investors and developers who want to contribute to improving markets without displacing current residents and local businesses.
For tax purposes, forming an LLC may be the best approach to a development partnership. The partners generally benefit from reporting their share of LLC taxable income on their individual tax returns, avoiding the double taxation of a C corporation. An increase in equity creates a win-win situation. In this example the property owner converts his equity to cash and retains title to his business property. The developer takes advantage of an improved loan-to-value ratio to leverage her cash and secure project financing. An LLC may allow for more flexible terms when negotiating the details of community development partnerships. It is unlikely that each member will contribute an equal value of property or cash. It’s important for the operating agreement to comply with IRC section 704. This substantiates that income allocations have economic substance and are likely to be accepted for tax purposes. Curtis O. Sanders, CPA, is the former CFO of Abyssinian Development Corp., Harlem, N.Y. He can be reached at tljbear@hotmail.com . |
A major challenge of community development is crafting a plan to revitalize neighborhoods without displacing current residents and local businesses. CPAs can use their expertise to help structure partnerships between people with long-term investments in their community and developers looking to invest in the improving market conditions. This article uses a hypothetical situation involving a businessman named Mr. Smith to explore several tax and accounting issues that can arise through such a partnership. Mr. Smith owns a five-story, corner building on a prime commercial boulevard. From the first floor of this building, he operates a profitable business, Smith Hardware. The top floors of the building, which was originally a rooming house, have been vacant since he purchased it. The cellar is used for storage. (It is common for buildings in undervalued areas to be underutilized in this manner). There are no mortgages on the building, and Mr. Smith’s tax basis in the property is zero. As a result of neighborhood improvements, property values have increased dramatically since Mr. Smith originally invested in the property. He now wants to benefit from the improved market conditions while continuing to operate his hardware store.
Mr. Smith originally considered selling the building to profit from the economic turnaround, but he didn’t want to relocate his business or be forced to negotiate a lease with the new owner to remain at his current location. A more viable alternative came about when he was approached by Ms. Johnson, a community-oriented developer who offered to convert the top floors into condominiums, sell the units, and share the profits with Mr. Smith on an equitable basis. To accomplish this, a single purpose limited liability company (LLC) was formed (see “ The Choice-of-Entity Maze,” JofA, March 07, page 64). The LLC form was chosen over a C corporation to avoid double-taxation issues later on. The resulting company, Smith Development LLC (SDL), has two members: Mr. Smith (who would contribute his property to SDL) and Ms. Johnson (who would contribute cash to cover the pre-development and soft cost of development). Soft costs generally include architectural, engineering, legal fees, financing fees and other costs not directly associated with construction of the project. Construction financing would cover the cost directly associated with renovating the units, often referred to as hard costs. Once the condominium units are completed and sold, Mr. Smith will receive the first floor and cellar as a non-taxable liquidating distribution. This alternative allows Mr. Smith to convert equity in his property to cash, to benefit from the development and sale of the condominium units, and retain title to the space he uses to operate his hardware store. Ms. Johnson significantly improves her loan-to-value ratio (the amount the bank will finance based on the projected value of the completed project) by partnering with someone who has clear title to the property. Generally, the lower the loan-to-value ratio, the easier it is to obtain financing. Since a significant portion of the value of the completed project is the result of the appreciated value of the land, Ms. Johnson minimizes her cash investment. | Tax Considerations The transfer of property from Mr. Smith to SDL should be a tax-free event, under the Internal Revenue Code (IRC). However, it may be subject to state or local transfer taxes. For book purposes, the fair market value of the property will be credited to Mr. Smith’s equity account. For tax purposes, Mr. Smith’s basis in the property remains unchanged. The difference between the property’s book basis and tax basis results in a built-in gain that will be recognized upon sale of the units. IRC section 704(c) requires special allocations to accommodate built-in gains. The regulations provide for three methods of making special allocations: the Traditional Method; the Traditional Method with Curative Allocations; and the Remedial Allocation Method. The regulations also allow the use of any other reasonable method as long as it is consistently applied. Under IRC section 707, if Mr. Smith receives a cash distribution within two years of contributing his property to SDL, this distribution would be presumed to be part of a disguised sale. However, this presumption can be overcome. The underlying principle to guide the exchange of Mr. Smith’s property for an equity interest in SDL is that in substance, as well as form, Mr. Smith’s equity in SDL is subject to the entrepreneurial risks of entity operations. This will mitigate the risk of the transaction being designated as a disguised sale.
Several factors are considered when determining if an LLC member is subject to entrepreneurial risk. Some of these factors include the timing and amount of the distribution, a member’s legal right to receive a distribution, how the distribution is funded, and the liquidity of the business. The type and amount of liabilities assumed by the LLC are also factors in determining if a disguised sale has occurred. It is possible that the transaction could be reclassified as a sale or partial sale if in substance the transaction is deemed to be a sale SDL profits may be divided in a manner that does not correspond to the percentage of equity contributed at fair market value. Accordingly, a CPA should review SDL’s operating agreement to ensure that provisions regarding compliance with IRC section 704 are included. The three primary provisions of IRC section 704 that should be incorporated in the operating agreement are: 
Proper maintenance of capital accounts.
Liquidating distributions made in accordance with the positive capital balances of the partners.
Partners with negative balances in their capital accounts will be subject to qualified income offset. These provisions substantiate that income allocations have substantial economic effect and are likely to be accepted for tax purposes. Mr. Smith’s equity account will be credited for the full fair market value of the property contributed. However, the first floor and the basement will be returned to Mr. Smith as a liquidating distribution, and the upper floors will be developed and sold as condominium units. The value of the property that will eventually be returned to Mr. Smith should be classified as “Held for Use.” The value of the property that will be allocated to the cost of the condominiums should be classified as “Held for Sale.”
| Adding numerical data to the hypothetical case illustrates how the project would be funded and how cash derived from projected profits would be distributed. The value of the property contributed by Mr. Smith should be determined by a qualified real estate appraiser when it is contributed. The AICPA Audit and Accounting guide Use of Real Estate Appraisal Information is an excellent resource for selecting and instructing the appraiser. | New Valuation Standard AICPA members should be aware of AICPA Statement on Standards for Valuation Services no. 1, Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset (SSVS1). Paragraph 6 of that statement says SSVS1 does not apply when the subject of the valuation is provided by the client or a third party (such as a real estate appraiser) and the CPA does not apply valuation approaches and methods. SSVS1 would not apply in this example, assuming the CPA is not estimating the value of Smith Development LLC or its equity. As a practical matter, the CPA should have a clear understanding of the services being provided. |
A real estate appraiser estimates the fair market value of Mr. Smith’s property at $1.6 million. Of this amount, $1 million is allocated to property “Held for Sale” and $600,000 is allocated to property “Held for Use” (see sidebar “Tax Considerations”). The building does not have a mortgage. The project manager determines that 12 condominium units can be developed at a total hard cost of $1,837,500, to be financed by a construction loan (the total includes interest expense). The estimated soft cost of $367,500 is to be funded by the developer. Thus, the total cost to develop the property is $3,205,000. The projected sales price for each unit is $450,000 for total projected revenue of $5.4 million. Mr. Smith and Ms. Johnson agree to share the profits equally. The sources and uses of funds for the transaction are presented in Exhibit 1.
SDL’s Statement of Position before construction financing illustrates how equity contributed by each partner is reflected on its Source & Use of Funds (see Exhibit 2). SDL’s Statement of Position after the units are completed illustrates that the equity and financing have been used to complete development of the condominium units (see Exhibit 3). SDL’s Statement of Position after the sale of the condominiums is presented in Exhibit 4. The $5,184,000 cash shown in Exhibit 4 reflects the projected sales cost of the 12 condominiums minus sales costs of 4% or $216,000.
By partnering with a community-oriented, for-profit developer, Mr. Smith has the potential of earning more than the estimated $1.6 million FMV of his property (see exhibits 5 and 6). In addition, he will be able to retain title to the commercial space of the property that he develops. Mr. Smith has the option of selling or renting his commercial space in the future.
In real estate deals everything is negotiable. In this case, the developer (Ms. Johnson) would assume the financial risk of all pre-development and soft costs in exchange for 50% of the profits and a developer’s fee. The transfer of title from Mr. Smith to SDL would occur contemporaneously at the loan closing for construction financing. Mr. Smith could focus on operating his hardware store knowing that his partner has a financial interest in completing the project in a timely and profitable manner. Depending on the facts of the particular deal, the profit distribution percentages may vary. Some deals will require a cash payment from the developer to the property owner. If the property has an existing mortgage, this will also affect how a deal would be structured.
| Accounting for Impairment FASB Statement no. 144, Accounting for Impairment or Disposal of Long-Lived Assets, provides guidance on the impairment of real estate assets for financial reporting purposes. While a project is being developed, its carrying amount is equal to its cost, as long as that amount is not greater than the expected future cash flows of the project (undiscounted). If the project incurs an impairment loss while under development, the impairment would be recorded as a write-down, which reduces the carrying amount of the assets and establishes a new cost basis for the asset. Restoration of previously recognized impairment losses is prohibited. After the project is completed, an impairment loss against assets designated as held for sale would be recorded as an allowance against the net carrying amount of the asset. Subsequent increases in fair value may reduce the allowance; however, the allowance cannot be reduced below zero. An impairment loss against the assets designated as held for use would be reflected as a write-down. In both cases the impairment losses should be reported as part of income from continuing operations before income taxes. |
Another scenario for which this type of deal may be appropriate is one in which a longtime resident owns property in an area that is developing condominiums. The homeowner would partner with a community developer to develop condominiums, then share in the profits of the condominium sales and receive one of the units as a liquidating distribution.
Community development corporations in conjunction with state, local and federal agencies are doing an outstanding job in developing and revitalizing underserved communities. Major for-profit entities will invest in underserved communities once they are confident the area is in transition. CPAs serving clients in underserved communities can help them take advantage of new opportunities as their neighborhoods improve.   | | AICPA RESOURCES Book
Adviser’s Guide to the Tax Consequences of the Purchase and Sale of a Business, Second Edition , William Olson, CPA, Ph.D. (#091025) CPE
Taxation of LLCs, LLPs, LPs and Other Partnerships , a CPE self-study course (#731706)
LLC and Partnership Taxation: Beyond the Basics , a CPE self-study course (#731675)
Advanced Planning for LLC & Partnership Transactions , a CPE self-study course (#731536) For more information or to place an order, go to www.cpa2biz.com or call the Institute at 888-777-7077. | |
