Tax Season 2010

Recession Losses Create Partner Cash Flow Issues

By Arthur P. Jensen, CPA

Many businesses have continued making usual monthly partner draws to support living normally and have encountered decreased profits or even losses. As a result, such partners have received annual K-1s reflecting cash draws greatly exceeding reportable taxable income. Although tax burdens benefited, the day will come when the recession is gone, higher profits have returned and recession-caused debt will need to be amortized and paid off.

When this reversal of fortune starts to take hold, the partners likely will find the tax effects unpleasant. The generated taxable income and resulting tax liability will absorb a healthy share of the new cash flow. Thus, the disposal cash flow might be greatly reduced by the tax obligations. Businesses surviving the recession will face increased taxes (also generated by pending higher tax rates) and will have to pay for debt amortization and probably cash flow used to meet expansion opportunities.

Tax management of partner earnings and tax obligations will be critical in order to avoid surprises. Management of loan principal amortization requirements will need to be addressed. The firm might consider instituting a tax payment draw system, in which the firm determines the expected taxes to the business income and makes "tax draws" accordingly for those estimated payments on a quarterly basis. This approach brings centralized management and close attention to the tax obligations stemming from the business income and relieves the individual partners of that burden and possible oversight. When the firm is managing the taxable income and tax payments, it will have knowledge of how these factors impact other firm business, such as loan repayment commitments.

Tax draws would supplement the normal separate monthly living draws. If such an approach had been used during the reduced-profit years of the recession, the firm could have preserved its much-needed cash and perhaps, avoided extra borrowing that might have occurred.

For those firms that really got in over their heads, debt modification or debt forgiveness might be in their futures. These firms will want to get their manageable debt resolved by Dec. 31, 2010. They can elect to completely defer the resulting debt modification taxable income until 2014 and then amortize the income recognition equally over the five following years. This interest-free tax deferral election is made at the firm level, not by individual partners. The election must be evaluated in light of possible income exclusion opportunities of partners at or near insolvency after the release.

If a partner has a so-called negative capital account, having taken both losses and cash distributions financed by the existing debts of the firm, such a partner might consider a sale of the equity position in advance of the eventual ordinary income expected. Such a sale could convert the negative capital account balance into long-term capital gain income and avoid the future ordinary income. If the sale is designed to qualify as an installment sale, this gain might be deferred. For example, if the partner arranges to retain his or her share of the debt obligation, then the negative basis phantom gain is mitigated by the debt arrangement, and the sale price is equally grossed up, leaving the possibility of complete income tax deferral of an installment sale.

A new investor purchasing the old interest of the seller will have the opportunity by firm election to step up the tax basis to the purchase cost, thereby establishing more amortization and depreciation deductions solely allocated to the purchaser. Such deductions could help absorb future income, including possible debt forgiveness not otherwise deferred or excluded.

The income recognition timing could be a factor in planning better results. In the old days of virtually burned-out tax shelter investments, when huge negative tax basis and income recapture loomed, we often did anything legal to forestall termination of the entity and the ending of loans that gave rise to the multiple losses used. Even if a partner might put up more capital, which likely would be lost, that added loss was less expensive than the loss of the use of money if the tax became due immediately. The planning employed was to make the best out of a bad situation, and that concept is useful again now. With the prospect of higher tax rates and the new issues created by the recession, tax advisors should be very busy and creative.