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Editorial 10 MIN READ

The limited partnership, revisited: a form rebuilt around Opportunity Zones and the BBA

Twenty months after our 2017 LP piece, the form has a new constituency, a new audit regime, and a pass-through deduction that treats most limited partners kindly

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 6 sections
  1. The statute has not moved. The neighborhood has
  2. Why the form is suddenly everywhere: the Qualified Opportunity Fund
  3. The BBA audit regime is now load-bearing
  4. Section 199A for limited partners, with the SSTB footnote
  5. The form, re-scoped for late 2018
  6. Sources

he limited partnership at the end of 2018 does three jobs its 2017 version did not. It sits under roughly every Qualified Opportunity Fund being assembled this quarter. It runs through the new centralized IRS audit regime that went live January 1. And its limited partners, for the first time since the statute was written, get a 20 percent federal deduction on their distributive share, with enough carve-outs to matter.

Our February 2017 piece laid out the mechanics of the LP form as of early 2017. Twenty months later the mechanics are the same and the context around them has changed enough to justify rereading the form from scratch.

The statute has not moved. The neighborhood has

Delaware's Revised Uniform Limited Partnership Act is still codified at 6 Del. C. Chapter 17, and the two-page formation job is still what § 17-201 describes: a Certificate of Limited Partnership listing the partnership's name, its Delaware registered office and registered agent, and the name and business address of each general partner. The operating document (the LP agreement) is private and is not filed. The Division of Corporations charges $200 to file the Certificate and $300 a year for the franchise-style annual tax imposed on every Delaware LP under 6 Del. C. § 17-1109, due June 1 with a $200 late penalty and 1.5 percent monthly interest. Those numbers are the same numbers we printed in 2017 because Delaware did not change them.

The ULPA (2001) enactment count continues to creep. The Uniform Law Commission's current enactment map shows the 2001 Act (as last amended in 2013) in force in roughly twenty-two jurisdictions, with a handful of others on the older Revised ULPA (1976/1985) vintage and Delaware, as ever, running its own non-uniform statute. For a fund sponsor picking a state of formation, the decision is still Delaware in almost every case, and the choice is still made on the strength of § 17-303(b)'s safe harbor and the Court of Chancery rather than on the statute's tax treatment.

Two provisions deserve a second look because the market now invokes them more often. Section 17-303(a) says a limited partner is not liable for partnership obligations "unless, in addition to the exercise of the rights and powers of a limited partner, the limited partner participates in the control of the business." Section 17-214 lets an LP elect to operate as a limited liability limited partnership, a designation that extends an LLP-style shield to the general partner itself. The LLLP election saw a small uptick in 2018 filings, driven less by practice evolution than by foreign investors who read the GP's residual liability as a live risk and wanted the belt-and-suspenders. Most fund sponsors still do not use § 17-214, because the GP is already a single-purpose LLC and the layering accomplishes the same thing in a form the LP investor's counsel is used to reading.

Why the form is suddenly everywhere: the Qualified Opportunity Fund

The 2017 tax act added IRC §§ 1400Z-1 and 1400Z-2, the Opportunity Zone provisions. Treasury's first round of proposed regulations dropped on October 19, 2018, three days after this article posts, and the October interest in OZ fund formation is running ahead of the rules. We covered the state-by-state zone designations in our September 25 piece; what matters here is the vehicle.

A Qualified Opportunity Fund under § 1400Z-2(d)(1) must be a corporation or a partnership organized for the purpose of investing in Qualified Opportunity Zone Property, holding at least 90 percent of its assets in such property, measured on a semiannual basis. The statute says corporation-or-partnership, which means an LLC taxed as a partnership can qualify, and many of the smaller QOFs being formed in Q4 2018 are in fact LLCs. The larger and more institutionally sponsored QOFs are limited partnerships, and they are LPs for the same reasons private-equity funds are: the investor base reads the form, the allocation flexibility under IRC § 704(b) is the native language of fund waterfalls, the § 752 debt-basis inclusion is load-bearing for leveraged real-estate plays, and the ERISA, UBTI, and state-level unitary-tax analyses every institutional LP has on file all assume a partnership.

The operational fact that drove the LP pick this quarter is the combination of the 2017 LP statute's maturity and § 1400Z-2's ten-year holding requirement. An LP agreement has forty years of drafting convention behind it for the kind of long-dated, illiquid investment the OZ program contemplates: lockup periods, capital-call mechanics, transfer restrictions, side-letter machinery, key-person provisions, and clawback waterfalls all translate directly. A Delaware Series LLC could in theory host the same structure; in practice, the fund formation bar took one look at the ten-year horizon and reached for the form it has been papering for four decades.

The still-open question on October 16 is what the proposed regulations will say about the 90-percent asset test at the fund level when the QOF deploys through a Qualified Opportunity Zone Business subsidiary rather than directly into real property. The statute's working capital safe harbor, the timing of the substantial improvement requirement, and the treatment of interim gains are all material to fund structuring and none of them are resolved. Most counsel are papering the LP agreement to require the fund to comply with "any proposed or final regulations under §§ 1400Z-1 and 1400Z-2" and moving on. Expect redrafts in December.

The BBA audit regime is now load-bearing

The Bipartisan Budget Act of 2015 rewrote partnership audit procedures at IRC §§ 6221 through 6241, effective for partnership tax years beginning after December 31, 2017. That effective date has passed. For every LP whose fiscal year started January 1, 2018, the new regime is the regime. We walked through the statute at length in our ten-months-out piece, and Treasury closed the loop with final regulations under T.D. 9844, published at 84 Fed. Reg. (forthcoming) after prior proposed and temporary rules cycled through 2017 and 2018. By October the operational picture is clear enough.

Three features of the regime interact with the LP form in ways that have reshaped LP agreements this year. First, the default rule that the IRS assesses and collects at the partnership level, computing an "imputed underpayment" at the highest applicable tax rate, makes the LP's economic exposure in an audit functionally a GP-and-current-LP liability rather than a reviewed-year-LP liability. Fund agreements drafted in 2018 universally include a mandatory push-out election under § 6226 where economically feasible, together with reviewed-year clawback language to pull liability back to the LPs who were in the fund when the adjustment originated.

Second, § 6221(b)'s election out is unavailable to nearly every institutional LP. The election out is limited to partnerships with 100 or fewer eligible partners, and eligible partners do not include other partnerships, trusts (including grantor trusts and revocable living trusts), or disregarded entities. A fund of funds is ineligible by definition. A real-estate LP with a family-trust investor is ineligible by definition. The fact pattern where the election out is actually available is a small operating LP with individual, C-corp, or S-corp partners and nothing more complex. For the form's natural habitats (PE funds and real-estate syndications), electing out is not on the table.

Third, § 6223's partnership representative is a single individual or entity (with a designated individual if the representative is an entity) who has sole authority to bind the partnership in dealings with the IRS. The LPs have no statutory right to notice, participation, or consent. Every 2018 LP agreement our desk has seen papers around this by naming the GP or a GP affiliate as partnership representative and then building the consultation, consent, and indemnity mechanics the Code does not provide. Older 2016 and 2017 LP agreements that still reference "tax matters partner" are getting amendments this quarter.

Section 199A for limited partners, with the SSTB footnote

Subchapter K did not change in 2017. What changed is that limited partners now get a new federal deduction on their distributive share. IRC § 199A, enacted in the 2017 tax act, grants an individual a deduction equal to 20 percent of qualified business income from each qualified trade or business, subject to taxable-income thresholds of $157,500 for singles and $315,000 for joint filers for 2018 and an overlay of W-2-wage and qualified-property limits above those thresholds. For an LP, the deduction is computed partner by partner on each partner's share of partnership QBI.

The operational questions for an LP limited partner are three. Is the underlying trade or business a specified service trade or business under § 199A(d)(2). If so, is the limited partner above or below the threshold. And does the LP's allocation structure (preferred return, promote, carried interest) produce QBI that is characterized in a way § 199A recognizes.

On the first question, Treasury's proposed regulations (REG-107892-18, 83 Fed. Reg. 40884, August 16, 2018, which we covered in our SSTB piece) read most of the enumerated SSTB fields narrowly. For a real-estate LP, the proposed regs' confirmation that real-estate brokerage is outside § 199A(d)(2)(A) brokerage services and that property management is not a financial-services SSTB is the operative fact: a normal real-estate LP is a qualified trade or business, full stop. For a PE or VC fund LP, the SSTB analysis is less favorable. Investment advice and asset management are within the financial-services SSTB, which means management-company fee income is SSTB at the manager level. The fund LP's own character depends on what the fund does with its capital, which in most PE and VC structures is buy-and-hold investment rather than an active trade or business, and investment partnerships generally do not produce § 199A QBI at all because the income is investment income, not trade-or-business income.

The LP allocation twist is § 199A-specific and deserves a sentence. Guaranteed payments to partners under IRC § 707(c) are expressly excluded from QBI by § 199A(c)(4), as is reasonable compensation paid to the taxpayer. The GP's carried-interest allocation under a § 704(b) waterfall is not a guaranteed payment and is not compensation, and it picks up the character of the underlying partnership income. For a real-estate LP producing rental trade-or-business income, the sponsor's promote flows through as QBI and the limited partners' preferred return does too. The gating question is always whether the LP's activity rises to a § 162 trade or business in the first place, which is a fact question Treasury did not try to answer.

The form, re-scoped for late 2018

The 2017 version of this analysis said the LP survives because of where it is embedded, not because it is the right answer for a new operating business. That is still true. What has changed is that the LP's embedded base grew. The Opportunity Zone program landed on the LP's doorstep this year and dropped a new cohort of fund sponsors onto the form. The BBA audit regime did the same kind of thing in reverse: it raised the drafting-sophistication floor for every LP agreement and pushed a wave of sponsors to amend documents that had been sitting untouched since formation. Section 199A is a tailwind for the limited partners in real-estate LPs and essentially neutral for PE and VC limited partners, who were not getting a deduction on fund-level investment income in 2017 either.

If you are forming an LP this quarter for a QOF, Delaware this week, name a capable partnership representative, paper the push-out, and plan to amend when the OZ regulations land. If you are forming an LP for anything other than real estate or a pooled investment vehicle, you are probably reaching for the wrong form; the LLC's operating agreement does the same work without the general partner's residual exposure. The LP is once again a specialist's tool, and in October 2018 the specialists are busy.

Sources

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