What is a “Minimum Gain Chargeback?”

Typically, clients for whom we draft partnership agreements and/or limited liability company operating agreements fall into four categories: 1) those who briefly skim the agreements, and glaze over at the section entitled “Allocations of Net Income and Net Loss and Other Tax Items” (1) without giving it a second thought; 2) those who read the agreements, and call their accountants to discuss this section; 3) those lucky clients who are already familiar with the terms in this section from their previous dealings; and 4) those who attempt to read this section, suffer a severe headache, and call us with the question: “What is a Minimum Gain Chargeback?”

This article is directed at those falling into the fourth category, but may also be useful and cost-saving for classes 1 and 2.

In short, the Minimum Gain Chargeback is an allocation of gain, for tax purposes only, to partners or members who have received the benefit of prior nonrecourse deductions(2) or received distributions of partnership proceeds attributable to nonrecourse borrowing. In effect, such deductions or distributions are “charged back” to such partners or members upon either (1) a disposition of underlying properties subject to nonrecourse debt or (2) a change in the character of nonrecourse debt (either by conversion to recourse debt, or by forgiveness). Again, this allocation has no partnership economic effect, as monies are not dispersed in connection with the chargeback, it is merely a tax allocation.

Minimum Gain:

In order to understand what Minimum Gain Chargeback is, one must first understand Minimum Gain. Internal Revenue Code (“I.R.C”) Regulation §1.704-2(b)(2) defines Minimum Gain as the gain generated upon the disposition of a property when a nonrecourse partnership liability exceeds the adjusted tax basis of the partnership property it encumbers.(3) Thus, partnership Minimum Gain generally equals the excess of a partnership’s nonrecourse liabilities over the adjusted tax basis of the security (or the depreciated book value of partnership property if the two differ). For example, if a partnership purchased a property for $100,000, had since taken $25,000 in depreciation deductions, and then refinanced the property with $150,000 of nonrecourse debt because the fair market value of the property was now $200,000, the Minimum Gain would be $75,000 ($150,000 minus (($100,000 minus $25,000)).

Partnership Minimum Gain can be calculated by:

1. determining, for each partnership nonrecourse liability, any gain the partnership would realize upon disposition of the property subject to that liability for no consideration other than full satisfaction of the liability; and

2. aggregating these individual values.(4)

If the book values of the liabilities differ from the tax values, minimum gain is determined with reference to the adjusted book value.(5)

Or, as the I.R.S. advises its auditors: “Minimum Gain is created as the partnership claims deductions, typically depreciation, that decrease the partnership’s book basis in the property below the balance of the nonrecourse debt securing the property.”(6) Another source of Minimum Gain occurs when the partnership refinances the property, and, as a result, the nonrecourse debt exceeds the book basis of the property securing it.(7)

Minimum Gain Chargeback:

I.R.C. §1.704-2(d)(d) states:

If there is a net decrease in partnership minimum gain for a partnership taxable year, the minimum gain chargeback requirement applies and each partner must be allocated items of partnership income and gain for that year equal to that partner’s share of the net decrease in partnership minimum gain.

Thus a decrease in Minimum Gain triggers the chargeback for partners or members who have received past nonrecourse deductions. In this way, Minimum Gain Chargeback can be seen as the counterpart to nonrecourse deductions. Minimum Gain (again, the excess of nonrecourse liabilities over the book value of the securing assets) can decrease, and trigger, in most cases, a Minimum Gain Chargeback as a result of the following:

1. the sale of the secured property;

2. foreclosure upon the secured property;

3. repayment of debt principal;

4. a change in the nature of the liability from nonrecourse to recourse;

5. the cancellation or gratuitous reduction of the nonrecourse liability;

6. when the adjusted tax basis, or depreciated book value, of the property encumbered by the liability increases (such as from the improvements made to the property)(8); or

7. the revaluing of the property securing the nonrecourse debt in a mandatory or optional book-up.(9)

An Illustration:

The following illustration is useful is explaining how a simple Minimum Gain Chargeback might apply(10):

Widgets, LLC receives capital contributions of $100,000 from each of its members, B, K, and F. Each member has an equal 1/3 interest in the company, and items of gain and loss are allocated according to percentage interest. Thus, initially the company’s balance sheet looks like this:

Assets

Cash: $300,000.00

Total: $300,000.00

Liabilities and Capital

B $100,000.00

K $100,000.00

F $100,000.00

Total: $300,000.00

Widgets, LLC then purchases a widget factory, at a total cost of $1,000,000. Per the terms of the Purchase Agreement, Widgets acquires the factory for $300,000.00 in cash and $700,000.00 in nonrecourse debt (as evidenced by a promissory note). The initial tax basis in the building is $1,000.000.00, and the post-transaction balance sheet looks like this:

Assets

Building: $1,000,000.00

Total: $1,000,000.00

Liabilities and Capital

Nonrecourse Note $700,000.00

B $100,000.00

K $100,000.00

F $100,000.00

Total: $1,000,000.00

If the factory then depreciates at the rate of $100,000.00 per year, which is allocated 1/3rd to each member, after six years the balance sheet looks like this:

Assets

Building: $1,000,000.00

Accumulated Depreciation: ($600,000.00)

Total: $400,000.00

Liabilities and Capital

Nonrecourse Note $700,000.00

B $(100,000.00)

K $(100,000.00)

F $(100,000.00)

Total: $400,000.00

Because B, K, and F initially contributed $300,000 in cash, the first $300,000 in deductions are recourse deductions. Additional depreciation deductions after this amount create Minimum Gain because they are nonrecourse. Thus, after six years Widgets, LLC would have Minimum Gain in the amount of $300,000.

If Widgets, LLC sells the factory in year six for $1,500,000, the adjusted tax basis is $400,000 (initial basis minus accumulated depreciation), and Widgets, LLC realizes gain in the amount of $1,100,000 (amount realized minus adjusted tax basis). The sale decreases Widgets, LLC Minimum Gain from $300,000 to $0, and B, K, and F will each be allocated $100,000 in Minimum Gain Chargeback.

Thus, B, K, and F will then be allocated, and taxed upon, this $100,000 to counter their previous nonrecourse deductions. As described by the I.R.S. in their audit guide: “The general idea behind the minimum gain chargeback is that a partner who receives the tax advantage of a deduction for which he or she bears no economic risk of loss (such as depreciation deductions generated by basis created by non-recourse borrowing) may bear a tax liability in the future due to an allocation of income.”(11)

Exceptions to the Chargeback:

In certain instances a decrease in Minimum Gain will not trigger a Minimum Gain Chargeback. The two most prominent instances are where:

1. The non-recourse debt decreases because it was converted to recourse debt for which some or all partners will bear the economic risk of loss.   The partners who do not assume any economic risk of loss will, however, be allocated minimum gain.  

2. If a partner or member contributes money to pay down the non-recourse debt or increase the basis of the property, minimum gain will decrease but no chargeback will be allocated to such partner or member.   In this case, the partner or member “has restored her prior non-recourse deductions with her own money; therefore an allocation of minimum gain is not necessary.”(12)

Why does a Partnership Agreement or Operating Agreement need a minimum gain chargeback provision?

Minimum Gain Chargeback is a statutory creation and applies whether or not a particular partnership or operating agreement explicitly provides for one. However, certain potentially beneficial I.R.C. provisions apply only in the face of a satisfactory Minimum Gain Chargeback provision in a partnership or operating agreement, such as I.R.C. §1.704-2(e), which allows allocations of nonrecourse deductions to be made in accordance with the partners’ interests in the partnership only if a satisfactory Minimum Gain Chargeback provision is found in the agreement.

Also, because these chargebacks have very real economic consequence to the individual partners or members, who must pay the tax resulting from the chargebacks, these Minimum Gain Chargeback provisions conform the partners’ or members’ contractual agreement among each other to the required result under the I.R.C.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written, and cannot be used, for the purpose of (a) avoiding penalties under the Internal Revenue Code or (b) promoting, marketing or recommending to another party any transaction or matter addressed herein.

For further information contact William Morrison, Esq. at (858) 551-2440 or via e-mail at wmorrison@bkflaw.com