Partners & Partnerships
A recent decision by the Tax Court illustrates the limitations of the leveraged partnership exception to the disguised sale rules of Sec. 707(a)(2)(B). That provision requires sale or exchange treatment when (1) there is a direct or indirect transfer of money or other property by a partner to a partnership, (2) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and (3) the transfers described in (1) and (2), when viewed together, are properly characterized as a sale or exchange of property.
Facts of Canal Corp.
In Canal Corp., 135 T.C. No. 9 (2010), the taxpayer attempted to monetize an appreciated asset without triggering taxable gain, purporting to rely upon a regulatory exception from the disguised sale rules. The exception is intended to apply, essentially, when a partner is not truly cashing out of an asset—by contributing it and obtaining a cash distribution from the partnership—because the partner remains liable on partnership debt.
Canal Corporation contributed assets with an agreed-upon value of $775 million in exchange for a 5% interest in an LLC (taxed as a partnership) and a special cash distribution of $755.2 million. The other member of the LLC, Georgia Pacific, contributed assets with an agreed-upon value of $376.4 million. Georgia Pacific guaranteed the bank loan used to obtain the $755.2 million of cash distributed to Canal, but Canal partially indemnified Georgia Pacific as to that guarantee. Such an indemnification could in theory have resulted in Canal’s being the ultimate obligor on the bank loan. However, the indemnification applied only to principal payments, required Georgia Pacific to proceed first against the assets of the LLC (of which it was a majority owner) before proceeding against Canal, and increased Canal’s interest in the LLC to the extent it made payments under the indemnity.
Making matters ostensibly worse, Georgia Pacific did not insist on the indemnity as a business matter. Instead, Canal provided it, following the advice of its tax advisers, in order to ensure that it was considered to be ultimately liable on the bank loan and thus to ensure that it was not viewed as cashing out of its contributed asset in a disguised sale for tax purposes. Nevertheless, the transaction was characterized as a sale for financial accounting purposes, and Canal recorded no book liability for Canal’s potential liability under the indemnification. Indeed, in calls with rating agencies, Canal executives represented that the only risks associated with the transaction were tax risks.
The Tax Court’s Holding
The Tax Court held that the transaction was a disguised sale. In particular, it failed to qualify for the exception from the disguised sale rules for debt-financed distributions. Under this regulatory exception, certain debt-financed distributions are not taken into account in determining whether a distributee partner received “money or other consideration” for disguised sale purposes. However, the exception applies only to the extent of the distributee partner’s allocable share of the liability that financed the distribution. The Tax Court found that Canal was not entitled to the benefit of this exception because it did not bear any allocable share of the liability that financed the distribution from the LLC. Thus, Canal was required under the disguised sale rules to treat the distribution as payment for the assets it transferred to the LLC in the transaction.
The Tax Court relied upon the anti-abuse regulations under Regs. Sec. 1.752-2. Those regulations provide that a partner’s obligation to make a payment to or for the benefit of the partnership (e.g., Canal’s purported obligation under the indemnification) may be disregarded (among other circumstances) if a principal purpose of the arrangement “is to eliminate the partner’s economic risk of loss with respect to that obligation or create the appearance of the partner or related person bearing the economic risk of loss when, in fact, the substance of the arrangement is otherwise” (Regs. Sec. 1.752-2(j)).
Applying these regulations, the court considered the purpose of the indemnity, the likelihood of Canal being called upon to make payment, and Canal’s ability to make payment on the indemnity in the event payment was required. The court noted that the indemnity was not requested by Georgia Pacific, as a business matter, but only served the tax needs of Canal. In fact, based upon the terms of the indemnification agreement, the court found that it was unlikely that Georgia Pacific would ever seek reimbursement from Canal. In addition, even after the special distribution of some $755 million, the Canal subsidiary that received the distribution did not retain sufficient assets to ensure payment of the indemnification agreement, even if it had been called upon to do so. Therefore, the Tax Court found that Canal did not bear a risk of loss for the LLC’s liability.
The facts of the case are so extreme, from an appearance perspective, that it is difficult to know exactly which factors the court viewed as dispositive. The court may have been concerned with the inconsistent tax and accounting treatment, the lack of apparent business purpose for the indemnification, the fact that the indemnification applied only after the assets had become worthless, or the apparent worthlessness of the guarantee itself, in light of the lack of assets in the distributee. Until the IRS provides further guidance, the Tax Court’s ruling casts a cloud of uncertainty over the disguised sale rules and the Sec. 752 liability rules generally.
Neal Weber is managing director-in-charge, Washington National Tax, with RSM McGladrey, Inc., in Washington, DC.
For additional information about these items, contact Mr. Weber at (202) 370-8213 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.