Partnership Freezes after Castle Harbour

A closely held C corporation that is growing rapidly or plans to enter into a new line of business may consider the creation of a “frozen” limited liability company (LLC)/partnership (frozen partnership) to reduce its income tax liability and shift future appreciation out of the corporation. However, if the frozen partnership’s existence is invalidated, there could be unintended income and/or gift tax consequences to the partners of the putative partnership. In light of recent IRS victories, these risks should be taken seriously.

Service Victories

Recently, the IRS was successful in invalidating the partnership form as a sham transaction; see Boca Investerings Partnership, 314 F3d 625 (DC Cir. 2003) (partnership form must be needed to accomplish a nontax business purpose, otherwise the partnership is a sham), and Asa Investerings Partnership, TC Memo 1998-305 (absence of a nontax business purpose is fatal to the legitimate existence of a partnership). The Service was also successful in attacking an “abusive” arrangement, arguing that a purported interest in a partnership constituted a debt, thus causing a reallocation of income to the other partners; see TIFD III-E, Inc., 2d Cir., 8/3/06, rev’g and rem’g TIFD III-E, Inc., 342 FSupp2d 94 (DC CT 2004) (Castle Harbour). These cases are largely viewed as tax-shelter cases; the tax benefit obtained by the shift of taxable income to a nontaxable entity appears to have greatly influenced the court’s decision. Thus, it is unclear if the courts would rule the same absent the tax-shelter aspect.

What Is a Partnership Freeze?

Typically, a closely held C corporation establishes a separate LLC/partnership with its shareholders. The shareholders may be family members or highly valued employees of a C corporation that contributes the bulk of the capital or a portion of its fixed assets to the venture and acts as the LLC/partnership’s manager. In exchange, the C corporation receives a “preferred” interest, in that it is entitled to certain profit allocations and cash distributions before they are received by the other partners. Allocations/distributions in excess of this “preferred” amount are generally capped or disproportionately small compared to the corporation’s capital contribution. The corporation’s interest is known as a “frozen” interest.

Shareholders, on the other hand, contribute relatively little capital to the venture and generally act as limited partners, with minimal involvement in management. In exchange, they receive “subordinated” profit allocations and cash distributions (because the corporation must first receive its preferential allocation). However, after the frozen interest receives its preference, the shareholders’ allocations of profits/cash are not capped or are disproportionately large relative to their capital contributions. Collectively, the shareholders’ interests are known as an “unfrozen” interest.

Assuming that the frozen partnership structure is respected by the IRS and the partnership is successful, the structure could reduce the tax liability associated with distributions of current earnings, and a majority of the subsequent appreciation of the business will avoid corporate-level tax.

Partnership-freeze transactions are subject to attack on various grounds, such as the disguised-sale provisions of Sec. 707, reallocation-of-income allocations under Sec. 482 as provided in Regs. Sec. 1.704-1(b)(1)(iii), partnership anti-abuse provisions under Regs. Sec. 1.701-2, valuation issues and the all-facts-and-circumstances analysis of Culbertson, 337 US 733 (1949). The Second Circuit recently applied Culbertson in the Castle Harbour decision.

Castle Harbour

Three subsidiaries of General Electric Capital Corporation (GECC) and two foreign banks (Dutch banks) organized Castle Harbour-I, LLC (Castle Harbour) for the business purpose of leasing aircraft to the airline industry. Through its three subsidiaries, GECC contributed several airplanes that were fully depreciated for tax purposes, but not for book purposes. The Dutch banks invested $117.5 million in the venture. Castle Harbour’s operations were effectively managed by GECC, while the Dutch banks had a minimal management role. The GECC entities could buy out the Dutch banks’ interest at any time for a nominal fee.

Castle Harbour was a self-liquidating partnership, because its operating agreement required the return of the Dutch banks’ invested capital plus a specified rate of return (minimum return) over a term of years. Based on the court’s decision, it is worthy to note that the minimum return was calculated to five decimal points (9.03587% or 8.53587%). To accomplish this, Castle Harbour Leasing Inc. (CHLI), a wholly owned subsidiary of Castle Harbour, was organized and required to hold cash essentially equal to 110% of the current value of the minimum return, ensuring that Castle Harbour would have the cash reserves needed to pay the minimum return. Additionally, GECC personally guaranteed the repayment.

Due to a complex allocation regime and huge book depreciation deductions, 98% of Castle Harbour’s taxable income was allocated to the non-U.S.-taxpaying Dutch banks, even though their actual return was, for all practical purposes, limited to the minimum.

Court Decisions

The Service challenged the venture on three grounds: the arrangement as a sham; the classification of the Dutch banks’ interest as equity; and the “overall tax effect.” The district court found in the taxpayer’s favor on all three accounts. The Second Circuit reversed the decision, relying on an application of the Culbertson totality-of-the-circumstances test. In Culbertson, the Supreme Court concluded that the parties’ intent should govern the determination of a partnership’s existence. To determine the parties’ intent and the existence of a business purpose, the Court stated that all of the circumstances surrounding the venture should be examined, including the operating agreement, the parties’ conduct while executing its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it was used, plus any other factors that might be helpful.

Debt-equity analysis: In Castle Harbour, the court did not analyze any of the delineated Culbertson factors; instead, it used a debt-equity analysis to determine if the intent was to enter into a partnership or if the Dutch banks were simply secured lenders; see Hambuechen, 43 TC 90 (1964) (holding that debt-equity criteria used in the corporate context should be applied in the partnership context), and Notice 94-47 (highlighting at least eight factors to consider in differentiating between an equity interest and a financing transaction). The Second Circuit applied Notice 94-47’s eight factors, plus a few of its own, to conclude that the Dutch banks were really lenders, as opposed to equity partners in Castle Harbour.

Although the court examined all of the debt-equity factors, two primary factors motivated its decision. First and most important, the Dutch banks did not meaningfully share in the partnership’s business risks; they did not bear a significant risk of loss should the partnership incur losses. Repayment of the minimum return did not depend on the partnership’s operations, but was secured by CHLI’s required cash reserves and GECC’s personal guarantee. Second, the income-allocation scheme would not benefit the banks significantly, because the GECC entities could buy out the banks’ interest at any time for a nominal fee; as manager, GECC could effectively move any of the operational assets to CHLI, which would reduce the income allocated to the Dutch banks. Based on these factors, the court held that the banks looked more like secured creditors than equity participants in the partnership. 

The court did point out that if the Dutch banks had a sufficiently sizable share in the LLC’s profit potential, they might be deemed equity participants for tax purposes, notwithstanding the guaranteed repayment of their initial investment at an agreed rate of return. However, it did not provide a definition of “sufficiently sizable.”

Effect on Partnership-Freeze Transactions

The Castle Harbour decision, specifically, the framing of the debt-vs.-equity issue as a part of the Culbertson analysis, potentially raises significant concerns with respect to the issuance of the preferred return. In Castle Harbour, the relationship was recast as a debtor-creditor relationship; however, a similar conclusion in a partnership-freeze transaction would result in a sale transaction, with the corporation selling the assets to the partnership or partners in exchange for a debt instrument.

To address (or, at minimum, take into account) the Castle Harbour decision in structuring a partnership freeze, tax advisers should address two primary issues: (1) a sufficiently sizable interest in profits should be created over and above the fixed preferred return and (2) the preferred interest, while protected, should be subject to a risk of loss. 

Sufficiently sizable: Based on Castle Harbour, a partner must have a sufficiently sizable stake in the partnership’s operations. This is incredibly difficult to determine. Is a 1% or 2% interest sufficient? Or 5%? Does the answer change if the partner is actively involved in the partnership or is only a limited partner? In freeze transactions, the corporate “partner” generally receives a small percentage of the partnership’s profits after its initial preference, but is usually actively involved in its operations. Ultimately, practitioners have no clear guidance on “sufficiently sizable,” but Castle Harbour serves notice that the interest should be real, not merely on paper.

Risk of loss: Whether or not the court’s debt-vs.-equity analysis was appropriate, Castle Harbour is in line with Culberston, holding that if a putative partner contributes cash and receives a guarantee that the investment plus a specified rate of return will be paid, the partner is not meaningfully sharing in the partnership’s business risks. Thus, when structuring a freeze transaction, practitioners should avoid partner or partnership guarantees of return and investment, and should also be wary of agreements that maintain collateral to cover the investment and preference.

Conclusion

The laws defining a partnership and classifying partners are a little murky. The recent decision in Castle Harbour has made the waters a little murkier. Assuming that Castle Harbour will apply absent a tax shelter, practitioners should carefully consider the facts and circumstances surrounding a partnership freeze to determine whether the resulting partnership, each partner and the related allocations, will be respected.