Partners & Partnerships
The recent decision of the Tax Court in Canal Corp., 135 T.C. No. 9 (2010), may provide some insight into when a partner’s potential obligation to pay partnership debts will be disregarded in determining liability allocations.
A partner’s share of partnership liabilities is important for a number of reasons. Liabilities are included in the basis of a partner’s interest in the partnership and, in certain circumstances, the partner’s at-risk basis in the partnership’s activity. That may enable the partner to avoid loss limitations under Secs. 465 and 704(d). It may also allow the partner to withdraw funds from the partnership without triggering at-risk loss recapture (Sec. 465(e)) or gain on excess distributions (Sec. 731(a)). And, as in the Canal case, the allocation of liabilities may have a direct bearing on whether certain transactions are treated as disguised sales (Sec. 707(a)(2)(B) and Regs. Sec. 1.707-5).
Regulations under Sec. 752 provide that a partner’s share of a recourse partnership liability equals the portion of that liability, if any, for which the partner or related person bears the economic risk of loss (Regs. Sec. 1.752-1(a)(1)). A partner generally bears the economic risk of loss for a partnership liability to the extent that the partner or a related person would be obligated to pay the liability if the partnership were unable to do so (Regs. Sec. 1.752-2(b)(1)). All statutory and contractual obligations relating to the partnership liability are taken into account for this purpose, including state law, the partnership agreement, and contractual obligations outside the partnership agreement such as guarantee or indemnification agreements (Regs. Sec. 1.752-2(b)(3)). Furthermore, it generally is assumed that all partners and related persons who have obligations to make payments will actually perform those obligations, regardless of their actual net worth, unless the facts and circumstances indicate a plan to circumvent or avoid the obligation (Regs. Sec. 1.752-2(b)(6)). However, two specific rules limit this assumption.
First, the payment obligation of a business entity that is disregarded as an entity separate from its owner, such as a single-member limited liability company or qualified subchapter S subsidiary, is taken into account only to the extent of its net value. Net value is defined as the fair market value of all assets owned by the disregarded entity that may be subject to creditors’ claims under local law less obligations other than for the debts of the partnership (Regs. Sec. 1.752-2(k)). This limitation does not apply to any entity that is not disregarded, so such an entity is subject to the general assumption that it will meet its obligations regardless of its net worth.
The second limitation—and primary focus of this item—is an anti-abuse rule contained in Regs. Sec. 1.752-2(j). Under this rule, an obligation of a partner or related person to make a payment may be disregarded or treated as an obligation of another person if facts and circumstances indicate that a principal purpose of the arrangement between the parties 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. Further, an obligation of a partner to make a payment is not recognized if the facts and circumstances evidence a plan to circumvent or avoid the obligation. The regulations provide a single example of when this rule would apply (Regs. Sec. 1.752-2(j)(4)).
Example: A and B form a general partnership. A, a corporation, contributes $20,000 and B contributes $80,000 to the partnership. A is obligated to restore any deficit in its partnership capital account. The partnership agreement allocates losses 20% to A and 80% to B until B’s capital account is reduced to zero, after which all losses are allocated to A. The partnership purchases depreciable property for $250,000 using its $100,000 cash and a $150,000 recourse loan from a bank. B guarantees payment of the $150,000 loan to the extent the loan remains unpaid after the bank has exhausted its remedies against the partnership.
A is a subsidiary, formed by a parent of a consolidated group, with capital limited to $20,000 to allow the consolidated group to enjoy the tax losses generated by the property while at the same time limiting its monetary exposure for such losses. These facts, when considered together with B’s guarantee, indicate a plan to circumvent or avoid A’s obligation to contribute to the partnership. The rules of Sec. 752 must be applied as if A’s obligation to contribute did not exist. Accordingly, the $150,000 liability is a recourse liability that is allocated entirely to B.
Prior to Canal, there was little additional guidance on this anti-abuse rule. Its application to disregard a partner guarantee was approved by the IRS National Office in Chief Counsel Advice (CCA) 200246014. There, the taxpayer contributed assets to a partnership and immediately received cash distributions funded by new partnership-level borrowing. The taxpayer guaranteed the new partnership debt and claimed that the guarantee caused it to bear the risk of loss within the meaning of Sec. 752. The increased basis associated with that liability allowed the taxpayer to receive the cash distributions without any gain recognition under Sec. 731.
The taxpayer’s guarantee in CCA 200246014 covered only the principal amount of the debt, was effective for a limited term ending when the taxpayer ceased to be a partner, and could be invoked only after all other remedies against the partnership were exhausted. In concluding that the guarantee should be disregarded under the anti-abuse rule, the IRS cited these restrictions as well as the taxpayer’s relative lack of capital and the partnership’s pledge of a note receivable from the other partner as suggesting a plan to avoid any performance obligation from the taxpayer on the guarantee. Unfortunately, the CCA omits dollar amounts and other information that might have shed more light on the IRS’s reasoning. In any event, the CCA may not be cited as pre-cedent, so its value is limited.
The Tax Court’s opinion in Canal offers additional insight into the IRS’s interpretation of the anti-abuse rule and provides a first glimpse of the Tax Court’s view. The case involves Wisconsin Tissue Mills, Inc. (Wisco), a wholly owned subsidiary of Chesapeake Corporation (Chesapeake), which subsequently changed its corporate name to Canal Corporation. Wisco transferred its tissue business worth $775 million to a newly formed limited liability company (LLC) in exchange for a 5% interest, with Georgia Pacific (GP) contributing a complementary business worth $376.4 million for the other 95% interest.
On the same day, the LLC borrowed $755.2 million and immediately distributed the proceeds to Wisco. GP guaranteed the loan, but Wisco agreed to indemnify GP for any principal payments GP might have to make under the guarantee. Wisco used a portion of the cash to pay certain liabilities, including an amount owed to Chesapeake and an affiliate, distributed a dividend, and loaned the remaining $151 million to Chesapeake in return for a promissory note. Wisco’s only assets after the transaction were its LLC interest, the note from Chesapeake, and a corporate jet worth about $6 million. Thus, exclusive of its LLC interest, Wisco had a net worth of about $157 million, or 21% of its potential exposure under the indemnity agreement. Wisco also retained a potential liability for environmental remediation costs, the amount of which was not specified.
Chesapeake contended that Wisco’s indemnity of GP’s guarantee imposed on Wisco the economic risk of loss for the LLC debt. Conversely, the IRS argued that Wisco’s indemnity agreement should be disregarded under the anti-abuse rule of Regs. Sec. 1.752-2(j). At stake was application of the disguised sale rules of Sec. 707(a)(2)(B). If the entire liability was properly allocable to Wisco, distribution of the loan proceeds would not be considered a disguised sale under a regulatory exception for debt-financed distributions (Regs. Sec. 1.707-5(b)). If the loan was not entirely allocable to Wisco, some or all of the distribution would be recast as a taxable sale of Wisco’s assets to the LLC.
The court’s recitation of the facts makes it clear that Chesapeake was ultimately seeking to divest itself of Wisco’s business because it did not fit with Chesapeake’s specialty packaging and merchandising focus. Chesapeake had considered selling Wisco to generate capital, but because of the low basis in its assets, the after-tax proceeds of a sale would have been low compared with the pretax proceeds. The leveraged partnership strategy was presented to Chesapeake by outside advisers as a means of monetizing Wisco’s value while deferring tax.
GP guaranteed the LLC’s debt and did not require Chesapeake to execute an indemnity. Rather, Chesapeake insisted on the indemnity when advised that it was necessary to defer tax on the transaction. The court found that the indemnity had been entered into by Wisco rather than Chesapeake in order to limit Chesapeake’s potential exposure to the amount of Wisco’s assets remaining after the transactions were completed. In addition, the indemnity limited the circumstances in which Wisco would be called upon to make payment. First, the indemnity covered only the principal amount of the debt, not interest. Next, GP was required to proceed against the LLC’s assets before demanding indemnification from Wisco. Finally, Wisco’s interest in the joint venture was to be increased proportionately by any payment on the indemnity. Wisco was not required to maintain any minimum net worth under the agreement, but its own advisers suggested that it should retain at least $151 million of net assets to avoid taxation.
The court ruled that the indemnity agreement was used to create the appearance that Wisco bore the economic risk of loss for the LLC’s debt when in substance the risk was borne by GP:
- The court found it compelling that a Chesapeake executive represented to Moody’s and Standard & Poor’s that the only risk associated with the transaction was the tax risk.
- The indemnity agreement did not require Wisco to retain the note or any other asset. Thus, Chesapeake could have caused Wisco to cancel the note at any time to reduce its asset level to zero.
- Wisco remained subject to potential environmental remediation liabilities and, along with other Chesapeake subsidiaries, guaranteed a credit line obtained by Chesapeake. These potential liabilities further reduced Wisco’s net worth.
- GP neither asked for nor received any assurances that Wisco would not further encumber its assets.
Based on the facts, the court concluded that Wisco had no economic risk of loss and should not be allocated any part of the debt incurred by the LLC.
Chesapeake sought to distinguish the transaction from the example provided in the anti-abuse regulation, noting that Wisco was not a newly created entity, as was the subsidiary in the example, but had been in business before the transaction. The court found Wisco’s prior existence insufficient to distinguish the Wisco transaction from the example. Instead, the court focused on Chesapeake’s use of Wisco to limit its exposure under the indemnity agreement. Thus, the court found the Wisco transaction analogous to the regulatory illustration because in both cases the true economic burden of the partnership debt was borne by the other partner as guarantor.
Chesapeake further argued that Wisco should be found to bear the economic risk of loss because Wisco was not an empty shell but held substantial assets after the transaction. It suggested that the court should apply a 10% net worth requirement, relying on Rev. Proc. 89-12 (subsequently obsoleted by Rev. Rul. 2003-99), which states that a limited partnership will be deemed to lack limited liability for advance ruling purposes if a corporate general partner of the partnership has a net worth equaling 10% or more of the total contributions to the partnership. The court declined to establish a bright-line percentage or other mechanical test to determine whether a partner has enough net value to be treated as bearing the economic risk of loss with respect to the LLC’s liability, instead finding that the anti-abuse rule mandates consideration of all the facts and circumstances. The refusal of the court to set a bright-line value requirement cannot be read to reject the 21% value-to-obligation ratio achieved by Wisco because the court found that in fact none of Wisco’s assets were truly at risk. It is possible that, had Wisco been contractually required to maintain that level of value, the court might have concluded otherwise.
Finally, Chesapeake argued that intercompany transfers of the distributed debt proceeds could be subject to fraudulent conveyance claims and that such potential claims exposed Wisco and its affiliates to a risk of loss in excess of Wisco’s net worth. The term “fraudulent conveyance” generally is used to describe an improper transfer of property undertaken by debtors in order to place their property beyond the reach of creditors. Creditors may be able to enforce liens against such property in the hands of the transferee. The court noted that a finding of a fraudulent conveyance gives the creditor a cause of action but does not constitute an obligation of the debtor and that creating an exception for such speculative claims would render the anti-abuse rule meaningless. Accordingly, it rejected the argument.
It is not uncommon for partners to attempt to alter the allocation of partnership liabilities through guarantees and similar arrangements where there is a need for additional basis. When the terms of such arrangements are not dictated by nontax business circumstances, there is an understandable desire to limit the risk that the partner will incur an actual loss. But if the risk is so limited that the arrangement merely gives the appearance of economic risk of loss where in substance such risk may be lacking, the purported tax effect of the arrangement may run afoul of the anti-abuse regulation and be disregarded.
The Tax Court’s decision in Canal sheds some light on what factors the courts might consider in applying the anti-abuse rule. Clearly, courts will consider any contractual terms that limit the likelihood that a partner will actually have to perform on its obligations. The net value of the obligor’s assets that are available to satisfy claims is another factor, as is the freedom of the partner to withdraw such assets from the reach of creditors. Conversely, speculative legal claims to additional assets will apparently carry little weight. The fact that Wisco was a preexisting entity with substantial historical operations did not sway the court and may therefore represent a neutral factor. Nevertheless, based on the regulatory example, the insertion of a newly formed entity with no business operations may be considered evidence of a plan to circumvent or avoid the obligation.
In addition, the regulation by its terms applies when the facts and circumstances indicate a principal purpose to eliminate the partner’s economic risk of loss or create the appearance of an economic risk of loss when in fact the substance is otherwise. The regulations may also apply when the facts and circumstances evidence a plan to circumvent or avoid the obligation. The Tax Court found such a principal purpose in Canal where there was extensive planning to achieve the desired allocation of liabilities while limiting risk. The rule may not be so easily applied in the more common case of a partner that simply guarantees partnership debt to increase its tax basis in its partnership interest.
Kevin Anderson is a partner, National Tax Services, with BDO USA, LLP, in Bethesda, MD.
For additional information about these items, contact Mr. Anderson at (301) 634-0222 or email@example.com.