S Corporations
On June 14, 2013, the IRS issued Chief Counsel Advice (CCA) 201324013. The CCA focuses on the treatment of leveraged partnership transactions and the consequence of indemnity agreements in regard to disguised sales. In the CCA, the Office of Chief Counsel (OCC) advised that an indemnification agreement should be disregarded and, accordingly, the underlying partner contribution and distribution should be treated as a disguised sale under Sec. 707(a)(2)(B). The OCC based its conclusion on the precedents established in Canal Corp., 135 T.C. 199 (2010), and the anti-abuse rules under Regs. Sec. 1.752-2(j).
Background
Partnership taxation is renowned for its flexibility as well as its complexity. Two or more parties can decide to establish a business by contributing assets to the partnership in exchange for a partnership interest, and generally neither the partnership nor the partners recognize gain or loss (Sec. 721(a)). To forestall potential tax abuse, the IRS has an arsenal of weapons at its disposal for challenging a perversion of the partnership rules, including challenging the economic substance of a transaction and recharacterizing a partnership contribution of property as a disguised sale (Regs. Sec. 1.707-3), as well as applying the anti-abuse rules of Regs. Sec. 1.752-2(j).
In general , if a partner transfers property to a partnership and that partner receives one or more transfers of money or other consideration by the partnership, the transfer may be treated as a sale of property, in whole or in part, to the partnership (Regs. Sec. 1.707-3(a)(1)). Regs. Sec. 1.707-3(c)(1) states that transfers occurring within two years of a contribution to the partnership are assumed to be a sale of the property to the partnership unless the facts and circumstances clearly establish that a transfer does not constitute a sale.
Facts of the CCA
In year 2, A purchased Corporation X, which in year 1 had been a C corporation but converted to an S corporation effective date 1. Originally, A had planned for X to retain certain select assets while selling others. However, A changed his mind after X ’s business started to deteriorate. X began negotiations with several potential buyers for the sale of the contributed assets and decided upon Y as the purchaser. Y was willing to accept X ’s desired structure. Since X was an S corporation, there would be no corporate-level tax. However, X would potentially be subject to built-in gains tax under Sec. 1374(a) if the assets were disposed of within 10 years after date 1.
Corporation X had acknowledged that the contributed assets had a built-in gain of $ b . X structured the transaction with Y as a leveraged partnership in an attempt to permanently avoid built-in gain recognition under Sec. 1374. Specifically, on date 2, X formed a qualified subchapter S subsidiary, QSub-X , which combined with Sub-Y2 , a second-tier subsidiary of a wholly owned subsidiary of Y ( Sub-Y1 ), to form the partnership. QSub-X contributed assets with a fair market value of $ c for a d % partnership interest. Sub-Y2 contributed Y notes, with a fair market value of $ e , plus cash of $ f, in exchange for an a % partnership interest.
The Y notes were issued at the same time of the transaction and had identical terms and indenture as Y notes issued to the public in year 1, and matured in year 4. The associated credit agreement precluded the partnership from disposing of or subordinating the Y notes except to the extent that any proceeds were used to refinance the Y notes or otherwise invest in cash or cash equivalents (but held as restricted assets).
In year 3, the partnership refinanced the Y notes so that the new Y notes were not due until years 7 and 8.
Also, on date 2, the partnership’s newly formed subsidiary, Sub-P , borrowed $ e from a bank. The debt matured in year 5, and the partnership agreed to maintain a certain amount of the debt for a period of years, subject to an amortization schedule. The borrowed funds were used to finance a special distribution to QSub-X for $ g million, which represented a stipulated amount plus prepaid rent for the use of company facilities. This loan was later refinanced until year 6, with the bank taking back a first priority interest in collateral consisting of all the assets of the partnership, Sub-Y1 ’s equity interest in the partnership, the capital stock of the partnership’s subsidiaries, and the Y notes.
In short, the partnership, Sub-Y1 , and Sub-Y2 guaranteed the bank debt. Since the guarantees were guarantees of payment, the lender had the right to collect from the guarantors any unpaid due amounts without having to first exhaust other remedies.
X entered into an indemnity agreement that indemnified Sub-Y1 and Sub-Y2 on their payment guarantees. Y could proceed against X only for amounts it actually had to pay on the guarantees. Under this indemnity agreement, X did not have any net-worth maintenance obligation or the typical financial reporting requirements. Corporation X disclosed the indemnity in its financial statements, but it did not record it as a liability or contingent liability.
Beginning in the 10th year and ending with the 13th year, Sub-Y2 had a call option with respect to X ’s partnership interest, priced at fair market value. After the 13th year from closing, X had a put option with respect to its partnership interest, subject to Sub-Y2 ’s right of first refusal.
On X’s tax returns, it reported the contributed assets as nontaxable under Sec. 721(a), with all the distributions (other than the prepaid rent) as a nontaxable distribution under Sec. 731(a)(1).
Law and Analysis
The disguised-sale rules provide that Sec. 752 and the regulations thereunder apply when calculating a partner’s share of partnership liabilities. A partner’s share of recourse liability equals the portion of that liability, if any, for which the partner bears the economic risk of loss (Regs. Sec. 1.752-2(a)). For a partner to bear the economic risk of loss, the partner must be obligated to make a payment or a contribution to the partnership in the event of a constructive liquidation, which makes the liability due and payable, and such payment is unreimburseable (Regs. Sec. 1.752-2(b)(1)).
According to Regs. Sec. 1.752-2(b), all statutory and contractual obligations relating to the partnership liability are taken into account for purposes of determining the economic risk of loss. These obligations include guarantees, indemnifications, reimbursement agreements, and other obligations running directly to creditors or to other partners. Accordingly, if an indemnification agreement contains the substantive elements, it will be considered an obligation of a partner.
According to the anti-abuse rules, an obligation of a partner or related person to make a payment may be disregarded or treated as an obligation of another person if the 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’s or related person’s bearing the economic risk of loss when, in fact, the substance of the arrangement is otherwise (Regs. Sec. 1.752-2(j)).
According to the OCC, if X ’s indemnity agreement were respected, X probably would bear the economic risk of loss for the partnership liability and be allocated the full amount of that liability. However, the OCC concluded that, based on the facts, the indemnity should be disregarded under the anti-abuse rules. Based on Canal Corp. , an indemnity agreement should be disregarded if it actually is a “guise to cloak” a partner “with an obligation for which it bore no actual economic risk of loss” ( Canal Corp. , 135 T.C. at 213).
In Canal Corp. the Tax Court considered both the purpose of an indemnification agreement, as well as whether the entity had adequate assets to cover the agreement. The indemnification agreement had several deficiencies that the IRS analyzed to conclude that the agreement should be disregarded.
As in Canal Corp ., the lenders in this case did not impose a net-worth requirement on the taxpayer, which provided an exit strategy that most lenders would want to be protected against. However, in this loan, the lenders were not even looking for X ’s credit protection. The OCC noted that neither the lenders nor the guarantors required X to provide an indemnification and that X ’s insistence for its inclusion was self-serving and thus specious.
Typically, the features included in an indemnity agreement confirm whether it is a commercially driven transaction. According to the OCC, these features include net-worth maintenance requirements, an arm’s-length indemnity fee, obligations to provide financial statements, and evidence that the parties engaged in genuine negotiations over the indemnity. The OCC found that the lack of such features in this case suggested a lack of concern or interest on the part of the lenders and guarantors in having X pay on the indemnity.
In addition, the OCC concluded that there was no feasible way to enforce the indemnity agreement. Essentially, the Y affiliates guaranteed Y ’s own debt. Since the Y notes contributed to the partnership were truly intercompany debt, these notes were collateral on the bank loan. If Y were unable to pay the loan, the indemnity would not be enforceable on X . It is important to remember X ’s indemnity was only for the payments made on Y ’s guarantee. If Y were to default on its guarantee, the indemnity agreement did not require X to pay, since X had no obligation to pay the bank but merely to reimburse the Y affiliates on actual payments made to the bank.
The OCC further determined that the partnership was designed as a conduit to borrow money from the bank to accommodate X ’s structure. The Y notes and bank loan were similar in many ways: The principal amount and the loan amount were the same, as were the contribution dates and the issue date. The maturity date for the Y notes was year 4 and that of the bank loan was year 5. The OCC found these loans were similar to back-to-back loans.
Secs. 721 and 731, which generally provide for nonrecognition treatment of contributions by a partner to the partnership and distributions from the partnership to that partner, will not apply in the case of a disguised sale, under Sec. 707(a)(2)(B) and Regs. Sec. 1.707-3(a)(1). The OCC advised that the indemnity agreement should be disregarded under the anti-abuse provisions in Regs. Sec. 1.752-2(j). X’s basis would not reflect the allocation of that liability and X’s distribution would be taxable under Sec. 731 because the distribution would exceed X’s basis in the partnership.
The OCC alternatively determined that it could reach a similar result by arguing that the structured partnership should be disregarded under the anti-abuse rules of Regs. Sec. 1.701-2(b) and that the transaction should be recast as Y’s borrowing from the bank to purchase a% of the contributed assets, followed by the formation of a partnership. Finally, the OCC stated that it also could have reached a similar result by arguing substance vs. form and recasting the transaction as a sale of a% of the contributed assets.
Observation
One can see from the facts of the CCA that the substance of the transaction was that of a sale. The economic substance of the transactions concocted by X to avoid the tax from the sale of built-in gain assets to Y ultimately prevailed, notwithstanding the window dressing that X designed. The IRS disregarded the indemnity agreement because there was no business purpose for the indemnity, and as a consequence the agreement did not have the features that would be common to protect the lender and restrict the indemnitor. The OCC argues persuasively in the CCA that the transaction should be recast to meet the economic reality of the underlying transaction.
EditorNotes
Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP, in New York City.
For additional information about these items, contact Mr. Wong at 212-792-4986, ext. 986, or awong@bakertilly.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.
