Structuring Decisions of Leveraged Partnership Transactions After Canal

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May 4, 2011

On August 5, 2010, the Tax Court applied an anti-abuse rule in the Treasury Regulations to hold that a leveraged partnership transaction designed to defer the recognition of gain on a nonrecognition contribution to a partnership was in actuality a “disguised sale” and an immediate taxable sale of assets. The case provides insights into the taxation of leveraged partnership transactions.

In the past several years, the IRS has taken a strong position that certain leveraged partnership transactions should be challenged to test the transaction s validity under the Internal Revenue Code. The IRS succeeded in its challenge in Canal Corporation. Although Canal’s holding was arguably incorrect, a practitioner needs to structure transactions carefully and use diligence in understanding the Internal Revenue Code, including the impact on structuring and drafting loan guarantees and indemnity agreements.

Facts of the Case
Wisconsin Tissue Mills, Inc (WISCO) and an unrelated third party (GP) were interested in forming a joint venture. The two businesses formed a limited liability company (LLC), which was taxed as a partnership for income tax purposes. Federal tax law allows both the LLC and its members from recognizing any gain or loss on the transfer of property to an LLC in exchange for a membership interest. WISCO contributed its tissue business with a value of $775 million to the LLC in exchange for a 5% membership interest. GP contributed its tissue business with a value of $376.4 million in exchange for a 95% membership interest.

On the same day the assets were transferred to the newly formed LLC, it borrowed $755.2 million from Bank of America. The LLC then immediately distributed the loan proceeds to WISCO. GP guaranteed the loan, and WISCO agreed to indemnify GP for the principal amount of the loan. The indemnity agreement only covered the principal amount of the loan and provided that GP must proceed against the LLC’s assets before making a claim against WISCO.

WISCO used all of the loan proceeds to repay other debt, distribute a dividend to its Chesapeake (Parent), and made a $151 million 5-year intercompany loan to its Parent (the Note). Soon after the entire transaction closed, the LLC borrowed money from GP’s subsidiary to retire the Bank of America loan. The LLC borrowed money in two different years following the closing of the entire transaction.

Partnership Disguised Sales Rules
The general rule is that the transfer of assets to a partnership is tax free. However, this general rule does not apply if the transfer is a “disguised sale.”

A disguised sale occurs when a partner contributes property to a partnership, there is a “related” distribution of cash or other property by the partnership to the contributing partner, and the two events are “properly characterized” as a sale.
The IRS’s regulations create a presumption that a distribution by a partnership to a partner within 2 years of the partner contributing property to it is a disguised sale, unless the facts clearly establish that the contribution and distribution do not constitute a sale.

Not all partnership distributions will be subject to the disguised sale rule. Among the distributions which are excluded from the disguised sale rule include the following:

  1. A guaranteed payment for the use of capital.
  2. A preferential distribution of partnership cash flow.
  3. The distribution of a partner’s ratable share of net cash flow from operations for the year.

There is also an exception from the disguised sale rule for distributions of borrowed funds. Under this exception, if a partnership borrows funds, and, within 90 days of borrowing those funds, makes a distribution to a partner who contributed property to the partnership, the disguised sale rule only takes into account the amount of the distribution which exceeds the partner’s share of the partnership liability for the borrowed funds.

Under the anti-abuse rules, in order to be liable for a debt, a partner has to bear the “economic risk of loss.” Generally, this means that the partner is obligated to make a nonreimbursable payment to the partnership.
Analysis

In the Canal case, WISCO claimed the distribution to it was excluded from the disguised sale rule because the distribution was made with loan proceeds and the indemnification agreement caused WISCO to bear an economic risk of loss for these borrowed funds.
The Tax Court rejected the claim that the indemnification agreement caused an economic risk of loss noting, among other facts, that

  1. GP had not asked for the indemnification,
  2. WISCO was not required to maintain a certain level of net worth,
  3. The indemnification covered only GP’s loan principal, not interest, and GP would have to go against the LLC’s assets before being able to demand indemnification from WISCO, and
  4. WISCO’s primary asset, the Note from its Parent, was subject to cancellation by its Parent at any time and was in fact cancelled.

In short, the Tax Court concluded that the indemnification agreement and the Note worked to create the appearance of an economic risk of loss but not the reality.

The case illustrates several important points. First, tax planning should be based on economic substance. Attempts to obtain favorable tax treatment by use of cleverly drafted documents which do not reflect economic realty can lead to trouble. Second, partnership tax rules are complex, technical and ambiguous. Partnership transactions should be approached with caution and with the assistance of competent advisors.

If you have questions regarding the above, please contact Sam Geraci, the author of this article, or any of the attorneys in the Business Transactions Practice Group of Ruder Ware.

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