CCAs Address Partnership Transactions

In late 2002, the IRS National Office issued a pair of Chief Counsel Advice (CCA) scrutinizing the form of two structured partnership transactions. Each memorandum analyzed a transaction involving a property transfer between a partnership and one of its partners. In each, the IRS took the position that, under Sec. 707(a)(2)(B), the property transfer should be treated as a transaction between a partnership and a party who is not a partner (a disguised sale of property). In so doing, the Service appears ready to challenge these types of transactions using an array of statutory provisions and judicial theories. It issued these heavily redacted memoranda less than one month apart, indicating that it may be sharpening its focus in examining these types of transactions.

In the first memorandum, issued Nov. 15, 2002, the IRS argued (based on several different theories) that the form of a partnership-formation transaction should be recast as a property sale.

A taxpayer sold certain high-basis/high-value assets to X and contributed certain low-basis/high-value assets to a wholly owned subsidiary, Y. Y then contributed those assets to a partnership, Z, in exchange for a common equity interest and a preferred interest. X contributed assets (including a portion of the assets previously purchased from the taxpayer) and cash to Z for a common equity interest. Z then borrowed funds and immediately distributed a portion of them to Y. Y guaranteed the loan to Z and immediately distributed the funds as a dividend to the taxpayer.

The taxpayer argued that Ys guarantee of the loan to Z made the liability recourse to Y under Regs. Sec. 1.752-2, so that Y should be allocated the entire loan amount. This allocation would enable Y to increase its basis for its Z interest by the loan amount.

Without this additional basis, the distribution to Y could exceed Ys basis for its Z interest, resulting in gain to Y under Sec. 731. In addition, if Y were allocated less than the entire loan amount, the distribution of loan proceeds to Y could be treated as consideration in a disguised asset sale by Y to Z under Regs. Sec. 1.707-5(b)(1), to the extent the distribution exceeded Ys allocable share of the liability.

Concluding that Y was severely undercapitalized and had no real performance obligation on the guarantee, the Service determined that Ys guarantee should be disregarded. The IRS then determined that Zs loan was a nonrecourse liability to be allocated among its partners under Regs. Sec. 1.752-3. It did not address whether this allocation would provide Y with sufficient basis to avoid gain recognition under Sec. 731, instead deferring further analysis until the taxpayer advanced its argument against gain recognition.

For Regs. Sec. 1.707-5(b)(1) purposes, Ys allocable share of the loan was to be determined using the same percentage used to determine the partners share of excess nonrecourse liabilities under Regs. Sec. 1.752-3(a)(3). Although the Z partnership agreement provided that a certain percentage of the excess nonrecourse liabilities would be allocated to Y, the IRS concluded that such an allocation was not consistent with any significant partnership allocation of profits or losses, as required by the regulations. Accordingly, the IRS argued that the allocation provided in the partnership agreement should be disregarded and Ys share of nonrecourse liabilities should be determined in accordance with its overall interest in partnership profits. As a result, any loan proceeds distributed to Y in excess of its allocable share of the loan should be treated as consideration in a Regs. Sec. 1.707-5(b)(1) disguised sale.

The IRS also argued that the Regs. Sec. 1.701-2 partnership anti-abuse rules applied. It found that the taxpayer had effectively monetized its equity interest in the businesses, while transferring the benefits and burdens of ownership to X. The partnership structure provided the taxpayer with the current benefit of a cash distribution, while deferring the gain recognition and associated tax liability until some future time. Further, the IRS stated that the taxpayers direct sale of its high-basis/high-value assets to X was a strong indicator that a principal purpose of ultimately contributing its low-basis/high-value assets to Z was the reduction of the taxpayers Federal tax liability. Based on these points, it concluded the transaction was inconsistent with the intent of subchapter K and could be recast under the Regs. Sec. 1.701-2 anti-abuse rule.

The IRS also applied the substance-over-form doctrine, which looks through a transactions form to determine its actual substance in light of economic realities. The Service believed that the facts established a strong argument that the taxpayer should be taxed according to the actual substance of the transaction (a sale), not its form (a contribution to a partnership followed by a distribution).

Finally, the IRS concluded that Z was not a valid partnership for Federal tax purposes, and that the transaction should be recast as a sale. The facts just did not show that the taxpayer (through Y) and X, acting in good faith and with a business purpose, intended to join together to conduct a business. In reaching that conclusion, the Service found (1) no legitimate business purpose for creating Z; (2) Ys interest in Z was nominal, and most of its capital contribution was returned to it through a distribution; (3) Y did not participate in the management and control of the business being carried on by Z; (4) Y provided no services to Z (meaning that if Y withdrew, Zs business would probably not suffer); and (5) the existence of a tax avoidance motive indicated that a bona fide intent to carry on a business venture as a partnership never existed.

In the second memorandum, issued on Dec. 12, 2002, the Service argued that a proposed redemption transaction should be recast as a disguised sale or was otherwise taxable under Sec. 731(c).

A domestic partnership, PRS, was equally owned by two domestic corporations, W and X. The corporations sought to liquidate their interests in PRS, and identified a prospective buyer, A. PRS borrowed money and purchased a note. Xs parent, Z, guaranteed the loan. The note was secured by units of participation in a trust securitizing bank credit card receivables. To enable PRS to remain a partnership after the redemption of X, W transferred a portion of its PRS interest to a sister corporation, V. Z exchanged its X stock for newly issued stock of As subsidiary, B. PRS later redeemed X by distributing all of its assets except for the note. At the same time, X assumed the loan and repaid it with cash from A or B.

The IRS concluded that the distribution of PRSs operating assets to X should be treated as a distribution of a portion of the assets, coupled with a disguised sale of the remaining portion. Alternatively, it indicated that the transaction could be recast as a disguised sale of Ws and Vs interests in PRS to X. The Service also concluded that the distribution should be recast under the Sec. 731(c) anti-abuse rule contained in Regs. Sec. 1.731-2(h), as a taxable distribution of marketable securities to W and V.

The IRS found that Xs assumption of PRSs liabilities and the subsequent distribution of PRSs operating assets were properly characterized as a sale when viewed together. Because the transfers occurred within two years of each other, they were presumed to be a sale under Regs. Sec. 1.707-3(c) (unless the facts and circumstances clearly indicated otherwise). The Service identified several factors in support of sale treatment, including that the effect of the distribution, when coupled with PRSs retention of the note and Xs withdrawal, was to exchange the burdens and benefits of property ownership.

Alternatively, the IRS suggested that the transfer of the historical business of PRS to X could be viewed as a disguised sale of partnership interests from W and V to X. Although regulations addressing the disguised sale of partnership interests under Sec. 707(a)(2)(B) have yet to be issued, the Service indicated a willingness to use this argument on the basis of the statute and legislative history.

The IRS also concluded that the note met the definition of marketable securities under Sec. 731(c). Under Sec. 731(c), marketable securities are treated as money for Sec. 731 purposes, so that a distribution of marketable securities by a partnership will result in gain to the distributee partner if the distributions fair market value exceeds the distributee partners basis in its partnership interest. Generally, marketable securities are defined to include securities that are actively traded, as well as certain other similar financial assets. The Service held that although not actively traded, the note nonetheless fell within the scope of Sec. 731(c)(2)(B)(ii), which defines marketable securities to include any financial instrument which, pursuant to its terms or any other arrangement, is readily convertible into, or ex-changeable for, money or marketable securities.

The IRS pointed out that the investment bank that created the note was in the business of making private placements of similar notes, and the bank that generated the credit card receivables formed two or more credit card trusts each year. Based on these facts, it concluded that the note had a ready market for resale and met the definition of marketable security under Sec. 731(c). The IRSs conclusion that the note was readily convertible to money because of the availability of private placements appears to signal that the Service may be taking an expansive view of that standard.

Concluding that the note constituted marketable securities for Sec. 731(c) purposes enabled the IRS to contend that the distribution of substantially all of PRSs assets and liabilities in redemption of X was, in substance, equivalent to a distribution of the note to the remaining partners, and should be recast accordingly. The Service cited the Regs. Sec. 1.731-2(h) anti-abuse provision, which provides that a distribution of substantially all of the assets of a partnership other than marketable securities and money to some partners may also be treated as a distribution of marketable securities to the remaining partners if the distribution of the other property and the withdrawal of the other partners is, in substance, equivalent to a distribution of the securities to the remaining partners.

Although the issuance of these two memoranda seems to indicate the IRSs willingness to challenge these types of transactions based on multiple statutory and judicial theories, the sustainability of such challenges in a court has yet to be determined. Until such time, however, the issuance of these two memoranda should serve as a warning to both taxpayers and practitioners alike that the IRS appears to be developing an increased interest in these types of transactions, ultimately resulting in a higher degree of scrutiny.

From Christopher T. Kelley, J.D., LL.M., and Charles J. Giambalvo, Jr., CPA, J.D., LL.M., Washington, DC