FSA Outlines IRS Position on Partnership Aspect of Lease-Stripping Transaction

In FSA 200134002, the IRS used the regulations under Sec. 701 to attack a lease strip that a promoter arranged to generate duplicative losses. Through a series of transactions that began with a lease strip, a foreign entity classified as a partnership (FP) purported to transfer a lease payment obligation and Treasury securities to corporations in exchange for preferred stock. FP claimed that its basis in the stock exceeded the stock's value. Further, FP transferred the stock to an upper-tier partnership (UTP). It later sold its interest in UTP to a UTP partner (Transferee) when UTP did not have a Sec. 754 election in effect. The Service argued (among other things) that the partnership anti-abuse regulations should be applied to deny Transferee any loss on the subsequent sale of the preferred stock.

In a transaction whose steps were apparently prearranged, FP leased property from D, which it subleased. The sublessees prepaid the rent, which FP invested in Treasury securities. It held the prepayments in an account of Bank for later disbursement to D in satisfaction of FP's lease obligation to D. A portion of FP's payment obligation was guaranteed by Bank, which took a security interest in the Treasury securities. Bank loaned the sublessees the money to prepay their obligations to FP. The prepayments held by Bank were paid to D, the original lessee, semiannually. D made payments on the loan incurred by the sublessees as it received rent payments from FP, through the Bank account. It is unclear whether D was related to any of the entities involved in the lease strip.

When it contributed the loss stock to UTP, FP acquired a right to put its UTP interest to Transferee. The owners of FP simultaneously acquired a right to buy into the UTP partnership group on an individual basis. It seems that FP always intended to exercise the put.

With regard to the partnership anti-abuse regulations, the Service held the above transactions were very similar to Ex. 8 of Regs. Sec. 1.701-2(d). In Ex. 8, as part of a prearranged plan, a seller of built-in loss property formed a partnership by contributing the built-in loss property. The other partners were related to the property's potential buyer. Subsequently, the seller liquidated his partnership interest, taking property whose basis was stepped up as a result of its distribution to the seller (creating a loss in such property). The partnership did not make a Sec. 754 election, preserving the built-in loss in the property that the seller originally contributed. Later, the partnership sold the property for a tax loss.

In the FSA, the IRS argued that FP's contribution of the loss stock to UTP should be recast, because the business purpose for the transaction was insignificant (when compared to the tax savings). The Service argued that the recast under Regs. Sec. 1.701-2(d) was a sale of the loss stock by FP to Transferee, followed by a contribution of the stock by Transferee to the UTP group. This recast would eliminate the loss duplication on the stock. The IRS also made other arguments attacking the transaction, including substance-over-form and Sec. 482.

From Jeffrey A. Erickson, J.D., Washington, DC