A disguised sale may occur when a partner contributes property to a partnership and then immediately receives a cash distribution or other consideration from the partnership. Disguised sales are taxable to the partner as of the date of the contribution, just as if the partner had sold the appreciated asset to a third party. IRC Sec. 707(a)(2)(B). See also Lexis Tax Advisor -- Federal Code, IRC Sec. 707(a); Lexis Tax Advisor -- Federal Topical, Sec. 2D:7.04. A disguised sale is an important exception to the general rule that a partner does not recognize gain or loss when the partner contributes property to a partnership. IRC Sec. 721(a). See also Lexis Tax Advisor -- Federal Code, IRC Sec. 721(a); Lexis Tax Advisor -- Federal Topical, Sec. 2D:1.01. Similarly, distributions to a partner generally have no tax consequences because most distributions are typically a return of the partner's capital or constitute a payment of the partner's tax-paid income. IRC Sec. 731(a). See also Lexis Tax Advisor -- Federal Code, IRC Sec. 731(a); Lexis Tax Advisor -- Federal Topical, Sec. 2D:1.01. This non-recognition that generally occurs for both contributions and distributions is often a key factor in choosing between a flow-through entity and a corporation as a form under which to do business.
Despite a strong legislative history and detailed regulations, see Treas. Reg. Sec. 1.707-3, 1.707-4, 1.707-5, 1.707-6, the IRS has sometimes had difficulties in the courts in challenging a transaction as a disguised sale. But the IRS successfully raised a disguised sale challenge in Canal Corp. v Comm'r, 135 T.C. No. 9 (Aug 5, 2010).
In Canal Corp., Chesapeake (the former name of Canal Corp.) found that its tissue paper subsidiary, WISCO, was facing strategic disadvantages due to consolidation in this capital-intensive industry. Chesapeake wanted to exit the industry. The company considered selling its tissue paper business, but the low tax basis ruled against this option. Instead, Chesapeake decided upon a leveraged partnership structure with WISCO and Georgia Pacific as partners. Georgia Pacific entered into this transaction because it wanted to expand its own tissue paper business.
Under the leveraged partnership structure, WISCO, and then Georgia Pacific, contributed their tissue paper businesses to a newly-formed LLC. The LLC then borrowed funds from a third party and distributed the proceeds to WISCO in a special distribution. WISCO guaranteed this third-party debt; WISCO also executed an indemnity agreement with Georgia Pacific. After these transactions, WISCO held only a small minority interest in the LLC, while Georgia Pacific held a large majority interest.
The advantage of this structure was that Chesapeake would get cash out of the business, but would not recognize any taxable gain when the LLC distributed the proceeds of the third-party loan to WISCO. If this structure were tax free, Chesapeake would defer $524 million in capital gains for 30 years or longer. In addition, the tax deferral of the gain allowed Chesapeake to accept a lower valuation of its interests, thus making the deal more attractive to Georgia Pacific.
Unfortunately, the Canal Corp. Court ruled that the contribution followed by the cash distribution was a disguised sale and did not fall within the debt-financed transfer exception of Treas Reg 1.707-5(b). This exception requires that WISCO must have had an allocable share of the LLC's liabilities to finance the distribution. The key to the Court's decision was that WISCO's indemnity agreement should be disregarded because it created only a remote possibility that WISCO would actually be liable for payment to Georgia Pacific. Since WISCO had no economic risk of loss, it should not be allocated any part of the debt incurred by the LLC. Without this allocation, the distribution of cash to WISCO did not fit within the debt-financed transfer exception to the disguised sales rules.
Canal Corp. shows that tax attorneys still need to worry about disguised sales issues, especially with complex transactions that may not fit perfectly within safe harbors. In these situations, a court may well seize upon a bad fact, an ambiguity in the complicated regulations, or a questionable step in a transaction to rule against the taxpayer.
Viewe free on this site additional insights by Charles Zubrzycki on Accuracy-Related Penalties in a Disguised Sale Transaction - Canal Corp.
View free on this site excerpts from a commentary on the Implications of Canal Corp. v. Comm'r for U.S. Taxpayers and Their Advisors
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Hear further analysis of Canal Corp. v. Comm'r on this site in Robert Jennings and Elizabeth Sweigart's podcast interview.
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