Partnership distributions have been a key issue for the IRS in recent years. In 2016, the IRS and Treasury Department issued temporary regulations under the section 707 disguised sale rules that effectively turned off the debt-financed distribution exception by providing that all liabilities would be allocated for disguised sale purposes in accordance with a partner’s interest in partnership profits, regardless of whether the liability was a recourse or non-recourse liability. In 2018, proposed regulations were published that repealed the temporary regulations and reinstated the prior rules, including the debt-financed distribution exception, with retroactive effect. The IRS and Treasury issued final regulations in October 2019.
In September 2021, Senate Finance Committee Chair Ron Wyden, D-Ore., issued a detailed discussion draft that contained substantial changes to partnership taxation (the Discussion Draft). In particular, section 12 of the Discussion Draft contains a proposal to require “all debt [to] be shared between the partners in accordance with partnership profits,” a proposal that would effectively revive the approach of the 2016 proposed regulations. Just a month after, in October 2021, the Tax Court decided Tribune Media v. Commissioner, which involved a disguised sale transaction and the debt-financed distribution exception.
This article provides an overview of the disguised sale rules and the debt-financed distribution exception. Part I provides background of subchapter K rules. Part II explains the disguised sale rules under section 707(a)(2)(B) and discusses Tribune Media as an illustrative example. Continuing the discussion of Tribune Media, Part III analyzes the debt-financed distribution exception and introduces the concept of “economic risk of loss.”
I. Subchapter K Background and Otey
The purpose of the partnership tax provisions of subchapter K is to allow taxpayers “to conduct joint business (including investment) activities through a flexible economic arrangement without incurring entity-level tax” and without regard to the partners’ proportionate ownership of the enterprise. Several provisions in subchapter K work in tandem to execute this policy goal. Under section 721(a), a partner generally does not recognize gain or loss upon contribution of property to a partnership in exchange for an interest in the partnership, and any precontribution gain or loss is preserved until a future recognition event. Under section 731(a), a partner generally does not recognize loss on non-liquidating distribution, nor gain on the receipt of a distribution from a partnership, except to the extent a cash distribution exceeds the partner’s basis in its partnership interest. Thus, the amount of a partner’s basis in the partner’s partnership interest determines the extent to which gain is recognized by the partner upon receipt of a cash distribution from the partnership. Finally, under section 752(a), a partner generally includes its share of the partnership’s liabilities in the partner’s basis of its the partnership interest. Because a partner’s share of liabilities increases the partner’s basis in its partnership interest, how liabilities are allocated is a fundamental subchapter K question.
Taxpayers have used (perhaps overused) the flexibility of subchapter K to minimize tax liabilities. The taxpayer-friendly rules allow taxpayers to structure transactions that are otherwise taxable as related tax-free contributions and tax-free distributions. For instance, a “disguised sale” occurs when a taxpayer transfers property to a partnership in exchange for an interest in the partnership and receives cash or property from the partnership in a way that renders the transaction a sale. An illustration is Otey v. Commissioner, which Congress specifically identified as the kind of taxpayer victory that it sought to prevent. Otey involved a taxpayer from Nashville, Tennessee who wanted to sell the land he inherited from his uncle to a real estate developer. Instead of an outright sale, the taxpayer and the real estate developer agreed to form a partnership, with the taxpayer transferring his land to the partnership at an agreed value of $65,000 (basis of $18,500) and the real estate developer contributing his “ability to get financing for the partnership through his good credit.” The partners treated the taxpayer’s transfer of the land to the partnership as a contribution of capital under section 721. The partnership subsequently took out a construction loan of approximately $870,000 and, pursuant to the partnership agreement, distributed one-half of the loan proceeds to the taxpayer. The taxpayer argued that the distribution of cash by the partnership was tax free under section 731 because his basis in the partnership ($18,500 plus his one-half share of the partnership’s construction loan under section 752) exceeded the amount of cash distributed to him. The IRS, on the other hand, contended that the contribution and distribution of cash functioned in substance as a taxable sale of his land to the partnership.
The Tax Court held, and the Sixth Circuit affirmed, that the cash was a partnership distribution rather than sales proceeds. The Court noted that the taxpayer was personally liable for his share of the partnership debt; more importantly, the partnership would not have existed without the taxpayer’s transfer of the land to the partnership. The Tax Court recognized, however, that “[n]either the Code and regulations nor the case law offers a great deal of guidance.”
II. Section 707(a)(2)(B) Disguised Sale Rules
In 1984, Congress enacted section 707(a)(2)(B) out of concern that taxpayers, like the taxpayer in Otey, “were inappropriately deferring gain on transactions that were actually sales of property by structuring the transactions as partnership contributions and distributions.” Section 707(a)(2)(B) gives the Treasury Secretary the authority to prescribe regulations and establish criteria to determine whether related contributions and distributions are, in substance, a sale of property. Under section 707(a)(2)(B), a transaction is a taxable sale if: (i) there is a direct or indirect transfer of money or other property by a partner to a partnership, (ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and (iii) the transfers, when viewed together, are properly characterized as a sale or exchange of property.
The Treasury Regulations include a non-exhaustive list of factors used to determine whether a disguised sale occurred, including (i) whether the timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of an earlier transfer, (ii) whether the transferor has a legally enforceable right to the subsequent transfer, and (iii) whether the partnership has incurred or is obligated to incur debt to acquire the money or other consideration necessary to permit it to make the transfer. The Treasury Regulations also provide a rebuttable presumption that the transfers are a sale if a partner transfers property to a partnership and the partnership transfers money or other consideration to the partner within a two-year period.
Tribune Media provides a clear example of a disguised sale under section 707(a)(2)(B). That case involved the sale (the Cubs transaction) of the Chicago Cubs Major League Baseball team (the Cubs assets) by Tribune Media Co. (Tribune) to the Ricketts family. At the time of the Cubs transaction, Tribune was in deep financial trouble and the Cubs assets had appreciated significantly in value, making an outright sale of those assets (resulting in considerable gain recognition) undesirable. Tribune and the Ricketts family agreed to form a partnership, with Tribune contributing the Cubs assets valued at approximately $735 million in exchange for a 5 percent interest and the Ricketts family contributing $150 million in exchange for a 95 percent interest. To finance the Cubs transaction, the partnership also took out two tranches of debt, both of which were guaranteed by Tribune: one from the Ricketts family and one from a commercial lender. As required by the formation agreement, the partnership made a special distribution to Tribune on the closing date of approximately $705 million, financed by a combination of the equity contribution by the Ricketts family and the partnership’s debt. Tribune did not dispute that nature of the Cubs transaction; in fact, it reported the Cubs transaction on its 2009 tax return as a disguised sale.
Despite the enactment of section 707(a)(2)(B), distinguishing bona fide contribution and distribution transactions from disguised sales has remained challenging in practice. Not only has the government been “unable to craft workable rules nearly four decades after” it enacted the disguised sale rules, but also overlaps of the disguised sales rules with other areas of the tax law, such as the like-kind exchange rules under section 1031, have added more complexity. Furthermore, regulatory exceptions to the disguised sale rules have given rise to new tax planning schemes and tax mischief.
III. Section 707 Debt-Financed Distributions Exception and Economic Risk of Loss
One exception to the disguised sale rules is the debt-financed distribution exception. The debt-financed distribution exception allows a partner to receive from the partnership cash (or property) financed with debt on a tax-deferred basis up to the amount of the partner’s “allocable share” of the partnership’s debt. To determine a partner’s “allocable share” of the partnership’s debt, subchapter K adopts a concept of economic risk of loss (EROL). As noted in Part I, how partnership liabilities are allocated is fundamental to subchapter K, and EROL is the key mechanism by which partnership liabilities are allocated under subchapter K.
A recourse liability is defined as a liability for which any partner or related person bears the EROL for that liability. To the extent a partner bears EROL for a partnership debt, the debt is recourse and allocated to the partner. EROL is determined by applying the so-called “doomsday scenario.” This EROL test considers the worst-case scenario: all partnership assets, including cash, become worthless, all of the partnership’s liabilities become payable in full, and the partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor is limited solely to particular assets of the partnership), after which it liquidates. To the extent that a partner is “on the hook” for the partnership’s debt in this scenario, the liabilities are recourse and allocated to the partner.
Partnerships and partners have used various arrangements, such as guaranties, assumptions, and indemnity agreements, to influence the manner in which partners share the EROL with respect to partnership debts. If the arrangement is valid and sufficiently obligates the partner under the doomsday scenario, the debt is respected as a recourse debt. A partner’s obligation to make a payment on the debt is based on the facts and circumstances and includes any statutory or contractual obligations. To the benefit of taxpayers, the regulations assume that partners who have obligations will actually perform those obligations, “unless the facts and circumstances indicate a plan to circumvent or avoid the obligation” or there is no commercially reasonable expectation that the payment obligor will have the ability to make the required payments.
In Tribune Media, Tribune conceded that the Cubs transaction – the contribution of Cubs assets worth $735 million followed by a special cash distribution to Tribune of approximately $705 million – was a disguised sale but argued that it should be allowed to offset a portion of the taxable gain on the special cash distribution, under the debt-financed distribution exception, to the extent it guaranteed collection of the partnership’s debt. The IRS, on the other hand, argued that Tribune did not bear EROL for the debt and that its debt guaranty was an “illusion” intended to create the appearance that Tribune bore the EROL when, in fact, it did not “creat[e] any real risk” for Tribune. The IRS contended that under the terms of Tribune’s guaranty of the debt, which required the creditors to exhaust all other legal remedies before turning to Tribune, it was unclear that the creditors “would be capable of exhausting these legal remedies.” It further pointed to numerous “buffers” in place that made it unlikely that Tribune’s debt guaranty would ever be called.
The Tax Court rejected the IRS’s argument and held that Tribune ultimately bore the EROL for the senior debt. The Tax Court explained that in a worst-case scenario, “[n]o other party was liable for the debt, no partnership assets secured the loans, and if the debt were due in full in the world of a constructive liquidation, the senior debt creditors would seek repayment from Tribune and no other party.” The Tax Court emphasized that under the doomsday scenario, the low probability of Tribune’s fulfillment of its obligation is “irrelevant” because the test assumes a worst-case scenario under which everything, including the “buffers,” is rendered worthless and the debt guaranty is called. The regulation asks who, in this worst-case scenario, the creditors would look to for payment of the debt. The Tax Court observed that, “[b]y relying on the unlikeliness, [the IRS] concedes the possibility.”
IV. Conclusion
On July 27, 2022, Senator Joe Manchin, D-WV, and Senate Majority Leader Chuck Schumer, D-NY, announced a successful negotiation of the Inflation Reduction Act of 2022 (the Act), which includes significant federal income tax changes. President Biden signed the Act on August 16, 2022. The bill does not modify subchapter K, leaving debt-financed distributions, as still, the name of the subchapter K game. Given recent congressional focus on subchapter K reform and the lively debate taking place in the tax community, however, it may be too early for 'team maximum flexibility' to declare victory. Subchapter K reform may still be on Congress’s radar.