Flow-Through Entity Structuring Issues in Today’s Climate · 2017-09-19 · • Assume that X’s...

364
Tax Executives Institute Talking Points Webinar Flow-Through Entity Structuring Issues in Today’s Climate March 9, 2010 Aaron P. Nocjar Steptoe & Johnson LLP Mark J. Silverman Steptoe & Johnson LLP Copyright © 2010 Mark J. Silverman & Aaron P. Nocjar

Transcript of Flow-Through Entity Structuring Issues in Today’s Climate · 2017-09-19 · • Assume that X’s...

1

Tax Executives InstituteTalking Points Webinar

Flow-Through Entity Structuring Issues in Today’s Climate

March 9, 2010

Aaron P. NocjarSteptoe & Johnson LLP

Mark J. SilvermanSteptoe & Johnson LLP

Copyright © 2010 Mark J. Silverman & Aaron P. Nocjar

2

• As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

Internal Revenue Service Circular 230 Disclosure

3

Topics• Conversions to tax partnerships

• Codification of the economic substance doctrine and the effect recent economic substance cases may have on tax planning

• Debt workout issues with tax partnerships

• Using flow-through entities, including disregarded entities, in acquisition transactions

• The latest "carried interest" legislative proposal

• The application of sections 267 and 707 in partnership transactions involving loss property -- Can I recognize the loss?

4

Conversions to Tax Partnership Status

5

Conversion Transactions

• Significant number of closely-held businesses (some of them very large) are still operated in corporate form – either as C or S corporations– More S corporations today than tax partnerships

• These types of entities can be financially inflexible and tax inefficient – C corp – double tax, no pass-through of losses– S corp – shareholder limits, only one class of stock,

cannot specially allocate, no outside basis for 3P debt

6

Conversion Transactions• Primary way to eliminate this inflexibility and inefficiency is

conversion to tax-partnership status (e.g., convert to an LLC) – Common Benefits:

• No double tax• Flow-through of tax losses• Special allocations• Preferred returns• Typical players in market can invest• Investors able to use tax losses quicker• Distributions to investors more likely to be tax-free• Broader ability to compensate employees with equity• Ability to adjust (or not adjust) tax basis of entity assets to reflect investor tax

basis• Ability to shift tax basis among entity assets or between entity assets and

interests in the entity• Ability to distribute built-in gain assets without gain recognition• Opportunity to renegotiate non-economic aspects of deal

7

Conversion Transactions• Conversion mechanics need not be complicated or time-

consuming

• However, Code imposes a toll charge for such conversions

• Magnitude of toll charge based on number of elements– Primary elements are

• FMV of interests in (and assets of) business

• Applicable tax rates at entity and investor levels

– Many secondary elements to keep an eye on too

8

Conversion Transactions

• FMV of Interests in (and Assets of) Business

– Normal economic conditions – FMV is rising• Could tilt cost-benefit analysis away from

conversion

– Today’s economic conditions – FMV is falling or relatively low

• Over past two years or more, values across industries have fallen significantly

9

Conversion Transactions• Applicable Tax Rates

– Ten-year run of relatively low tax rates is likely to end after this year

• Now– Max. Indiv. Income Tax Rate – 35%– Max. Indiv. Tax Rate on Div. and LTCGs – 15%– Max. Corp. Tax Rate – 35%

• Next Year– Max. Indiv. Income Tax Rate – 39.6%+– Reinstate phase-outs/limits on it. ded. & pers. exempt.– Max. Tax Rate on Dividends – 39.6%– Max. Tax Rate on Capital Gains – 20%– Max. Corp. Tax Rate – 35%

10

Conversion Transactions

• Conclusions: – potential conversion toll charge for many

businesses may be relatively low and likely will increase significantly in approximately one year

– this year could be last best time to convert to tax-partnership status for a long time

11

Conversion TransactionsInterests Over Conversion

• Shareholders contribute stock to tax partnership owned in same manner as corporation, followed immediately by liquidation of corporation into tax partnership.

• Tax Results?

X

SH1 SH2

P

X

P

SH1 SH2

1

2

12

Conversion TransactionsAssets Over Conversion

• Corporation contributes all assets and liabilities to tax partnership owned in same manner as corporation in exchange for interest in such partnership, and, immediately thereafter, corporation liquidates

– Same steps can be accomplished via state-law merger of corporation into tax partnership as well

• Tax Results?

X

SH1 SH2

P P

SH1 SH2

1

2

13

Conversion TransactionsAssets Up Conversion

• Corporation first liquidates, and, immediately thereafter, former shareholders contribute the distributed corporate assets and liabilities to tax partnership owned in same manner as former corporation

• Tax Results?

X

SH1 SH2

P P

SH1 SH2

21

14

Conversion TransactionsElective Conversion

• Entity taxed as corporation converts to tax partnership by simply making a “check-a-box” election to be treated as a tax partnership

• Tax Results?

X

SH1 SH2

X

SH1 SH2

1Check-A-Box Election

15

Conversion TransactionsState-Law Entity Conversion

• State-law corporation converts to state-law partnership by filing articles of conversion with relevant Secretary of State

• Tax Results?

X

SH1 SH2

X

SH1 SH2

1

File Articles of Conversion with Secretary of State

16

Conversion Transactions• No matter what alternative form of

conversion used, the liquidation of the corporation creates the conversion toll charge

– Section 336 – entity level tax consequences

– Section 331 – shareholder-level tax consequences

17

Conversion Transactions

• Under section 336, liquidating corporation treated as selling its assets to shareholders for FMV

• Gain recognition on asset-by-asset basis and equals FMV over tax basis– Character as long-term capital gain, short-term capital gain,

unrecaptured section 1250 gain, collectibles gain, or ordinary income depends on a whole host of factors, such as the holding period of such assets and whether and how sections 1(h), 751, 1221, 1231, 1239, 1245, or 1250 apply

• Difference in tax treatment based on whether C or S corporation

18

Conversion Transactions• Under section 331, each shareholder treated as receiving

corporate assets in exchange for stock• Gain (loss) recognition = FMV of assets received in

exchange for stock (less corporate liabilities assumed or taken subject to) over the shareholder’s tax basis in such stock– Whether converting corporation is C or S is relevant in

determining shareholder tax basis for this purpose• Character of such gain (loss) as long-term capital, short-

term capital, or ordinary depends on a host of factors, such as holding period of stock – Section 331 gain (loss) more likely to be capital than section

336 gain (loss)

19

Conversion Transactions

• Under section 334, shareholder’s tax basis in assets received in liquidation is FMV

• Assets of corporation generate toll charge: – assets-up, interests-over, elective, or state-law entity

conversion• newly-issued interest in tax partnership generates toll

charge:– assets-over conversion

• This difference can be significant for tax purposes

20

Conversion TransactionsSimplified Example

• Assume that X’s assets consist of a single depreciable asset under the following conditions. • In 2007, X’s assets have an aggregate fair market value of $10M, tax basis of $0, and $6M of potential section

1245 depreciation recapture, and X’s shareholders have an aggregate basis of $0 in their stock of X. • On January 1, 2010, all variables remain the same, except that the fair market value of X’s assets has dropped

from $10M to $7.5M. • In 2011, all variables remain unchanged from January 1, 2010, except that the maximum individual tax rate

increases from 35 percent to 40.6 percent (39.6 percent plus a 1 percent health care-related surtax) and maximum capital gains rates increase from 15 percent to 20 percent.

• In 2012, all variables remain unchanged from 2011, except that the aggregate fair market value of X’s assets return to 2007 levels.

X

SH1 SH2

P P

SH1 SH2

1

2

Merger

Section 754 election

21

Conversion of Closely-Held C Corporation (in millions) Section 336 Gain

2007 January

2010 2011 2012 FMV 10 7.5 7.5 10 Adjusted basis of assets 0 0 0 0 Gain 10 7.5 7.5 10 Depreciation Recapture – section 751 6 6 6 6 Long-Term Capital Gain – section 1(h) 4 1.5 1.5 4 Applicable Max. Tax Rate 35% 35% 35% 35% Corporate-Level Tax on Section 336 Gain 3.5 2.625 2.625 3.5 Section 331 Gain (Loss) Net FMV (Gross value less section 336 tax & 20% valuation discount) 5.2 3.9 3.9 5.2 Adjusted basis of stock 0 0 0 0 Gain 5.2 3.9 3.9 5.2 Long-Term Capital Gain 5.2 3.9 3.9 5.2 Applicable Max. Tax Rate 15% 15% 20% 20% Shareholder-Level Tax on Section 331 Gain 0.78 0.585 0.78 1.04 Total Tax: 4.28 3.21 3.405 4.54

Conversion TransactionsSimplified Example – C Corporation

22

Conversion TransactionsSimplified Example – C Corporation

• Calculation of section 331 shareholder-level gain (loss) does not simply involve subtracting shareholder’s tax basis in stock from FMV of corporate assets, as determined for section 336 purposes

– FMV of corporate assets used for section 336 purposes reduced for any liabilities assumed or taken subject to by shareholder, such as corporate-level income tax obligation arising from section 336 gain recognized in liquidation

• Also, FMV of corporate assets used for section 336 purposes further reduced for section 331 purposes by applicable valuation discounts

• Note that discounts applied in shareholder-level gain determination under section 331, but no discounts applied in corporate-level gain determination under section 336

– See Pope & Talbot, Inc. & Subsidiaries v. Commissioner, 104 T.C. 574 (1995), aff’d, 162 F.3d 1236 (9th Cir. 1999); TAM 200443032 (July 13, 2004)

– Guidance effectively disallows lack of marketability and minority discounts for purposes of determining corporate-level gain under section 336, but does not foreclose taking of such discounts for purposes of determining shareholder-level gain (loss) under section 331

• Many closely-held C corporations may have generated significant NOLs (or CLs) over past few years

– To extent that those losses have been carried forward to future years, those losses can be used to reduce (or eliminate) amount of corporate-level income generated under section 336 in conversion

• Increase in maximum individual income tax rate does not affect conversion toll charge for closely-held C corporations -- only change in corporate income tax or capital gains rates affects the conversion toll charge

23

Conversion TransactionsSimplified Example – S Corporation

Conversion of S Corporation (in millions) Section 336 Gain

2007 January

2010 2011 2012 FMV 10 7.5 7.5 10 Adjusted basis of assets 0 0 0 0 Gain 10 7.5 7.5 10 Depreciation Recapture – section 751 6 6 6 6 Applicable Max. Tax Rate 35% 35% 40.6% 40.6% Total Shareholder Tax on Ordinary Income 2.1 2.1 2.436 2.436 Long-Term Capital Gain – section 1(h) 4 1.5 1.5 4 Section 331 Gain (Loss) Net FMV (gross value less 20% valuation discount) 8 6 6 8 Adjusted basis of stock – section 1367 10 7.5 7.5 10 Gain (Loss) (2) (1.5) (1.5) (2) Long-Term Capital Gain (Loss) (2) (1.5) (1.5) (2) Long-Term Capital Gain from Section 336 4 1.5 1.5 4 Net Long-Term Capital Gain Subject to Tax 2 0 0 2 Applicable Max. Tax Rate 15% 15% 20% 20% Total Shareholder Tax on Capital Gain 0.3 0 0 0.4 Total Shareholder Tax: 2.4 2.1 2.436 2.836

24

Conversion TransactionsSimplified Example – S Corporation

• Unlike conversion of closely-held C corporations, conversions of S corporations generally only involve one level of tax, which is imposed at the shareholder level, but gain upon which tax is imposed is generated at S corporation level under section 336

• Same discount principles apply in this situation as well -- shareholders’ tax bases in their stock increased for section 336 gain generated at corporate level, and, at same time, FMV of what shareholders receive in exchange for stock decreased by applicable valuation discounts, which generally creates a capital loss under section 331 that can be used to offset corporate-level capital gain taken into account by shareholders under sections 336 and 1366

• Word of caution: shareholder-level capital loss generated under section 331 cannot offset any portion of corporate-level ordinary income taken into account by shareholders under sections 336 and 1366, such as depreciation recapture

• Avoid negative tax rate arbitrage: – Recall that X’s assets generated $6 million of depreciation deductions, which created $6

million of depreciation recapture. If X waits until 2011 or 2012 to convert to a tax partnership, those prior depreciation deductions will be recaptured into income and subjected to a maximum tax rate of 39.6 percent (or more) – i.e., each $1 of depreciation deductions that reduced tax by, at most, $0.35 in the past will be recaptured into income and increase tax by almost $0.40 for each dollar of depreciation recapture. X and its investors can avoid this by converting before individual income tax rates exceed 35 percent – i.e., before 2011.

• Unlike closely-held C corporations, increase in individual income tax rates significantly increases conversion toll charge for S corporations

25

Conversion Transactions• No two C or S corporations are alike -- whether conversion to a tax partnership makes

sense to a particular business will depend on a variety of factors, such as the following: – current tax classification: C or S corporation status– “per se” corporation form or eligible entity “association” form– applicable tax rates, including relevant state and local tax rates– FMV of interests in, and assets of, business– existence and likely magnitudes of valuation discounts– adjusted tax bases of interests in, and assets of, business– holding periods of interests in, and assets of, business– amount of potential ordinary income inherent in assets of business, such as depreciation

recapture– any special characteristics of interests in, and assets of, business, such as interests being small

business stock, as defined in section 1244, or some assets being held primarily for sale to customers in ordinary course of business

– amount of liabilities of business, which investors, if any, are ultimately responsible for such liabilities, and expectations regarding which investors, if any, will be responsible for such liabilities after conversion

– need (or desire to have flexibility) to raise capital from outside sources– need (or desire to have flexibility) to allow employees to share in equity of the business– employment tax effects of converting (corporate employees with sliver equity – after conversion,

cannot be employee if also tax partner)– if C corporation, character and magnitude of any loss carryforwards

26

Conversion Transactions

• Businesses first need to get a handle on these factors, particularly valuation

• Typical corporate due diligence should be performed as well– Review relevant articles of organization, bylaws,

shareholders agreements, and debt covenants • Businesses should “run the numbers” under each

alternative conversion structure and at different projected times (e.g., 2-years ago, this year, and 2-years from now)

27

Economic Substance Developments

28

History of Proposed Bills

• The House’s health care reform bill, the “Affordable Health Care for America Act” (the “House Health Care Reform Bill”) (H.R. 3962), contains provisions to codify the economic substance doctrine.

• The Senate’s health care reform bill does not contain an economic substance provision.

• The most recent Senate-passed bill that contained provisions to codify the economic substance doctrine was “The Food and Energy Security Act of 2007” (H.R. 2419, the “2007 Farm Bill,” as amended by the Senate).

29

History of Proposed Bills• 2003: Jobs and Growth Tax Act of 2003 ~ $14B• 2003: Care Act of 2003 ~ $13B• 2004: Highway Reauthorization and Excise Tax

Simplification Act of 2004 ~ $14B • 2005: Telephone Excise Tax Repeal Act of 2005 ~ $18B• 2005: Bush Administration formally announces

opposition to codification• Feb. 2007: Senator Obama co-sponsored bill (S. 681) –

no rev. est. (but similar to 2007 Senate version)• The 2007 House version (H.R. 3970) ~ $4B• The 2007 Senate version (H.R. 2419/S.2242) ~ $10B• May 2009: Obama’s FY2010 Budget ~ $8B• Nov. 2009: House Health Care Bill ~ $6B

30

Most Recent Senate Bill

31

Most Recent Senate Bill(Section 7701(p))

• The Senate version provides that, in any case in which a court determines that the economic substance doctrine is relevant, transactions shall have economic substance only if:

– The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and

– The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

• Transactions will not be treated as having economic substance solely by reason of pre-tax profit, unless the present value of reasonably expected pre-Federal tax profit is “substantial” in relation to the present value of expected net Federal tax benefits.

– Fees (and other transaction costs) are taken into account.

– Foreign taxes are only taken into account “to the extent provided by the Secretary.”

• Financial accounting benefits cannot be relied upon to establish a valid purpose if their origin is a reduction of Federal tax.

• Taxpayers are not treated as having a valid purpose if the only purpose is the reduction of non-Federal taxes and the transaction will result in a reduction of Federal taxes substantially equal to, or greater than, the reduction in non-Federal taxes.

32

• Potential Limitations on Scope of Bill– The Senate Finance Committee Report (the “Finance Report”) on S.

2242 (which mirrored H.R. 2419) clarifies that the provision does not change current law standards used by courts in determining when to apply the economic substance doctrine.

– The Finance Report also provides that the economic substance provision is not intended to affect certain “basic business transactions”that have been respected “by long-standing judicial and administrative practice”:

• the choice between capitalizing a business enterprise with debt or equity; • a U.S. person’s choice between utilizing a foreign corporation or a domestic

corporation to make an investment;• the choice to enter a transaction or series of transactions that constitute a

corporate organization or reorganization under subchapter C; and• the choice to utilize a related-party entity in a transaction, provided that the

arm’s length standard of section 482 and other applicable concepts are satisfied.

• It is a non-exclusive list.

Most Recent Senate Bill(Section 7701(p))

33

• Which Transaction is Tested?– The Finance Report provides that the Senate bill does not limit a

court’s ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the economic substance doctrine (see Coltec).

• Interaction with Other Tax Rules– The Senate bill will apply in addition to any other rule of law or Code

provision. – Judicial Doctrines (fact-finding doctrines) –

• substance over form, step transaction doctrine, sham entity doctrine, debt vs. equity classification, tax ownership

– Anti-abuse rules in Code and Treasury regulations –• See Appendix for a list of many of the anti-abuse provisions contained in

the Code and regulations.

Most Recent Senate Bill(Section 7701(p))

34

• Treasury Regulations– The Senate bill provides that the Secretary “shall” prescribe regulations as may

be necessary or appropriate to carry out the purposes of the provision, including exemptions.

• Effective Date– The Senate bill will apply to transactions entered into after the date of enactment.

Most Recent Senate Bill(Section 7701(p))

35

Most Recent Senate Bill – Penalties(Section 6662B)

• The Senate bill imposes a 30% penalty on the amount of an understatement resulting from items attributable to a transaction lacking economic substance.– The amount of the understatement is determined under the

methodology set forth in section 6662A as the sum of --1. The product of the highest tax rate and the increase in taxable income

(and the decrease in any NOL or capital loss) resulting from the difference between the taxpayer's treatment of the item and the proper treatment of the item; and

2. The amount of any decrease in the aggregate amount of credits which results from a difference between the taxpayer's treatment of an item and the proper tax treatment of such item.

– The amount of the understatement is determined without regard toother items on the tax return.

• The amount of the penalty is reduced to 20% if the taxpayer adequately disclosed the relevant facts affecting the tax treatment in the return or in a statement attached to the return.

36

• Strict-Liability Penalty– The penalty cannot be avoided upon a showing of reasonable cause.

• Compare section 6662A (taxpayer can avoid penalties on understatements attributable to reportable transactions upon adequate disclosure if the taxpayer satisfies the reasonable cause exception of section 6664(d)).

– Reliance on opinions will not insulate a taxpayer from the penalty.• Chief Counsel Review, Authorization, and Compromise

– The Senate bill provides that only the Chief Counsel (or a delegate holding a position of chief of a branch within the Office of the Chief Counsel) can assert or compromise the penalty.

• If compromise, can only compromise in same proportion as underlying tax liability compromised.

– The Chief Counsel (or delegate) can only assert the penalty after the taxpayer is provided with notice and an opportunity to provide a written response.

– The Chief Counsel (or delegate) may assert, compromise, or collect a penalty even though a court has not determined that the economic substance doctrine is relevant.

– However, if a court issues a final order concluding that the economic substance is not relevant, any penalty imposed must be rescinded.

Most Recent Senate Bill – Penalties(Section 6662B)

37

• Public Reporting– A public entity must disclose in reports filed with the SEC that it was required to

pay the penalty. • Reporting must be made at the earlier of (i) when the penalty is paid or (ii) when all

administrative and judicial remedies have been exhausted. • Still must disclose even if penalty amount is not “material.”

– Under section 6707A(e), public disclosure must be made when penalties are required to be paid under section 6662A (reportable transactions).

• Interaction with Other Penalties– The penalty will not apply to any portion of an understatement to which the fraud

penalty of section 6663 applies. – Accuracy-related penalties under section 6662 or section 6662A do not apply if

the new penalty applies to the understatement.• Denial of Interest Deduction for Interest on Underpayments (Section

163(m))– Taxpayers cannot claim interest deductions for interest paid or accrued on

underpayments attributable to any noneconomic substance transaction. – The interest deductions are disallowed irrespective of whether the relevant facts

were disclosed (in contrast to interest deductions for underpayments attributable to reportable transactions).

Most Recent Senate Bill – Penalties(Sections 6707A(e) and 163(m))

38

House Health Care Reform Bill

39

House Health Care Reform Bill(Section 7701(o))

• The House bill provides that, in cases where the economic substance doctrine is relevant, transactions shall be treated as having economic substance only if:

– The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and

– The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

• Pre-tax profit may be considered in determining whether both the objective and subjective prongs are satisfied, but only if the present value of reasonable expected pre-tax profit is substantial in relation to the present value of expected net tax benefits.

– Fees (and other transaction costs) and foreign taxes are taken into account.• A reduction of state and local taxes that is related to a Federal income tax

effect cannot be considered.• Financial accounting benefits cannot constitute a valid purpose if the

transaction results in a Federal income tax benefit.

40

House Health Care Reform Bill – Penalties (Section 6662(b)(6) and (i))

• The House bill provides that the 20% underpayment penalty of section 6662(b) will apply to underpayments attributable to the disallowance of tax benefits by reason of a transaction lacking economic substance (or failing to meet the requirements of any similar rule of law).

• The House bill increases the underpayment penalty from 20% to 40% to the extent the taxpayer does not adequately disclose the relevant facts affecting the tax treatment of the transaction.

• The reasonable cause exception under section 6664(c) will not apply to any portion of an underpayment attributable to the transaction subject to the new penalty.

• The new penalty will not apply to any portion of the underpayment to which the fraud penalty of section 6663 applies.

• The section 6662A penalty applicable to listed and reportable transactions does not apply to the extent the new penalty applies.

41

Similarities & Differences Between the House and

Senate Bills

42

Similarities & Differences Between the House and Senate Bills

• Application of the Statutory Doctrine– Under the Senate bill, the statutory doctrine applies if a “court” determines that the doctrine is

relevant.– Statutory doctrine applies if relevant under the House bill.

• Scope of Statutory Doctrine– Both the House and Senate bills impose a conjunctive standard under which taxpayers must have a

substantial non-tax purpose and must change their economic position in a meaningful way.

• Application of Penalty– Both the House and Senate bills contain a “strict liability” penalty.– The House bill also applies to transactions that meet the statutory definition but fail “to meet the

requirements of any similar rule of law.”– Senate bill requires review, authorization, and compromise by the Chief Counsel (or delegate).

• Amount of Penalty– The Senate bill imposes a 30% penalty for non-disclosed transactions. – The House bill imposes a 40% penalty for non-disclosed transactions.– The Senate bill applies to “understatements” and the House bill applies to “underpayments.”

43

• Revenue Estimates– The House Health Care Reform Bill (2009) ~ $6B over 10 years– The Most Recently-Passed Senate Bill (2007) ~ $10B over 10 years.– Revenue estimates of previous incarnations of economic substance

codification have varied.• 2007 House Bill ~ $4B• Telephone Excise Tax Repeal Act of 2005 ~ $18B• Highway Reauthorization and Excise Tax Simplification Act of 2004 ~ $14B • Jobs and Growth Tax Act of 2003 ~ $14B• Care Act of 2003 ~ $13BThe JCT considers case law developments.

– How can we explain the difference between the revenue estimates for the House Health Care Reform Bill and the most recently-passed Senate bill?

Similarities & Differences Between the House and Senate Bills

44

Pros and Cons of Codification

45

Perceived Benefits of Codification

• Establish uniform standard and resolve differences between courts on the application of the economic substance doctrine (e.g., conjunctive vs. disjunctive).

• Ensure that no court may overturn the doctrine (e.g., trial judge in Coltec).

• Deter taxpayers’ use of tax shelters.

• Increase revenue.

46

Reasons Not To Codify Economic Substance

• It is unclear whether codification will clarify the contours of the economic substance doctrine.– How are ambiguous standards in the statutory provisions to be applied?

• E.g., the phrases “substantial purpose,” “change in a meaningful way,” profit “substantial in relation to present value”; the discount rate used in determining present value.

– Will codification resolve issues that courts have struggled with over time?

• Which transaction is to be tested?

• How much significance to afford relevant facts?

– If the IRS issues regulations to add clarity to the statutory doctrine, will taxpayers have a “road map” to engage in transactions that toe the line?

– Will clarity limit effective tax administration?

47

Reasons Not To Codify Economic Substance

• Recent case law confirms that codification is not necessary. – TP victories are preliminary or product of unique facts/transactions (not off-the-shelf)

2009Government Victories

•G-I Holdings, Inc., 2009 WL 4911953 (D. N.J. 2009) (though government still loses due to SOL issues)•Palm Canyon X Investments, LLC, TC Memo 2009-288•Country Pine LLC v. Commissioner, T.C. Memo. 2009-251•Marriott Int’l Resorts v. United States, 83 Fed. Cl. 291 (2008), aff’d per curiam, 104 AFTR 2d 2009-__ (Fed. Cir. 2009)•Maguire Partners-Master Investments, LLC v. United States, 2009-1 USTC ¶ 50,215 (C.D. Cal. 2009)•Southgate Master Fund, LLC v. United States, No. 3:06-cv-2335-K (N.D. Tex., August 18, 2009)•New Phoenix Sunrise Corp. v. Commissioner, 132 T.C. No. 9 (Apr. 9, 2009)•Schering-Plough Corporation v. United States, No. 05-2575 (D.N.J. Aug. 28, 2009)•Klamath Strategic Investment Fund, LLC v. United States, 472 F. Supp. 2d 885 (E.D. Texas 2007), aff'd, 568 F.3d 537 (5th Cir. 2009)•Clearmeadow Investments LLC v. United States, 2009-1 USTC ¶ 50,449 (Ct. Fed. Cl. 2009)•Altria Group, Inc. v. United States, No. 1:06-CV-09430-RJH-FM (S.D.N.Y.) (jury verdict)•American Boat Co. LLC v. United States, 104 AFTR 2d 2009-6666 (7th Cir. 2009)

Taxpayer Victories•Virginia Historic Tax Credit Fund 2001 LP, T.C. Memo 2009-295 (allocation of state rehabilitation tax credits and 707(a)(2)(B))•Consolidated Edison Co. v. United States, 104 AFTR 2d 2009-__ (Fed. Cl. 2009) (LILO).•TIFD-III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), on remand, 104 AFTR 2d 2009-__ (D. Conn. Oct. 7, 2009) (income shift to for. banks via ceiling rule and 704(e))

48

Reasons Not To Codify Economic Substance

• Recent case law confirms that codification is not necessary. – TP victories are preliminary or product of unique facts/transactions (not off-the-shelf)

2008Government Victories•Kornman & Assoc., Inc. v. United States, 527 F. 3d 443 (5th Cir. 2009)•Cemco Investors LLC v. United States, 515 F. 3d 749 (7th Cir. 2008)•BB&T Corp. v. United States, 2007-1 USTC ¶ 50,130 (M.D.N.C. 2007), aff'd, 523 F.3d 461 (4th Cir. 2008)•AWG Leasing Trust v. United States, 592 F. Supp. 2d 953 (N.D. Ohio 2008) •Petaluma FX Partners v. Commissioner, 131 T.C. No. 9 (2008)•Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008)•Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636 (2008)•Fifth Third Bancorp v. United States, No. 1:05-CV-350 (Apr. 18, 2008)•Enbridge Energy Co., Inc. v. United States, 553 F. Supp. 2d 716 (S.D. Tex. 2008), aff’d, __ F.3d __ (5th Cir, Nov. 10, 2009)Taxpayer Victories•Countryside Limited Partnership, T. C. Memo 2008-3 (basis-shift transaction, focus on only one of the many tax issues in transaction)•Shell Petroleum, Inc. v. United States, 102 AFTR 2d 2008-5085 (S.D. Tex 2008) (shift of corporate losses; application of 482 rejected)

49

Reasons Not To Codify Economic Substance

• Taxpayers should not be subject to strict liability penalties at the IRS’s discretion (that may be increased by failure to disclose transactions) for potential violations of an unclear standard such as the economic substance doctrine.– Reasonable minds may differ on the application of the economic

substance doctrine.

– Is Chief Counsel review and authorization (under Senate version) an adequate safeguard?

• Codification unlikely to lead to significantly increased revenue.

50

Recent Economic Substance Cases

51

Coltec Transaction

Facts: Coltec, a publicly traded company with numerous subsidiaries, sold the stock of one of its businesses in 1996 and recognized a gain of approximately $240.9 million. Garlock, a subsidiary of Coltec, and its own subsidiary had both previously manufactured or distributed asbestos products and faced substantial asbestos-related litigation claims. Coltec caused another one of its subsidiaries, Garrison, to issue common stock and Class A stock to Coltec in exchange for approximately $14 million. In a separate transaction, Garrison issued common stock to Garlock that represented approximately a 6.6% interest in Garrison and assumed all liabilities incurred in connection with asbestos related claims against Garlock, as well as the managerial responsibility for handling such claims. In return, Garlock transferred the stock of its subsidiary, certain relevant records to the asbestos-related claims, and a promissory note (from one of its other subsidiaries) in the amount of $375 million. Garlock then sold its recently acquired Garrison stock to unrelated banks for $500,000. As a condition of sale, Coltec agreed to indemnify the banks against any veil-piercing claims for asbestos liabilities. On its 1996 tax return, Coltec’s consolidated group claimed a $378.7 million capital loss on the sale of Garrison stock, which equaled the difference between Garlock’s basis in the stock ($379.2 million) and the sale proceeds ($500,000).

Coltec

GarrisonGarlock

7% C/S

Assumption of Contingent Liabilities

$14 million

C/SClass A Stock

$375 million Note

7% Garrison C/SUnrelated Banks

$500,000

1

23

52

Coltec Decision – Court of Federal Claims• The Court of Federal Claims entered a decision after trial in favor of Coltec, upholding the

capital loss claimed by Coltec from the contingent liability transaction at issue in this tax refund litigation. See Coltec Industries, Inc. v. United States, 63 Fed. Cl. 716 (Ct. Fed. Cl. 2004).

• The Court of Federal Claims relied on the District Court analysis in Black & Decker to hold that the operation of the applicable code sections justified a capital loss.

– The contribution of assets in exchange for stock and the assumption of the liabilities qualified as a nontaxable exchange under section 351.

– Under section 358, the transferor received a basis in the stock equal to the basis of the assets contributed. Ordinarily, when a transferee in a section 351 exchange assumes liabilities of the transferor, the transferor’s basis in the transferee’s stock is reduced by the amount of the liabilities. However, under sections 358(d)(2) and 357(c)(3), if the satisfaction of the liabilities would have given rise to a deduction to the transferor, the assumption of such liabilities does not reduce basis. Because satisfaction of the liabilities assumed by the transferee would have given rise to a deduction to the transferors (had the liabilities not been transferred), the basis of the stock is not reduced by the liabilities assumed under section 358(d)(2). After the transfer, payment of the liabilities would give rise to a deduction by the transferee. See Rev. Rul. 95-74, 1995-2 C.B. 36 (1995). The government argued that section 357(c)(3) requires that payment of the liabilities would give rise to a deduction by the transferor. The court held that this interpretation was incorrect.

– In addition, the court held that section 357(b) did not require basis to be reduced because there was a bona fide business purpose for the assumption of the liabilities.

53

Coltec Decision – Court of Federal Claims

• The Court of Federal Claims rejected the government’s argument that the capital loss should nonetheless be disallowed under the economic substance doctrine.

• The court refused to apply the economic substance doctrine to the transaction because the transaction satisfied the statutory requirements of the Code. The court stated: “[I]t is Congress, not the court, that should determine how the federal tax laws should be used to promote economic welfare…. Where the taxpayer has satisfied all statutory requirements established by Congress, as Coltec did in this case, the use of the ‘economic substance’ doctrine to trump ‘mere compliance with the Code’ would violate the separation of powers.”

54

Coltec on Appeal – Federal Circuit

• The Federal Circuit (Judges Bryson, Gajarsa and Dyk) reversed the opinion of the Court of Federal Claims and held that the taxpayer was not entitled to a capital loss because the assumption of the contingent liabilities in exchange for the note lacked economic substance. See Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006).

• The Federal Circuit upheld the technical analysis of the Court of Federal Claims in favor of the taxpayer.

• The court concluded that section 357(c)(3) applies because payment of the liability would give rise to a deduction. The court stated that the government’s interpretation that the liabilities must be transferred with the underlying business was plainly inconsistent with the statute.

• The court concluded that, if a liability was excluded by section 357(c)(3), then section 357(b)(1) was not relevant. The court reasoned that the exception in section 358(d)(2) for liabilities excluded under section 357(c)(3) does not contain any reference to section 357(b), nor does section 357(b) contain any reference to the basis provisions in section 358.

55

Coltec on Appeal – Federal Circuit

• However, the Federal Circuit reversed the Court of Federal Claims decision with respect to economic substance and held that the transfer of liabilities in exchange for the note should be disregarded.

• The Federal Circuit identified five (5) principles of economic substance.

– The law does not permit the taxpayer to reap tax benefits from atransaction that lacks economic reality;

– It is the taxpayer that has the burden of proving economic substance;

– The economic substance of a transaction must be viewed objectively rather than subjectively;

– The transaction to be analyzed is the one that gave rise to the alleged tax benefit;

– Arrangements with subsidiaries that do not affect the economic interest of independent third parties deserve particularly close scrutiny.

56

• In applying the economic substance test, the Federal Circuit focused solely on the transaction giving Coltec the high stock basis (i.e., the assumption of the liabilities in exchange for the note) and concluded that Coltec had not demonstrated any business purpose for that transaction.

• The court rejected Coltec’s claim that it would strengthen its position against potential veil-piercing claims, since it only affected relations among Coltec and its own subsidiaries and had no effect on third parties.

Coltec on Appeal – Federal Circuit

57

• Coltec filed a cert petition with the Supreme Court.

• One of the two questions presented for review in the cert petition relates to the disjunctive vs. conjunctive nature of the economic substance test and the current circuit split.

– The cert petition stated the question as follows: "Where a taxpayer made a good-faith business judgment that the transaction served its economic interests, and would have executed the transaction regardless of tax benefits, did the court of appeals (in acknowledged conflict with the rule of other circuits) properly deny the favorable tax treatment afforded by the Internal Revenue Code to the transaction based solely on the court’s “objective” conclusion that a narrow part of the transaction lacked economic benefits for the taxpayer?”

• The other question presented for review in the cert petition relates to the standard of review in economic substance cases.

– The cert petition stated the question as follows: "In determining that a transaction may be disregarded for tax purposes, should a federal court of appeals review the trial court’s findings that the transaction had economic substance de novo (as three courts of appeals have held), or for clear error (as five courts of appeals have held)?"

• Dow Chemical Co. filed a cert petition on October 4, 2006 that presented similar questions.

• On February 16, 2007, the Supreme Court denied certiorari in Coltec and Dow Chemical.

Coltec Cert Petition

58

Heinz Transaction

Facts: Between August 11, 1994, and November 15, 1994, H.J. Heinz Credit Company (“HCC”), a subsidiary of the H.J. Heinz Company (“Heinz”), purchased 3.5 million shares of Heinz common stock in the public market for $130 million. In January of 1995, HCC transferred 3.325 million of the 3.5 million shares to Heinz in exchange for a zero coupon convertible note issued by Heinz. In May of 1995, HCC sold the remaining 175,000 shares to AT&T Investment Management Corp. (“AT&T”), an unrelated party, for a discounted rate of $39.80 per share, or $6,966,120, in cash. As a result of this sale, HCC claimed a capital loss and carried this loss back to 1994, 1993, and 1992. The IRS disallowed Heinz’s claimed capital loss arguing, among other things, that the transaction lacked economic substance and a business purpose. Heinz paid the tax and filed a $42.6 million refund action with the Court of Federal Claims.

Heinz

HCC

PUBLIC

Heinz

HCC

PUBLIC$130M

3.325MHeinzshares

3.5MHeinzshares

Note

Heinz

HCC

PUBLIC

.175MHeinz shares

~ $7.0M

59

Heinz – Court of Federal Claims• H. J. Heinz Company and Subsidiaries vs. United States, United States Court

of Federal Claims, 76 Fed. Cl. 570 (Ct. Fed. Cl. 2007).

• All parties agreed that HCC had a basis of $124 million in the 3.325 million shares that were transferred to Heinz.

• Heinz asserted that the redemption qualified as a redemption under section 317(b), that the redemption should be taxed as a dividend, and that HCC’s basis in the redeemed stock should be added to its basis in the 175,000 shares which it retained. Accordingly, Heinz claimed that, when HCC sold its remaining 175,000 shares, it should recognize a large capital loss. Heinz then claimed it was entitled to carry back HCC’s capital loss to reduce the consolidated group’s taxes in 1994, 1993 and 1992.

• The IRS asserted that the Heinz acquisition was not a redemption because: (i) Heinz did not exchange property for the stock within the meaning of section 317(b); (ii) the transaction lacked economic substance and had no bona fide business purpose other than to produce tax benefits; and (iii) under the “step transaction doctrine,” HCC’s purchase and exchange of the stock for the note should be viewed as a direct purchase of the stock by Heinz.

60

Heinz – Court of Federal Claims

• The Court of Federal Claims dismissed the IRS’s first argument that no redemption occurred, but held that the acquisition and redemption of Heinz shares lacked economic substance and that the step transaction doctrine applied.

• The court followed the economic substance analysis set forth Coltec in addressing the IRS’s second argument, quoting the following language from Coltec – “the transaction to be analyzed is the one that gave rise to the alleged tax benefit.”

• Accordingly, the court stated that transaction in question is the purchase of Heinz shares from the public and the subsequent redemption. The court did not analyze the entire transaction (including the disposition) when applying the economic substance doctrine.

• The court in Heinz held that the acquisition and subsequent redemption of Heinz shares lacked economic substance.

61

Heinz – Court of Federal Claims

• The Court of Federal Claims was not persuaded by the taxpayer’s assertion that HCC acquired the Heinz stock for non-tax, business purposes: as an investment and to add “substance” to HCC’s operations for state tax purposes.

• In the eyes of the court, the taxpayer’s claim of an investment purpose was undercut by the factual record, as evidenced by the following factors. First, the convertible notes were contemplated and, in fact, were in the process of being drafted well before HCC purchased the Heinz stock. Second, because the acquired stock was not registered, HCC purchased the stock at full price in the market and sold the Heinz stock at a deep discount. Third, the purpose of the stock purchase program -- the funding of stock option programs – could not be achieved so long as HCC held the Heinz stock.

• The court also found the factual record to be inconsistent with the taxpayer’s second claim of business purpose, which was to bolster the taxpayer’s tax return position that HCC should be respected as a Delaware holding company. The court cited three factors in support of its position. First, the record did not suggest that the taxpayer was motivated by this non-tax purpose. Second, internal communications indicated that anytax return exposure could not be limited at the time of the stock acquisition or on a going forward basis. Third, the record indicated that, at the time of the stock acquisition, Heinz was considering eliminating HCC’s lending operations, which raised the very issue that the taxpayer sought to mitigate through the stock acquisition.

62

Jade Trading – Son-of-Boss Transaction

Facts: In March 1999, three taxpayers sold their cable business and realized an aggregate $40.2 million capital gain. Each of the three taxpayers created a single-member LLC on September 17, 1999. On September 23, 1999, Jade Trading LLC was formed by Sentinel Advisors, LLC (“Sentinel”) and a foreign financial institution. [Sentinel pitched the transaction to BDO Seidman, which marketed the transaction.] On September 29, 1999, each of the three LLCs purchased offsetting currency options for net premium paid of $150,000 to AIG. For each LLC, the options purchased and sold had a premium of $15 million and $14.85 million, respectively. On October 6, 1999, the LLCs contributed their spread options and $75,000 cash to Jade Trading LLC (“Jade”), in exchange for membership interests. About 60 days after the contribution, the three LLCs exited Jade with each receiving euros and Xerox stock (with a market value of approximately $125,000) in exchange for their interests.

LLC 1

Jade

LLC 2 LLC 3

LLC 1

Jade

LLC 2 LLC 3

Spread Options &$75,000 cash

Spread Options (w/ premium of ~ $15m)

Net $150,000 Payment

Euros & stock (worth $125k)

Interests

1

2

AIG

63

Jade Trading – Taxpayer’s Position• Each taxpayer claimed that the LLCs’ basis in the interest in Jade was increased by the value of the

premium paid on the option purchased ($15 million), but not decreased by the premium received on the options sold ($14.85 million). Accordingly, each taxpayer claimed a large capital loss upon exiting the partnership (approximately $14.9 million).

• The primary Code sections at issue in Jade Trading were section 752(b) and section 722.

– Section 752(b) provides that a decrease in a partner’s liabilities by reason of a partnership’s assumption of those liabilities will be treated as a distribution of money to the partner by the partnership (with the effect of reducing the partner’s basis).

– Under section 722, a partner’s basis acquired by a contribution of property, including money, is equal to the amount of money and basis of such property contributed.

• The taxpayers relied principally on Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975), which provided that a contingent obligation (such as an option) was not a liability for purposes of section 752.

• At the time of the transaction, the principle set forth in Helmer was good law.

– The IRS subsequently issued temporary regulations on June 24, 2003, which would have treated the sold option as a liability for purposes of section 752. See Treas. Reg. § 1.752-6T.

– The temporary regulations had retroactive effect to October 18, 1999 (the LLCs contributed the spread options on October 6, 1999).

– The Preamble to the temporary regulations explicitly states that the regulations do not follow Helmer.

64

Jade Trading – Court of Federal Claims• The Court of Federal Claims held that the transaction creating the basis increase lacked economic

substance. See Jade Trading, LLC v. United States, 80 Fed. Cl. 11 (Ct. Fed. Cl. 2007).

• The court found that basis increase claimed by each LLC satisfied the technical provisions of the Code.

• The court then analyzed the transaction under the economic substance doctrine.

– The court stated that Coltec unequivocally reaffirmed the vitality of the economic substance doctrine in the Federal Circuit.

– The court found that –

1. The transaction lacked economic reality because (i) the losses claimed were not tied to any economic loss (i.e., the LLCs did not incur a $15 million loss) and (ii) the use of the partnership structure had no real economic purpose.

2. The taxpayer had the burden of proving that the transaction had economic substance.3. The objective reality of the transaction was the relevant criterion rather than any subjective intent of

the taxpayer.4. The transaction to be analyzed was the spread transaction that gave rise to the inflated basis

(rather than any hypothetical transactions that could have occurred and/or any other trades).– The court found that there was no objective profit potential, because the maximum profit

potential on the spread ($140,000) was exceeded by the high fees ($934,100). – The court also noted that transaction was marketed as a tax avoidance mechanism.– The court also noted that the options had to be viewed together rather than as two distinct

legal entitlements because of the economic realities of the transaction.5. The transaction did not alter the economic interests of independent third parties (i.e., the other

partners in Jade). – The court held that the transaction lacked economic substance on the basis of the above conclusions,

which the court viewed as relevant based upon its interpretation of Coltec.

• Jade Trading, LLC has appealed to the Court of Appeals for the Federal Circuit.

65

Sala v. United States• The District Court of Colorado recently held in favor of a taxpayer that entered into a

transaction similar to the transaction described in Jade Trading. See Sala v. United States, 552 F. Supp. 2d 1167 (D.C. Co. 2008).

• The IRS has referred to the Sala decision as an “anomaly” in the government’s continued litigation of “Son-of-Boss” transactions.

• Relevant Facts

– The taxpayer in Sala realized $60 million of income in 2000 in connection with the exercise of stock options.

– In 2000, the taxpayer invested approximately $9 million in a foreign currency investment program (the “Deerhurst Program”).

– In connection with the “Deerhurst Program,” the investment manager acquired long and short options on foreign currencies for a net cost of approximately $730,000.

– On November 8, 2000, the taxpayer formed an S corporation as its sole shareholder (“Solid”). On November 28, 2000, the taxpayer transferred the long and short options and approximately $8 million of cash to Solid. On the same date, Solid transferred the options and cash to a general partnership (“Deerhurst GP”).

– Deerhurst GP liquidated prior to December 31, 2000. In the liquidation, Solid received approximately $8 million in cash and two foreign currency contracts.

– Solid subsequently sold the foreign currency contracts prior to December 31, 2000.

– Solid reinvested the liquidation proceeds into Deerhurst LLC for a minimum of five years.

66

Sala v. United States• Taxpayer Position

– Solid claimed a basis in Deerhurst GP equal to the value of the cash plus the long options, or approximately $69 million. See Helmer v. Commissioner, T.C. Memo 1975-60 (1975).

– Solid claimed a basis in the two foreign currency contracts received in liquidation of Deerhurst GP equal to its partnership basis (~ $69 million) less the cash received in liquidation (~ $8 million), or approximately $61 million.

– Upon the sale of the two foreign currency contracts, Solid claimed a loss equal to approximately $60 million.

– The taxpayer claimed the $60 million loss on its original 2000 tax return, but filed a subsequent amended return that did not claim the $60 million loss and paid tax, interest, and penalties of over $26 million in connection with the amended return. The taxpayer subsequently filed a second amended return that claimed the $60 million loss. The taxpayer sued in District Court to claim a tax refund on the basis of the second amended return.

• The Deerhurst Program

– The District Court found the facts of the Deerhurst Program particularly persuasive.

– In the program, investors place a minimum of $500,000 in an account for an initial trial period. The account was managed by Deerhurst Management Company, Inc., which was owned and operated by a well-known foreign currency trader.

– Investors that were interested in remaining in the Deerhurst Program were then required to place additional funds into the program equal to at least 15% of the expected tax loss (for the taxpayer, 15% of ~ $60 million, or ~ $9 million).

– If the account was profitable after the liquidation in late 2000, investors had to reinvest their liquidation proceeds in Deerhurst LLC for a minimum of five years or be subject to a withdrawal penalty.

67

Sala v. United States – District Court DecisionThe District Court made the following rulings with respect to the Deerhurst Program:

1. The transactions entered into in connection with the Deerhurst Program satisfied the sham transaction / economic substance standard --

– The court refused to focus its inquiry on the “Son-of-Boss” aspect of the Deerhurst Program and considered the entire investment program.

– The court found that taxpayer had a potential (albeit small) of obtaining an economic return in excess of the $60 million loss and that the taxpayer entered into the transaction for profit.

– The court found that the transaction had a good faith business purpose other than tax avoidance, concluding that –

– The taxpayer’s stated purpose of creating Solid to reduce liability exposure was a valid purpose;

– The creation of Deerhurst GP had the valid purpose of investing in currency options and its liquidation had the valid purpose of “easier accounting and redistribution of the partnership assets”;

– The investment “test period” in the Deerhurst Program had a valid purpose since it permittedtaxpayers to gauge their interest in the program at little cost;

– The fact that “digital options” were not purchased (that would not have created the large tax loss) was immaterial; and

– The Deerhurst Program, as a whole, had a legitimate business purpose – a good faith and reasonable belief in profitability beyond mere tax benefits.

– Compare Klamath Strategic Inv. Fund, LLC v. United States, 568 F.3d 537 (5th Cir. 2009) (held that the transaction did not have economic substance; court applied a conjunctive economic substance test)

68

Sala v. United States – District Court Decision2. The tax loss was permitted under the Code and applicable regulations --

– The basis obtained in Solid and Deerhurst GP was equal to the value of long options and contributed cash and was not decreased by liabilities associated with the short options.

– The at-risk rules of sec. 465 and the loss limitation rule of sec. 1366(d) did not apply.

– Each of the 24 options contributed to Solid and Deerhurst GP were separate financial instruments. Accordingly, offsetting options were not offset against each other for purposes of determining the “net” value of property contributed to Solid and Deerhurst GP.

– The two foreign currency contracts received by Solid upon liquidation of Deerhurst GP constituted “property” within the meaning of sec. 732. As a result, Solid obtained a basis in such property equal to Solid’s basis in the partnership reduced by any money distributed.

3. Treasury exceeded its authority when issuing Treas. Reg. § 1.752-6(b)(2) and when making the regulations retroactive. Compare Klamath Strategic Inv. Fund, LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006) with Cemco Investors, LLC v. United States, 515 F.3d 749 (7th Cir. 2008).

4. The taxpayer filed a valid qualified amended return, and the IRS was not entitled to offset excess interest payments made by the taxpayer with an accuracy-related penalty.

The government has filed an appeal in the Tenth Circuit Court of Appeals.

69

Countryside – Facts of Transaction

Facts: W and C are individual partners in a partnership (“Countryside”). W possessed a 70% interest and C possessed a 25% interest in Countryside. Two other partners held the remaining interests. On or about September 18, 2000, W, acting as president of two separate corporations, formed two separate LLCs (“CLPP” and “MP”). On October 27, 2000, each of the corporations contributed cash to obtain a 1% interest in the LLCs. Countryside borrowed $8.5 million from a third-party bank. On October 30, 2000, Countryside contributed the cash to CLPP in exchange for a 99% interest and CLPP contributed the borrowed funds to MP for a 99% interest. On or about that day, MP borrowed an additional $3.4 million from the third-party bank. On or about October 31, 2000, MP used the borrowed proceeds to acquire four privately issued notes (the “AIG Notes”) in the aggregate principal amount of $11.9 million. On December 26, 2000, Countryside distributed its 99-percent interest in CLPP to W and C in complete liquidation of their respective partnership interests. As a result of the distribution, both W and C were relieved of their share of Countryside’s liabilities, although each retained a share of MP’s liabilities. In April 2001, Countryside sold real property and used the sale proceeds to repay the $8.5 million obligation to the third-party bank. In 2003, the AIG Notes were redeemed from MP by AIG. In 2004, MP repaid the $3.4 million loan.

Countryside

WCOther partners

$8.5 million

Note

CLPP

MP

$8.5 million

$8.5 million

$3.4 million

Note

$11.9 million

AIG Notes

1

2

34

5

6 Distribution of 99% interest in CLPP in complete termination of W and C’s interest

99%

99%

7Loan Repayment

8

Sale of real property for Cash

70

Countryside – Tax Issues• The IRS issued a notice of final partnership administrative adjustment (the FPAA) on October 8, 2004.

The FPAA contained the following adjustments –

– The distribution in liquidation of W and C’s interest in Countryside constituted a taxable event resulting in a large capital gain,

– A denial of Countryside’s election to receive a basis step-up under section 734(b)(1)(B) for the property remaining after the liquidating distribution (including the real property sold in 2001), and

– A basis reduction in the AIG Notes held by MP.

• W filed a partial motion for summary judgment in the Tax Court to resolve the first of the above issues raised by the IRS in the FPAA.

• The IRS argued that Countryside’s distribution of its 99% interest in CLPP constituted a distribution of marketable securities for purposes of section 731(a)(1) or, alternatively, it should be treated as such under the economic substance doctrine.

– Section 731(a) provides that a partner does not recognize gain on a partnership distribution, except to the extent that money distributed (including “marketable securities”) exceeds the partner’s adjusted basis in the partnership.

– If the distribution was treated as a distribution of money, then W and C would recognize substantial gain because both would have a low basis in their interests in Countryside (in part, because the relief of Countryside liabilities assumed by W and C would be treated as a distribution under section 752 that would reduce W and C’s outside basis).

– Note that W and C claimed that the $3.4 million borrowing by MP increased their outside basis and thus offset potential gain on the liquidating distribution.

• The Tax Court decided this issue in favor of the taxpayer. See Countryside Limited Partners v. Commissioner, 95 T.C.M. (CCH) 1006 (2008).

71

Countryside – Economic Substance• The Tax Court rejected the IRS argument that the distribution of the 99% interest in CLPP constituted a

distribution of marketable securities under section 731(a)(1).

• The Tax Court also rejected the IRS argument that the economic substance doctrine should apply to treat the distribution as a distribution of money for purposes of section 731(a)(1).

• The crux of the IRS position was that W and C effectively permanently deferred the recognition of gain on their share of the sale proceeds Countryside received in the 2001 sale of real property.

• The IRS unsuccessfully argued that Countryside had no potential for profit in the transaction because of interest and transaction costs and, thus, the transaction lacked a business purpose and should be recast under the economic substance doctrine.

– The Tax Court rejected this IRS argument because it focused on Countryside’s pre-tax profit rather than the partners, W and C, who were the focus of the motion before the court.

– At most, the Tax Court stated that this argument could support a challenge to any interest deductions claimed by Countryside with respect to the $8.5 million loan.

• The Tax Court concluded that the means of the transaction (i.e., the liquidation of W and C’s interest in Countryside) were designed to avoid recognition of gain, but that these means also served “a genuine, nontax, business purpose” – to convert W and C’s investments in Countryside (that owned real property) into an interest in a 10-year promissory note (the AIG notes).

• The Tax Court observed that these two forms of investment were economically distinct and therefore, in form and substance, the transaction constituted a redemption of W and C’s interest for non-marketable securities.

• The Tax Court clearly viewed the tax benefits of the transaction as being incidental to the legitimate business purpose of the transaction. Accordingly, the Tax Court found no harm in structuring the transaction in a manner to minimize the tax burden of W and C

72

Countryside – Effect of Continued Litigation?• The Tax Court only resolved the issue addressed by the partial motion for summary judgment.

• The Tax Court did not resolve the remaining issues raised by the FPAA, and it is uncertain whether W, C, Countryside or MP will retain any tax benefits claimed in connection with the transaction if and when the remaining issues are addressed.

• A footnote in the decision suggests that the Tax Court believes that the tax benefits claimed may not be warranted.

• Footnote 29 states that, given the totality of the circumstances, including (i) the formation of CLPP and MP and (ii) the section 754 elections made by Countryside and CLPP (but not by MP), there may be grounds to invoke the partnership anti-abuse rule of Treas. Reg. § 1.701-2 and/or the economic substance doctrine in order to determine –

– Whether Countryside should obtain a basis step-up in the retained assets and/or

– Disregard CLPP and MP as sham entities, and/or

– Require a basis step-down in the AIG Notes held by MP.

• The remaining issues have been consolidated before the Tax Court judge.

73

Shell Petroleum – Facts of Transaction

• Facts: Step 1 – Formation of Shell Frontier. In August 1992, three lower-tier subsidiaries of Shell Petroleum transferred assets to newly formed Shell Frontier in exchange for voting common stock and nonvoting preferred stock. The assets consisted of producing and nonproducing properties. In addition, unrelated investors purchased 1100 shares of auction-rate preferred stock in exchange for $110 million. The auction-rate preferred stock entitled the unrelated investors to 25.88% of the vote in Shell Frontier. One of the three lower-tier Shell Petroleum subsidiaries, Shell Western, also transferred additional assets to Shell Frontier in exchange for 900 shares of auction-rate preferred stock. The assets transferred by Shell Western consisted of non-producing Colorado oil shale properties and offshore oil leases in California and Alaska. Shell Western had an aggregate basis in these assets of $679,335,936. (Continued on next slide.)

ShellEnergy

Resources

ShellWestern

ShellOffshore

ShellRoyalties

ShellFrontier

UnrelatedInvestors

74

Shell Petroleum - Facts of Transaction

• Facts: Step 2 – Sale of stock. In December 1992, Shell Western sold 540 shares of Shell Frontier stock to unrelated investors for $54 million. Shell Frontier was not a member of the Shell consolidated group for tax purposes because more 20% of the voting power in Shell Frontier was owned by outside investors. Accordingly, this transaction caused the Shell Group to recognize a capital loss of approximately $354 million and created a consolidated net operating loss of approximately $320 million. The carryback of a portion of this net operating loss to 1990 resulted in a refund of approximately $19 million. In addition, a portion of the NOL was carried back to 1989 and 1991 and a portion was carried forward to years after 1992.

ShellEnergy

Resources

ShellWestern

ShellOffshore

ShellRoyalties

ShellFrontier

UnrelatedInvestors

540 shares of Shell Frontier stock

cash

>20%

75

Shell Petroleum - IRS Challenge

• The IRS challenged the capital loss claimed by the Shell Group as a result of Shell Western’s sale of auction rate preferred stock in Shell Frontier to the unrelated investors.

• The IRS argued that the auction rate preferred stock was not issued in exchange for property under section 351 because the nonproducing real estate properties did not earn income and therefore were without value.

• In addition, the IRS argued that the transaction should be disregarded because it lacked economic substance. In making this argument, the IRS relied heavily on the Federal Circuit’s decision in Coltec.

• Note that this transaction would not result in a capital loss today because of section 362(e)(2). Section 362(e)(2) requires taxpayers that transfer built-in loss property in a section 351 exchange to take a fair market value basis in such property. Section 362(e)(2), however, was not enacted at the time of the transactions in Shell Petroleum.

76

Shell Petroleum – District Court Decision• The United States District Court for the Southern District of Texas rejected the IRS argument and

upheld the taxpayer’s capital loss. See Shell Petroleum Inc. v. United States, 2008-2 USTC ¶50,422 (S.D. Tex. 2008).

• The court determined that the transfer of property to Shell Frontier qualified as a tax-free section 351 transaction and therefore Shell Western obtained a basis in the stock received in the exchange equal to its basis in the transferred assets.

– The court determined that the nonproducing real estate properties transferred to Shell Frontier had value, even though they weren’t earning income, and therefore such properties were “property” under section 351.

• The court rejected the government’s economic substance argument.

– The court noted that different courts apply different versions of the economic substance test and that some require both objective economic substance and business purpose and others require only one or the other. The court did not identify which standard it was applying, but determined that the transaction had both economic substance and business purpose. The court concluded that the transaction allowed Shell to monetize certain assets and also established a better management structure by containing the assets at issue within a single subsidiary. The court acknowledged that the structure of the transaction was motivated in part by the tax consequences and that the use of Shell Frontier was proposed by Shell’s tax department. However, the court determined that the overall transaction was not proposed by the tax department, but rather by Shell business people. Further the court determined that the overall transaction had a legitimate business purpose and economic substance.

• The court criticized and declined to follow the step-by-step approach to economic substance analysis applied in Coltec:

“Moreover, the Court has found no Fifth circuit cases, and the parties have cited none, similarly dissecting, or “slicing and dicing” as it was referred to in oral arguments, an integrated transaction solely because the Government aggressively chooses to challenge only an isolated component of the overall transaction.”

• The government has appealed to the Fifth Circuit Court of Appeals.

77

Klamath Strategic Investment Fund et al. v. United States Fifth Circuit Decision

Presidio Growth

LLC

Patterson

NatWestPresidio

Resources LLC

St. Croix LLC

KlamathLLC

90% 9%1%

$1.5M

Loan of $41.7M plus a loan premium of $25M

(total of $66.7M)

Investment of $66.7M plus $1.5M

Facts: On January 20, 2000, St. Croix LLC (“St. Croix”) and Rogue Ventures LLC (“Rogue”) were formed as single-member Delaware LLCs. Individuals Patterson and Nix each contributed $1.5M to St. Croix and Rogue, respectively. On March 29, 2000, St. Croix and Rogue each borrowed $41.7M from National Westminster Bank plc (“NatWest”) for seven years at a fixed interest rate. St. Croix and Rogue opted to pay an increased interest rate (17.97%) on their loans in return for NatWest paying St. Croix and Rogue premiums of $25M each. On April 6, 2000, St. Croix and Rogue each invested $68.2M in Klamath and Kinabalu, respectively, in exchange for a 90% partnership interest. Klamath and Kinabalu used these funds to purchase very low risk contracts on U.S. dollars and Euros and short 60- to 90-day term forward contract trades in foreign currencies. The investments involved three stages – I, II, and II – with the risk increasing with each stage.

This example shows the facts for Patterson, St. Croix and Klamath; the facts are the same for Nix, Rogue, and Kinabalu.

78

Klamath Strategic Investment Fund et al. v. United States Fifth Circuit Decision

Taxpayer’s Position– On their income tax returns for 2000, 2001, and 2002, Patterson claimed total losses of $25,277,202

arising from Klamath’s activities and Nix claimed total losses of $25,272,344 arising from Kinabalu’s activities.

– Patterson and Nix calculated their basis in the partnership as the $66.7M plus $1.5M, minus the liability assumption of $41.7M and, thus, were able to deduct over $25M from their taxable income.

Government’s Position– The IRS disagreed with the basis calculation and stated that under Section 752, the partners should

have treated the entire $66.7M as a liability.

– Alternatively, the IRS argued that the transactions were shams or lacked economic substance and should be disregarded for tax purposes.

District Court– The Partnership filed suit against the Government under section 6226 for readjustment of partnership

items. The Partnerships moved for partial summary judgment, and the Government cross-moved for summary judgment on the issue of whether the partners’ tax bases were properly calculated; specifically whether the loan premiums constituted liabilities under section 752 of the Code.

– The district court granted the Partnership’s motion and denied the Government’s, holding that the loan premiums were not liabilities under section 752 and therefore the partners’ bases were properly calculated.

– However, following a bench trial the district court held that the loan transactions must nonetheless be disregarded for federal tax purposes because they lacked economic substance.

– The Government appealed the district court’s partial summary judgment in favor of the Partnerships, arguing that the “loan premiums” constitute liabilities under section 752.

79

Klamath Strategic Investment Fund et al. v. United States Fifth Circuit Decision

• The Fifth Circuit applied the majority view of the economic substance doctrine – that a lack of economic substance is sufficient to invalidate the transaction regardless of whether the taxpayer has motives other than tax avoidance (i.e., the conjunctive test).

• The court went on to explain that the Supreme Court in Frank Lyon set up a multi-factor test for when a transaction must be honored as legitimate for tax purposes. These factors include

– Whether the transaction has economic substance compelled by business or regulatory realities,– Whether the transaction is imbued with tax-independent considerations, and– Whether the transaction is not shaped totally by tax avoidance features.

• The Fifth Circuit found that the evidence supported the district court’s conclusion that the loan transactions lacked economic substance.

– Numerous bank documents stated that despite the purported seven-year term, the loans would only be outstanding for about 70 days.

– NatWest’s profit in the loan transaction was calculated based on a 72-day period.– In the event that the investors wanted to remain with the plan beyond 72 days, NatWest would force them out.– The Partnerships contend that the loan funds were critical to the high-risk foreign currency transactions;

however, the structure of the plan shows that these high-risk transactions could not occur until Stage III, which was never intended to be reached.

• The Fifth Circuit noted that various courts have held that when applying the economic substance doctrine, the proper focus is on the particular transaction that gives rise to the tax benefit, not collateral transactions that do not produce tax benefits.

– In this case, the transactions that provided the tax benefits at issue were the loans from NatWest. Therefore, the court found that the proper focus is on whether the loan transactions presented a reasonable possibility of profit.

– The Fifth Circuit found that the evidence clearly shows that Presidio and NatWest designed the loan transactions and the investment strategy so that no reasonable possibility of profit existed and so that the funding amount would create massive tax benefits but would never actually be at risk.

• The Fifth Circuit also held that the Government lacked standing to appeal the district court’s partial summary judgment ruling that Section 752 operates to eliminate the claimed tax benefits arising from the Partnerships’ participation in the loan transactions.

80

Schering-Plough Corp. v. United States

SP

Facts: Schering-Plough Corporation (“SP”) owned all of the stock of Schering Corporation (“SC”), which owned all of the stock of Schering Plough-International (“SPI”). SP, SC, and SPI were U.S. corporations.

SPI owned a majority of the voting stock of Schering-Plough Ltd. (“SPL”), which owned a majority share in Scherico, Ltd. (“SL”). SPL and SL were Swiss corporations.

SP entered into 20-year interest rate swaps with ABN, a Dutch investment bank, in 1991 and 1992. The swap agreements obligated SP to make payments to ABN based on LIBOR and for ABN to make payments to SP based on the federal funds rate for the 1991 swap and on a 30-day commercial paper rate (plus .05%) for the 1992 swap.

The swap agreements permitted SP to assign its right to receive payments under the swaps (the “receipt leg”of the swap). Upon an assignment, SP’s payment to ABN and ABN’s payment to the assignee could not be offset against each other.

SP assigned substantially all of its rights to receive interest payments to SPL and SL in exchange for lump-sum payments totaling $690.4 million.

SC

SPI

SPL

SL

(US)

(US)

(US)

(Swiss)

(Swiss)

ABNinterest rate swaps

Assignment of “receipt leg” of swaps

$690.4 million

1

2

81

Schering-Plough Corp. v. United States• Taxpayer Position

– SP relied on Notice 89-21 to treat the swap and assignment transaction as a sale of the receipt leg of the swap to its foreign subsidiaries (SPL and SL) for a non-periodic payment that could be accrued over the life of the swap.

– The IRS issued Notice 89-21 to provide guidance on the treatment of lump-sum payments received in connection with certain notional principal contracts in advance of issuing final regulations.

• Notice 89-21 required that a lump-sum payment be recognized over the life of a swap in order to clearly reflect income.

• Notice 89-21 stated that regulations would provide the precise manner in which a taxpayer must account for a lump-sum payment over the life of a swap and that similar rules wouldapply to the assignment of a “receipt leg” of a swap transaction in exchange for a lump-sum payment.

• Notice 89-21 permitted taxpayers to use a reasonable method of allocation over the life of a swap prior to the effective date of the regulations.

• Notice 89-21 cautioned that no inference should be drawn as to the treatment of “transactions that are not properly characterized as notional principal contracts, for instance, to the extent that such transactions are in substance properly characterized as loans.”

– The IRS issued final regulations in 1993 that reversed the basic conclusion of Notice 89-21 and provided that an assignment of the “receipt leg” of a swap for an up-front payment (when the other leg remained substantially unperformed) could be treated as a loan. See Treas. Reg. 1.446-3(h)(4) and (5), ex. 4.

• IRS position– The IRS argued that the swap and assignment transaction should be treated as a loan from

the foreign subsidiaries to SP, which would trigger a deemed dividend under section 956.

82

Schering-Plough Corp. v. United States• Court Decision

– The District Court found in favor of the government on four separate grounds that, in the court’s view, would be sufficient to deny the taxpayer's claim for tax-deferred treatment under Notice 89-21. Schering-Plough Corp. v. United States, __ , (D.C. N.J. 2009).

1. Substance Over Form• The court noted that the integrated transaction had the effect of a loan in which SP borrowed an

amount from its foreign subsidiaries in exchange for principal and interest payments that were routed through ABN.

• The court discounted SP’s arguments (i) that there was an absence of customary loan documentation, (ii) that SP did not directly owe an amount to the foreign subsidiaries (even if ABN failed to fulfill its obligations), and (iii) that the amount of interest paid by SP to ABN would not equal the amount received by its foreign subsidiaries because of the different interest rate bases used under the swap.

• The court determined that SP’s efforts to structure the transactions as sales failed to overcome the parties’ contemporaneous intent and the objective indicia of a loan.

– The court stated that the foreign subsidiaries received the “economic equivalent” of interest and noted that SP “consistently, materially, and timely made repayments” to its foreign subsidiaries.

– The court found that SP officials considered the transaction to be a loan. – The court observed that SP did not use customary loan documentation for intercompany loans.

• The court also concluded that ABN was a mere conduit for the transactions which, according to the court, further supported its holding that the transactions were, in substance, loans.

– ABN faced no material risk since it entered into “mirror swaps” to eliminate interest rate risk (but not the credit risk of SP).

– The court found that ABN did not have a bona fide participatory role in the transactions, operating merely as a pass-through that routed SP’s repayments to the Swiss subsidiaries.

83

Schering-Plough Corp. v. United States• Court Decision (con’t)

2. Step Transaction• The court also applied the step transaction doctrine as part of its substance over form

analysis to treat the swap and assignment transaction as a loan.• In applying the “end-result test,” the court determined that the steps of the swap and

assignment transaction could be collapsed because they all functioned to achieve the underlying goal of repatriating funds from the foreign subsidiaries (SPL and SL).

– In the court’s view, the evidence established that the swaps and subsequent assignments were pre-arranged and indispensible parts of a “broader initiative” of repatriating earnings from the foreign subsidiaries.

• The court also concluded the steps of the swap-and-assign transactions to be interdependent under the “interdependence test.”

– The court found that the goal of the interlocking transactions was to repatriate foreign-earned funds, and the interest rate swaps would have been pointless had SP not subsequently entered into the assignments with its subsidiaries.

• The court rejected SP’s argument that, in applying the step transaction doctrine, the IRS created the fictitious steps that (i) the foreign subsidiaries loaned funds to SP, (ii) SP entered into an interest rate swap for less than the full notional amount with ABN, and (iii) SP satisfied its obligation under the imaginary loans by directing ABN to make future payments under the swap to its foreign subsidiaries.

• The court also rejected SP’s argument that the step transaction doctrine should not apply because the IRS failed to identify any meaningless or unnecessary steps.

84

Schering-Plough Corp. v. United States• Court Decision (con’t)

3. Economic Substance • The court concluded that the swap and assignment transaction failed the economic

substance doctrine and, thus, SP was not entitled to tax-deferred treatment. • The court followed 3rd Circuit precedent, ACM Partnership v. Commissioner, 57 F.3d 231

(3d. Cir. 1998), which treats the "objective" and "subjective" elements of the doctrine as relevant factors (rather than applying a rigid conjunctive or disjunctive standard).

• The court rejected the taxpayer's position that the repatriation proceeds represented "profit" from the transaction. The court also noted that any interest rate risk due to the swaps was hedged and that SP incurred significant costs in executing the transaction. In sum, the court found that there was little, if any, possibility of a pre-tax profit.

• The court concluded that both the swap and assignment lacked a business motive.– SP contended that it entered into both swaps for cash management and financial

reporting objectives, the 1991 swap for hedging purposes, and the 1992 swap for a yield enhancement function. The court rejected each of these non-tax motivations.

– Notably, the court avoided the difficult legal determination of whether the court must examine the whole transaction or, as the government argued, just the component part that gave rise to the tax benefit (here, the assignment step of the transaction).

4. Subpart F Principles• The court determined that permitting the repatriation of $690 million in offshore earnings

without at least a portion of those earnings being captured under subpart F would contradict Congressional intent.

• The court noted that Notice 89-21 did not supplant, qualify, or displace subpart F, nor was the notice intended to permit U.S. shareholders of controlled foreign corporations to repatriate offshore revenues without incurring an immediate tax.

• In the court’s view, the notice only dealt with the timing of income recognition.

85

ConEd v. United States

Headlease

SubleaseCEL Trust EZH

ConEd

CEL

Facts: ConEd, a U.S.-based utility, entered into a leveraged lease with EZH, a Dutch utility, on December 15, 1997. The lease property was an undivided 47.7% interest in a gas fired cogeneration power plant located in the Netherlands (the “RoCa3 Facility”). Under the “Headlease,” EZH leased the interest in the RoCa3 Facility to CEL Trust, a trust formed by a subsidiary of ConEd, for a period of 43.2 years. CEL Trust leased the interest back to EZH under the “Sublease” for a period of 20.1 years. CEL Trust was required under the Headlease to make an upfront rental payment ($120.1m), which was financed by an equity commitment of $39.3 million and a nonrecourse loan ($80.8m) from a third-party bank (“HBU”), and a deferred rent payment ($831.5m) due at the end of the Headlease term. Pursuant to the Sublease, EZH was required to make periodic rent payments, exclusive of certain payments, directly to HBU in satisfaction of CEL Trust’s obligations under the non-recourse loan. At the end of the Sublease term, three options could be exercised: (1) EZH could exercise the Sublease Purchase Option for the price of $215.4 million, (2) CEL Trust could exercise the Sublease Renewal Option to extend the lease term for approximately 16.5 years, or (3) CEL Trust could exercise the Retention Option pursuant to which EZH would return its interest in the RoCa3 Facility to CEL Trust.

The parties entered into defeasance arrangements to finance their obligations under the LILO arrangement. EZH established a defeasance account with the upfront payment attributable to the nonrecourse financing ($80.8m) to fund the “debt portion” of the periodic rental payments under the Sublease. EZH also established a defeasance account with a portion of the upfront payment attributable to the equity commitment ($31.2m) to fund the ”equity portion”of the periodic rental payments and the equity portion of the Sublease Purchase Option, if exercised by EZH. ConEd received a pledge of the equity and debt defeasance investments and re-pledged the debt defeasance to the nonrecourse lender, HBU, to secure its obligations under the nonrecourse note. For simplicity, the precise mechanics of the defeasance arrangements are not shown in the above diagram.

CED, as a subsidiary of ConEd, claimed deductions in 1997 for the prepaid rent transferred to EZH and for the interest attributable to the nonrecourse financing.

HBU

Note

Upfront and deferred rent

$ PeriodicRent (debt portion)

86

ConEd v. United States – Court of Federal Claims• Spoliation Claim

– The government alleged that, at the time of the change to a new email system in late 2000, ConEd had a duty to preserve evidence relevant to the LILO arrangement because it anticipated litigation starting in 1997.

• The government’s argument was based on the fact that Con Ed claimed work product protection for three memoranda drafted in 1997 that evaluated the tax consequences of the LILO arrangement.

• In the alternative, the government argued that ConEd anticipated litigation in 1999 when Rev. Rul. 99-14 was issued.

• The government sought an inference in its favor regarding open factual issues as to ConEd’s intent and understanding of the LILO arrangement.

– The Court of Federal Claims ruled in favor of ConEd.

• The court already had concluded that the memoranda at issue were not work product.

• The court also held that Rev. Rul. 99-14 by itself was not sufficient to give rise to an anticipation of litigation.

• Accordingly, the court held that ConEd did not have a duty to preserve documents at the time of the email conversion.

87

• Substance Over Form

– The government argued that the taxpayer did not qualify as the “true owner” of the leasehold interest in the RoCa3 Facility such that it possessed the “benefits and burdens” of ownership.

– The Court of Federal Claims rejected the government’s argument.

– The court found that there was some risk of loss and some opportunity for profit.

• The court acknowledged that, if EZH does not, or is not certain to, exercise the Sublease Purchase Option, then ConEd would likely satisfy the benefits and burdens standard due to the risk incurred during the retention period.

• The court referred extensively to the record (using both taxpayer and government experts) and, on the totality of the factual circumstances, concluded that the purchase option was not compelled to be exercised.

– From an economic perspective, the court relied on expert testimony that confirmed that the cost of exercising the purchase option would exceed the remaining value in the RoCa3 Facility interest at the end of the Sublease term.

– In addition, the court found persuasive the fact that numerous conditions that may affect the decision to make the election could change over time (e.g., discount rates, inflation, market changes, technological evolution, state of Dutch utility industry) and, thus, it was unlikely that an election was “virtually certain” at the time of the transaction.

– The court discounted government expert testimony (used in multiple LILO litigation cases) to the effect that the option would be exercised, in part, because it failed to address the specific facts at issue in the case.

• The court relied on ConEd expert testimony regarding the various risks that may arise upon an early termination of the LILO arrangement.

ConEd v. United States – Court of Federal Claims

88

• Substance Over Form (continued)

– The Court of Federal Claims rejected the government’s argument that only a future interest was acquired because EZH held possession of the property during the Sublease period.

• The court noted that possession is transferred in almost all true leases, including the lease in Frank Lyon.

– The Court of Federal Claims also concluded that the nonrecourse debt was valid.

• The court noted that all leveraged leases involve nonrecourse debt, that the nonrecourse loan permitted ConEd to acquire property, and that ConEd’s property rights had substantial value such that ConEd would not walk away from the property and default on the loan.

• The court rejected the government’s circular funds argument and found that the defeasance arrangements, which only reduced risk, did not disqualify the debt as valid debt.

• Economic Substance

– The Court of Federal Claims viewed the Coltec decision as consistent with past economic substance decisions that, in the aggregate, set forth the “general approach” to reviewing economic substance rather than “formulaic prescriptions” for determining which elements will result in a finding of economic substance.

– The court stated that the Coltec decision reduced the relative weight afforded to subjective business motivations when applying the economic substance standard, although the court considered non-tax business purposes to remain relevant, if not necessary, for the economic substance analysis.

– The court articulated the standard in the opinion’s conclusion as follows –

“Coltec expands on the guidance in Frank Lyon, offering a methodology to analyze economic substance by reviewing whether the taxpayer’s sole motivation was tax avoidance, which party bears the burden of proof and, if the evidence does not demonstrate that the taxpayer’s sole motive was tax avoidance, a requirement for objective evidence of economic substance in the transaction at issue.”

ConEd v. United States – Court of Federal Claims

89

• Economic Substance (continued)

– Subjective Factors

• The Court of Federal Claims lists numerous non-tax business reasons for entering into the LILO arrangement based on testimony offered by ConEd, including (i) the ability to pursue new opportunities and alternatives in the deregulated market, (ii) the expectation of making a pre-tax profit, (iii) ConEd’s entry into Western European energy markets, (iv) potential to benefit from the residual value of the RoCa3 Facility, and (v) technical benefits from operating a high tech plant in its own field of expertise.

– Objective Factors

• The Court of Federal Claims states that a “significant consideration” in the economic substance analysis is whether there is a reasonable opportunity for profit at the time of the transaction.

• The court concludes that Con Ed had a reasonable opportunity for profit under each of the possible scenarios at the end of the Sublease (i.e., purchase option, renewal, retention).

– The court noted that other decisions have accepted relatively low percentage of pretax profit (e.g., 3% or more) for leasing transactions.

– In determining the profit percentage, the court did not accept the government’s position that a discount rate must be used.

• In sum, in applying the substance over form doctrine and the economic substance standard, the court reiterated that it was applying the judicial standards to unique set of facts and cited extensively to the record in this regard. On the basis of the totality of factual evidence, the court distinguished recent court decisions (BB&T, Altria, Fifth Third) involving LILO arrangements that were decided in favor of the government.

ConEd v. United States – Court of Federal Claims

90

Southgate Master Fund v. United States

Cinda

Facts: China Cinda, an entity owned and operated by the Chinese government (“Cinda”), paid face value (approx. $1.1 billion) for certain nonperforming loans (“NPLs”) held by the state-owned Chinese Construction Bank (the “CCB”). On July 31, 2002, Cinda contributed these NPLs to Eastgate, a Delaware limited liability company, in exchange for 100% of the interests in Eastgate. On or about July 31, 2002, Eastgate contributed the NPLs to Southgate, a Delaware limited liability company, in exchange for a 99% membership interest. The remaining 1% membership interest was acquired for $100,000 cash and a note by Montgomery Capital Advisers, a Delaware limited liability company formed to pursue investment opportunities in China (“MCA”). D. Andrew Beal (“Beal”) formed Martel Associates, LLC, a Delaware limited liability company (“Martel”), which purchased 90% of Eastgate’s interests in Southgate for approximately $19.4 million on August 30, 2002. After the acquisition, Martel owned an 89.1% interest in Southgate, and Eastgate and MCA owned a 9.9% interest and a 1% interest, respectively.

Eastgate

NPLs

SouthgateNPLs

MCA

$100k & note 1%

99%

$19.6mMartel

Beal

89.1% interest in Southgate

Cinda

Eastgate

SouthgateNPLs

MCA

1%

99%

NPLs

$CCB

91

Southgate Master Fund v. United States

Facts (continued): Southgate adopted a strategy to monetize the NPLs by selling a portion of low-quality NPLs to third parties and collecting on the remaining high-quality NPLs. Southgate planned to sell 20% to 25% of the NPLs in 2002, which would trigger a substantial amount of built-in losses to shelter Beal’s personal income in 2002. In late 2002, Beal and Martel entered in a sale-repurchase transaction (a “repo” transaction) and a restructuring of Beal’s interest in Martel (collectively, the “Repo/Restructuring”) in order to increase Beal’s outside basis in Southgate so that he could recognize the built-in losses that would be allocable to Beal (approx. $265 million).

The repo transaction consisted of the following steps: (i) Beal contributed Ginnie Mae securities (“GNMA” securities) with a basis and value of approximately $180.5 million to Martel, (ii) Martel entered into a repo transaction with UBS in exchange for $162 million and an agreement to repurchase identical GNMAs from UBS, and (iii) Martel distributed the $162 million to Beal and Beal guaranteed Martel’s obligation to repurchase.

In the restructuring, (i) Martel distributed its interest in Southgate to Beal and (ii) Beal contributed his interest in Martel to Southgate. Beal became the sole manager of Martel under amended operating agreements and, in such capacity, held sole discretion inter alia to direct the purchase and sale of securities by Martel and the use of all proceeds from the repo transaction. After the restructuring, Beal’s percentage interest in Southgate increased to approximately 93.3% while Eastgate’s percentage interest decreased to 5%.

SouthgateNPLs

Martel

Beal

89.1%

GNMA Repo

$162m

$162m

Other partners

Southgate

NPLs

Martel

Beal

89.1%

Other partners

89.1% Southgate

interest

Southgate

GNMAs (FMV = $180.5m)

Martel

Martel

1 2

GNMAs

GNMAs

1

2

3

UBS

92

Southgate Master Fund v. United States• Taxpayer’s position

– Allocation of Southgate Losses

• Southgate incurred approximately $294.8 million in losses in 2002, of which approximately $292.8 million were built-in losses (within the meaning of section 704(c)) and $2.0 million were post-contribution losses.

• Beal was allocated 90% of both the built-in losses and post-contribution losses in 2002 (approx. $265 million) pursuant to section 704(c) and Treas. Reg. § 1.704-3(a)(7) (as those provisions were in effect in 2002).

– Beal’s Outside Basis in Southgate

• Beal acquired a cost basis in Southgate upon acquisition from Eastgate (increased prior to the Repo/Restructuring by a payment of a placement fee on behalf of Southgate and a loan to Southgate).

• Beal’s contribution of the GNMAs to Southgate increased his outside basis in Southgate by his basis in the GNMAs, or $180 million.

• The $162 million in repo liabilities assumed by Southgate in connection with the restructuring (through its ownership of Martel), and Beal’s guarantee of such liabilities, resulted in offsetting basis adjustments.

• Beal’s basis in Southgate was approximately $210.5 million as of December 31, 2002, and he reported an ordinary deduction of approximately $216.3 million arising from his interest in Southgate.

• IRS position

– The IRS argued that judicial doctrines (economic substance, sham partnership, and substance over form) prevented Beal’s outside basis increase from the Repo/Restructuring.

– The IRS also raised three separate so-called “basis killer” arguments that would require a step-down in the basis of the NPLs contributed to Southgate and, thus, deny all of built-in losses claimed by the partnership and allocated to Beal:

• The IRS argued that Cinda was a dealer in securities and therefore Cinda would be required to mark-to-market the NPLs transferred to Southgate.

• The IRS argued that section 482 should apply to reallocate income from the purchase of the NPLs by Cinda from the CCB at face value.

• The IRS argued that NPLs were worthless at the time they were acquired by Cinda.

93

Southgate Master Fund v. United States• Court Decision

– The district court held that the judicial doctrines of economic substance, sham partnership, and substance over form applied to deny Beal the increase in basis from the Repo/Restructuring. Southgate Master Fund v. United States, __ , (N.D. Tex. 2009).

– Economic Substance

• The district court stated that the transaction as a whole must be divided for purposes of the economic substance analysis: (i) the partnership between Cinda, MCA, and Beal in the Southgate acquisition of the NPLs and (ii) the Repo/Restructuring that increased Beal’s basis in Southgate.

• The district court held that Southgate itself had economic substance on the basis that the formation was not shaped solely by tax-avoidance features. In that regard, the district court found that there was a potential for profit (even though the venture turned out unprofitable) and noted that section 704(c), as it existed prior to 2004, arguably encouraged these types of transactions.

• The district court held that the basis-increasing steps undertaken by Beal lacked economic substance. The court found that Southgate did not have a reasonable possibility for profit from the transaction (even though Southgate did in the original NPL transaction), in part, because Beal controlled the income streams from the GNMAs and had sole discretion to award gains or losses to the partnership. Furthermore, in the court’s opinion, the taxpayer also did not establish a valid business purpose other than the tax benefits obtained by Beal.

– Sham Partnership

• The district court held that the Repo/Restructuring resulted in a sham partnership thereby denying Beal any resulting basis increase. Note that the district court did not disregard the partnership for all purposes.

• The district court found, as described above, that there was no substantive non-tax business reason for structuring the Repo/Restructuring.

– Substance Over Form

• The district court also applied the substance over form doctrine to deny Beal the basis increase resulting from the Repo/Restructuring.

• The district court appears to conclude that the Beal should be treated as entering into the repo transactions directly, thereby disregarding the use of Martel in the transaction.

94

Southgate Master Fund v. United States

• Court Decision (con’t) – Basis-Killer Arguments

• Dealer status of Cinda– The district court rejected the government’s argument that Cinda should be treated as a dealer

in securities required to mark-to-market the NPLs contributed to Southgate. – The district court noted that Cinda commonly entered into debt-to-equity swaps and other non-

sale transactions in which it collected for its own account in the years preceding the transaction. • Section 482 adjustment

– The district court rejected the government’s argument that section 482 should apply to adjust the consideration paid by Cinda to acquire the NPLs from the CCB.

– The district court concluded that section 482 could not apply to the sale between Cinda and the CCB because the adjustments contemplated by section 482 must be made to entities having a U.S. tax liability.

– The district court also questioned whether Cinda and CCB could be viewed as related parties for purposes of section 482.

• Worthlessness of NPLs– The district court rejected the government’s argument that the NPLs were worthless when

acquired by Cinda and therefore Southgate could not recognize a taxable loss on their disposition.

– The district court cited evidence that the NPLs were sold for consideration.– The district court did not impose accuracy-related penalties asserted by the government, finding that Beal

acted in good faith and with reasonable cause.

95

Country Pine Finance, LLC v. Commissioner

ZurichBank

U.K. Residents

Country Pine

Members

Fairlop

Facts: In 2001, several individual taxpayers sold stock in the Burnham Insurance Group (“BIG”) to HUB International (“HUB”) (referred to as the “Members”), recognizing gain on the exchange of BIG stock for HUB stock and cash.

In the CARDS transaction entered into in 2001, Fairlop Trading, LLC (“Fairlop”), an entity formed by two U.K. residents, borrowed €16.6 million from Zurich Bank. Fairlop used the loan proceeds to purchase two promissory notes from Zurich Bank to collateralize the loan: one for €13.6 million and another for €2.9 million. Fairlop later exchanged the €2.9 million note for a new note of €1.9 million and €1.0. [Note that this exchange not shown in diagram above.]

The Members formed Country Pine Finance, LLC (“Country Pine”) to participate in the CARDS transaction. The Members purchased the €1.9 million note and €1.0 from Fairlop in exchange for an agreement to become jointly and severally liable for the entire €16.6 loan from Zurich Bank to Fairlop. The Members then contributed the €1.9 million note and €1.0 to Country Pine. In exchange, Country Pine guaranteed the loan to Fairlop. The Members and Country Pine pledged the contributed property as collateral for the loan.

Country Pine and Zurich Bank entered into a currency swap pursuant to which Country Pine exchanged the €1.9 million note and €1.0 for $2.6 million in cash. Country Pine claimed a $11,952,871 loss on the exchange (allocated between a short-term capital loss on the note and an ordinary loss on the euro) since it claimed a basis in the exchanged property equal to the full amount of the joint and several liability assumed by the Members -- €16.6 million or $14.6 million.

The amounts exchanged served as the notional amounts under the swap. The swap required Zurich Bank to pay interest on €2.9 million received from Country Pine (that equaled Country Pine’s payments to Zurich Bank on the assumed loan) and Country Pine to pay interest on the $2.6 million received from Zurich Bank (that Country Pine used to obtain a promissory note from Zurich Bank, which was pledged back to Zurich Bank as collateral).

€16.6 million

€16.6 million

€13.6 note€1.9 note€1.0

1

2

€1.9 note€1.0

€1.9 note€1.0

J&S liability on €16.6 million note

Currency rate swap

34

5

note

96

Country Pine Finance, LLC v. Commissioner

• IRS argued that the claimed losses should be denied because (i) the CARDS transaction lacked economic substance, (ii) substance-over-form principles should apply to disallow the loss, and (iii) neither Country Pine nor the Members could claim deductions under section 165, 465, or 988.

• The Tax Court held that the transaction did not have economic substance under either the standard applied in the 6th Circuit (no rigid test) or D.C. Circuit (disjunctive test), and denied the claims for losses in the CARDS transaction. See Country Pine Finance, LLC v. Commissioner, T.C. Memo 2009-51 (Nov. 5, 2009).

– The Tax Court did not address other arguments in the T.C. Memo opinion raised by the government.

• The taxpayer argued that the CARDS transaction had economic substance and was entered into to permit Country Pine to finance real estate investments on the members’ behalf.

– Taxpayer argues that Country Pine and the Members were jointly and severally liable for the entire € 16.6 million, and that Fairlop, the Members and Country Pine were at risk for the loan proceeds.

– Taxpayer also argues that there was profit potential since real estate could have been substituted for collateral on the loans.

• The IRS argued that transaction had no economic substance and no practical effect other than creating tax losses.

97

Country Pine Finance, LLC v. Commissioner• The Tax Court held that the tax losses must be denied under both an objective and a subjective analysis. • Objective Analysis

– Tax Court concluded that the transaction did not have a profit potential. • None of the loan proceeds ever left Zurich Bank’s control as loans acquired promissory notes

that were pledged as collateral. • Expert testimony established that the transaction had a negative net present value and rate of

return – fees of $700,000 paid in order to borrow €2.9 million for 1 year, the funds from which purchased investments that could never earn a profit (e.g., promissory notes from Zurich Bank).

– Tax Court concluded that the transaction should not be analyzed as if real estate were substituted as collateral.

• Country Pine could only earn a profit if it could substitute collateral and earn a return in excess of the cost of the initial loans.

• However, the court found that Zurich Bank would not have permitted the substitution without imposing more onerous terms to account for its increased risk and that the Members knew prior to the transaction that real estate could not be substituted as collateral without a “haircut.”

• The Tax Court further held that any substitution would be viewed as a separate transaction so that the currency exchange creating the tax loss would still have no pre-tax profit, citing Coltec.

• Subjective Analysis– Tax Court held that the Members did not have a nontax business purpose for entering into the

CARDS transaction. – Tax Court noted that the Members knew that real estate could not be substituted prior to the

transaction, the petitioner testified that the decision to enter into the transaction was to take advantage of tax benefits, and that Members repeatedly testified that they did not read any of the relevant documents or otherwise engage in due diligence.

98

United States v. G-I Holdings, 2009 WL 4911953 (D. N.J. 2009)

Facts: In 1990, G-I Holdings Inc. and ACI Inc. (collectively, “GAF”) and Rhone-Poulenc S.A. (“RP”) entered into a partnership agreement forming Rhone-Poulenc Surfactants and Specialties, LP (“RPSSLP”). GAF transferred the assets of its surfactants chemicals business, valued at $480 million, to RPSSLP as a contribution to the partnership. In exchange, GAF received a limited partnership interest representing a 49-percent interest in RPSSLP. RP transferred approximately $480 million in assets to RPSSLP in exchange for a 49-percent limited partnership interest and created a holding company, Rhone-Poulenc Specialty Chemicals, Inc (“RPSC”), to act as the general partner in RPSSLP. GAF assigned its limited partnership interest in RPSSLP to CHC Capital Trust (“CHC Trust”), which pledged the partnership interest as collateral for a loan of approximately $460 million from Credit Suisse, the proceeds of which were required by the CHC Trust agreement to be distributed to GAF. GAF subsequently received approximately $450 million of the loan proceeds. GAF’s asset contribution to RPSSLP and the distribution of the loan proceeds to GAF took place on the same date. The loan was nonrecourse, and was secured only by GAF’s partnership interest in RPSSLP. The loan required monthly interest payments, which were financed through an agreement between GAF and RPSSLP that entitled GAF to a monthly priority return distribution. The priority return distributions were distributed to CHC Trust and used to pay any interest due on the loan, with any surplus proceeds distributed to GAF. Under the partnership agreement, RPSC was required to cause RPSSLP to pay the priority return distribution each month regardless of RPSSLP’s profit or loss. The financial obligations of RPSC under the partnership agreement were guaranteed by RP. Further, the transactions were structured with protections that assured that GAF would have the necessary money to repay the loan.

RPSSLP

RP

$480 million asset contribution Credit

Suisse

CHC TrustRPSSLP Interest

Non-recourse loan secured by

RPSSLP Interest

$460 million loan

$450 million loan

proceeds

GAF

99

United States v. G-I Holdings

• Positions of the Parties– GAF argued that the contribution of assets to RPSSLP was a non-taxable contribution to a partnership under section

721(a). GAF made various arguments that the form of its contribution to RPSSLP should be respected, and that the entire $480 million in assets represented a valid equity contribution.

– The government contended that GAF’s purported contribution transaction was a taxable disposition of the transferred assets because (i) the transaction constituted a disguised sale under section 707(a)(2)(B), or, alternatively, (ii) RPSSLP was not a valid partnership for tax purposes or, if RPSSLP was a valid partnership, neither G-I Holdings or ACI was a partner in the partnership.

• Court Decision– The district court held that $450 million of GAF’s asset contribution to RPSSLP should be recharacterized as a sale of

property. – The court concluded that RPSSLP was a valid partnership for Federal tax purposes, but found that only $30 million of

GAF’s asset transfer represented a valid, non-taxable contribution to the partnership under section 721(a) (the excess of GAF’s $480 million investment in the partnership over the $450 million received by GAF from the loan).

– The remaining $450 million in assets purportedly contributed by GAF to RPSSLP was more properly characterized as a sale of property. The court relied on four considerations in reaching its conclusion that a disguised sale existed: (1) the risk of loss, (2) the potential profits, (3) the historical context in which the transactions occurred, and (4) the disguised sale analysis of the transactions.

• GAF had no risk of loss on the transfer of the $450 million in assets to RPSSLP; the parties stipulated that GAF’s potential loss was capped at $26.3 million.

• GAF did not enter into the partnership arrangement with the intent of making a profit. Because GAF’s transaction costs exceeded its expected gain from the partnership, any assertion of a profit-motive by GAF was not credible.

• The historical circumstances surrounding the transactions demonstrated that GAF did not intend to enter into a joint venture with RP. GAF and RP had previously decided to structure the transaction as an asset sale, which suggested that GAF selected the RPSSLP partnership structure solely as a means to sell its assets in a manner that minimized taxation.

100

United States v. G-I Holdings

Court Decision (cont’d)• Section 707(a)(2)(B) Disguised Sale Analysis

– The district court concluded that the $450 million in assets transferred by GAF to RPSSLP was properly characterized as a sale pursuant to section 707(a)(2)(B).

• The court stated that this determination received the greatest weight in its assessment of the substance of GAF’s transaction.

– The court found that each of the statutory elements listed in section 707(a)(2)(B) were present. • GAF’s transfer of $450 million in assets to RPSSLP was a direct transfer of money or other property by a partner to a

partnership under section 707(a)(2)(B)(i). • The $450 million in loan proceeds received by GAF constituted an indirect transfer of money or other property by the

partnership to a partner under section 707(a)(2)(B)(ii). In substance, the loan was structured to function as a payment to GAF, as GAF was not liable for the loan and repayment rested indirectly with RPSSLP, RPSC, or RP.

– The court held that GAF’s asset contribution and loan transaction, when viewed together, were properly characterized as a sale of property under section 707(a)(2)(B)(iii).

• In reaching this conclusion, the court noted that the application of the section 707(a)(2)(B) disguised sale statute was a matter of first impression, and turned to the statute’s legislative history for guidance.

– The court cited six factors from the Senate Finance Committee’s explanation of section 707(a)(2)(B) for determining whether a disguised sale exists, of which four were identified by the court as applicable to the instant case: (1) whether the payment received by the partner is subject to an appreciable risk as to amount, (2) whether the partner status of the recipient is transitory, (3) whether the distribution made to the partner is close in time to the partner’s transfer of property to the partnership, and (4) whether, under all the facts and circumstances, it appears the taxpayer became a partner primarily to obtain tax benefits that would not have otherwise been available.

» The court held that none of the four factors weighed in favor of finding that the $450 million of GAF’s asset transfer was a valid contribution to RPSSLP, as the $450 million received by GAF through the loan was subject to no risk, the contribution and loan transactions took place on the same day, and GAF’s primary motivation for participating in the transaction was to receive tax benefits (the court noted that GAF’s continued partner status did not weigh in either direction).

– The court also looked to the relevant Treasury regulations issued under section 707(a)(2)(B) for guidance on the factors to be considered in deciding whether GAF’s transaction was properly recharacterized as a sale. The courtrecognized that the regulations were promulgated after the transaction at issue and were thus non-binding, but nevertheless viewed the regulations as informative. The court examined each of the ten factors listed in Treas. Reg. § 1.707-3(b)(2) and summarily concluded that the relevant factors weighed in favor of finding that the transactions should be characterized as a sale.

101

United States v. G-I Holdings

Court Decision (cont’d)• After examining the legislative history of section 707(a)(2)(B) and the relevant Treasury regulations, the court then

conducted its own analysis of GAF’s $450 million contribution transaction, listing seven factors that, according to the court, received the greatest weight in its determination that the transaction should be recharacterized as a sale:

– historical context suggested a sale was intended, – contribution and loan transactions were carefully planned and structured together, – GAF restructured the asset sale with the principal objective of reducing taxation in an exchange of assets for

cash, – contribution and loan transactions were integrated and interlocking, – contribution and loan transactions closed on the same date, – in making the contribution, GAF ceded operational control of its assets, and– the transactions were structured so that the loan functioned as a payment in substance.

• Despite the finding that GAF’s transaction constituted a disguised sale, GAF ultimately prevailed because the government’s asserted deficiency was time-barred.

– The government was unable to establish that it was entitled to the six-year statute of limitations for assessments provided in section 6501(e)(1)(A) for substantial omissions from gross income.

102

Virginia Historic Tax Credit Fund 2001 LP v. Comm’r, T.C. Memo. 2009-295

• Facts: In 1996, Virginia enacted the Virginia Historic Rehabilitation Credit Program (“Virginia Program”) to provide State tax credits to individuals and businesses to encourage the preservation of historic buildings. The amount of credits granted for a rehabilitation project depended on the amount of eligible expenses incurred. The Virginia Program included a partnership allocation provision that allowed owners to use their excess credits to attract capital contributions. This allocation provision permitted State tax credits granted to a partnership to be allocated among all partners either in proportion to their ownership interest or as the partners agreed. Consequently, owners frequently engaged in partnership arrangements that allocated a disproportionate share of the State tax credits to investor partners in order to attract capital investment. The partnerships and LLC at issue (collectively, the partnerships) were formed to provide funding for small historic rehabilitation projects. The partnerships acquired interests in other partnerships or LLCs that were involved in the rehabilitation of property and thus entitled to State tax credits. The partnerships pooled capital from investors to support these rehabilitation projects, resulting in the allocation of State tax credits to the partnerships. Investors who contributed capital to the partnerships received a partnership or LLC interest and were allocated a share of credits from the pool of credits generated by the partnerships.

VHTCF 2001 SCP LP

VHTCF 2001 SCP LLC

VHTCF 2001 LP

Various Developer Partnerships

Investors Investors

Investors

103

Virginia Historic Tax Credit Fund 2001 LP v. Comm’r

• IRS Position– The Commissioner primarily contended that the investors were not partners for Federal tax purposes and

that, consequently, the investors’ capital contributions to the partnerships and receipt of the State tax credits should be treated as sales of the credits.

– As an alternative argument, the Commissioner contended that the investors’ capital contributions to the partnerships coupled with the allocations of State tax credits were disguised sales under section 707(a)(2)(B) between the partnerships and their respective partners.

• Court Decision– The Tax Court first concluded that the investors were partners in the partnerships for Federal tax purposes. – The court then held that the transactions should not be treated as disguised sales under section

707(a)(2)(B). – In its disguised sale analysis, the court found that the substance of the transactions reflected valid

contributions and allocations rather than sales.• The investors made capital contributions to the partnerships in furtherance of their purpose to invest in

developer partnerships involved in historic rehabilitations and to receive State tax credits. • Because of the investor’s pooled capital, the partnerships were able to participate in the developer

partnerships. • The partnerships’ allocation of the resulting pooled credits to the investors as agreed in the partnership

agreements was consistent with the allocation provisions of the Virginia Program.

104

Virginia Historic Tax Credit Fund 2001 LP v. Comm’r

• Court Decision (cont’d)– In holding that the transactions should not be recharacterized as disguised sales, the court also relied in part

on the fact that the transfers were not simultaneous. • The investors contributed capital at various times during the years at issue, while the State tax credits

were allocated to the partners when the partnerships attached the certificates to their respective Schedules K-1.

– The court also noted that the subsequent transfer of the State tax credits was subject to the entrepreneurial risks of the partnerships’ operations.

• Although the investors were promised certain amounts of credits in subscription agreements, there was no guarantee that the partnerships would pool sufficient credits.

105

Transactional Tax Issues Raised by Coltec

106

Coltec Transactional Tax Issues• How Would the Analysis Change if Certain Facts Were Altered?

– What if Garlock did not guarantee up to $200 million to cover Garrison’s capital needs?

– What if Garlock never sold the stock of Garrison? Does a taxpayer need a business purpose to transfer liabilities to a subsidiary even if no sale of the subsidiary is contemplated?

• What Does it Mean to Disregard a Transaction?– In Coltec, the Federal Circuit court disregarded both the transfer of the liabilities

and the transfer of the note. The entire transaction was voided.– What happens when the subsidiary pays off the liabilities? – Who gets the deduction?

• Are there other tax consequences? Is the payment of the liability by the subsidiary a deemed payment to the parent?

• Why is the transfer of the note voided? Do you need a business purpose to transfer a note to a subsidiary? Why are the transfer of the note and the transfer of the liabilities treated as a single step and not analyzed separately under the courts theory that “the transaction to be analyzed is the one that gave rise to the alleged tax benefit?

– What happens when the subsidiary receives payments on the note?• What happens to the buyer of the Garrison stock if the transfer of the liabilities and

transfer of the note are ignored? Is the purchase also ignored? Is the purchase price adjusted?

107

Coltec Transactional Tax Issues

• What are the implications of the technical analysis in Coltec for other Transactions?• In light of the rulings by both the Fourth Circuit in Black & Decker and the Federal

Circuit in Coltec, have any of the government’s positions been revised with respect to the application of section 357(c)(3) in other rulings?

• What is the Service’s current position with respect to contingent liability transactions? Is the position that section 358(h) applies? Or is the position that Coltec controls and section 358(h) does not apply because the transfer was a sham? If the latter, does section 358(h) ever apply?

• There is a critical difference between the result under section 358(h) and the result in Coltec. Under section 358(h), the transaction is respected, but the basis in the stock of the subsidiary is reduced by the amount of the contingent liabilities. In contrast, the Federal Circuit in Coltec declared that the transfer of a note and the transfer of contingent liabilities should be completely ignored. These two different treatments could lead to different results (e.g., who gets the deduction when the liabilities are paid, what happens when payments are made on the note).

• Assuming that section 358(h) applies, will the government follow Rev. Rul. 95-74 and allow the transferee subsidiary to claim a deduction on payment of the liabilities?

108

Implications of the Step-by-Step Economic Substance Analysis in Coltec for Other Transactions

• Just as the Supreme Court’s shifting and hard to define standards in its obscenity jurisprudence left many examining works to determine whether they were so offensive as to be prohibited speech, the Federal Circuit’s new conception of the economic substance doctrine raises many questions about current common transactions and whether such transactions will be deemed prohibited by the courts, even if authorized by the Internal Revenue Code.

• The following slides depict common transactions that may be subject to review based on the analysis in Coltec.

• Under current law, all of these transactions should have clear results and these results should not be undone by the Federal Circuit’s Coltec analysis.

109

Sale to Recognize Loss

• May a taxpayer sell stock solely to recognize a loss under the Federal Circuit’s analysis in Coltec?

• The Supreme Court in Cottage Savings allowed a taxpayer to exchange mortgage securities for other mortgage securities and recognize a loss. The transaction was done solely for tax purposes and was disregarded for regulatory purposes. Can Coltec and Cottage Savings be reconciled?

P

S

ThirdPartySale of S stock

P has built-in loss in S stock

110

Accelerating a Built-In Gain

P

100%

S1 S2

LLC

100%

50% 50%

Facts: P, a domestic corporation, owns 100% of the stock of S1 and S2, and they file a consolidated return. In Year 1, S1 sells an asset to S2 for cash, resulting in a deferred intercompany capital gain. In Year 3, the P group has a capital loss that it would like to use, so S2 contributes the asset to a newly formed LLC owned by S1 and S2.

Result: Because the asset is no longer owned by a member of the P consolidated group, the deferred capital gain should be triggered. However, is this result consistent with the business purpose and economic substance analysis in Coltec?

cash

asset

Contribute asset

111

Busting Consolidation -- Example 1

P

100%

S1 S2

X

LLC

100%

50% 50%

Facts: P, a domestic corporation, owns 100% of the stock of S1, S2, and X, and they file a consolidated return. In order to deconsolidate X, P contributes 50% of the X stock to each of S1 and S2, and S1 and S2 contribute the X stock to a newly formed LLC.

Result: Because X is no longer an includible corporation, it should not be a member of P’s consolidated group. However, is this result consistent with the business purpose and economic substance analysis in Coltec?

112

Busting Consolidation -- Example 2

Facts: FP, a foreign corporation, owns 100% of the stock of P, which owns all of the stock of S, which owns all of the stock of X. P, S, and X file a consolidated return. In order to deconsolidate X, S contributes the stock of X to an LLC formed by S and FP.

Result: Because X is no longer an includible corporation, it should not be a member of P’s consolidated group. However, is this result consistent with the business purpose and economic substance analysis in Coltec?

FP

100%

P

X

50%

50%

SLLC

113

Avoiding Loss Disallowance Rules

P

100%

S1 S2

X

LLC

100%

50% 50%

Facts: P, a domestic corporation, owns 100% of the stock of S1 and S2. The P group wants to purchase the stock of X, but X has built-in gain assets that could trigger the application of the loss disallowance rules if the P group later disposes of the stock of X. To avoid the potential application of the loss disallowance rules, S1 and S2 form LLC, and LLC acquires the stock of X.

Result: Because X is not an includible corporation, it should not be a member of P’s consolidated group. However, is this result consistent with the business purpose and economic substance analysis in Coltec?

Z

X

X Stock

Cash

114

Section 331 Liquidation

P

S FS

25% S stock

cash

P

S FS

75%

25%

100%

Facts: P, a domestic corporation, owns all of the stock of S, which is a domestic subsidiary, and FS, which is a foreign subsidiary. P has a $100 basis in its S stock. The value of its S stock is $10. If P liquidates S, the loss in the S stock will not be realized. P therefore sells 25% of the S stock to FS and, after a period of time, S liquidates into P.

Result: P can recognize the loss on the remaining 75% of stock in S. However, is this result consistent with the business purpose and economic substance analysis in Coltec?

Liquidation

115

Section 332 Liquidation

P

S FS

25% S stock

cash

P

S FS

100%

25%

75%

Facts: P, a domestic corporation, owns 75% of the stock of S, which is a domestic subsidiary, and 100% of FS, which is a foreign subsidiary. P has a $10 basis in its S stock. The value of its S stock is $100. If P liquidates S, the gain in the S stock will be realized. P therefore purchases 25% of the S stock from FS and, after a period of time, S liquidates into P.

Result: P does not recognize the gain on the liquidation under section 332. However, is this result consistent with the business purpose and economic substance analysis in Coltec?

Liquidation

116

Purchase and Liquidation

• Section 269(b) states deductions, credits, or other allowances may be disallowed, but only if the liquidation occurs within 2 years.

• Does Coltec replace section 269(b)?

T

PT stock

$A P

T

Liquidation

117

Liquidation and Sale

• In Commissioner v. Court Holding, the Supreme Court held that a liquidation of a corporation followed by a sale of the corporation’s assets resulted in tax to the corporation because “a sale by one person cannot be transformed into a sale by another by using the latter as a conduit through which to pass title.” However, five years later, in U.S. v. Cumberland Public Service Co., the Court held that a liquidation followed by a sale did not result in tax to the corporation. The Court stated, “The subsidiary finding that a major motive of the shareholders was to reduce taxes does not bar this conclusion. Whatever the motive and however relevant it may be in determining whether the transaction was real or a sham, sales of physical properties by shareholders following a genuine liquidation distribution cannot be attributed to the corporation for tax purposes.”

• In both Court Holding and Cumberland the sole purpose of the liquidation was to reduce tax. Under Coltec, could the Federal Circuit disregard the liquidation in each transaction?

P

S

ThirdParty

Liquidation

Sale of S assets

118

Check-and-Sell Transaction

P

CFC1

CFC2

Bus. 1

Bus. 2

Deemed Liquidation

Bus. 2X

Facts: P owns 100 percent of CFC1, which engages in business 1. CFC1 owns 100 percent of CFC2, which engages in business 2. CFC1 and CFC2 are controlled foreign corporations incorporated in the United Kingdom. On Date 1, P causes CFC1 to check-the-box for CFC2, which results in a deemed section 332 liquidation of CFC2. Immediately thereafter, P causes CFC1 sells all of the assets of business 2 (i.e., CFC2 assets) to X for cash.

Issue: Under the rationale of Dover Corp. v. Commissioner, 122 T.C. 134 (2004), the income generated from the sale does not constitute Subpart F income. However, does this transaction satisfy the step transaction doctrine and/or economic substance requirements in light of Coltec?

119

• If a corporation transfers stock of a subsidiary to a newly formed subsidiary (“Newco”) and sells the stock of Newco to the public to “bust” the section 351 transaction and to be eligible to make the section 338(h)(10) election, does the analysis in Coltec allow the sale to be disregarded?

Busted Section 351 Transaction to Make Section 338(h)(10) Election

P

Z

X Y

N

PUBLIC

(1) Newco formed

(2) X & Y Stock

(3) N stock

120

• A corporation transfers an asset with a built-in loss to its subsidiary in exchange for subsidiary stock. Does S hold the transferred asset with a carryover basis and/or does P obtain the S stock with an exchanged basis?

• What if section 362(e)(2) does not apply? See Shell Petroleum Inc. v. United States, 2008-2 USTC ¶50,422 (S.D. Tex. 2008); Klamath Strategic Investment Fund v. United States, 568 F.3d 537 (5th Cir. 2009).

Section 351 Transaction with Built-in Loss Asset

P

S

Built-in loss assetS stock

121

“C” Reorganization

• What if, as is likely the case, certain steps are undertaken solely to come within the reorganization provisions in section 368? For example, assume that substantially all of a target corporation’s assets are acquired by another corporation solely in exchange for voting stock. If that corporation liquidates following the asset transaction to come within the terms of a “C” reorganization, is the liquidation step subject to risk under Coltec because it occurred solely for tax reasons?

TP Stock

T Assets

P S/H’sT S/H’s

T Assets

P S/H’s

T Assets

PP

T

T S/H’s P S/H’s

T Assets

P

T S/H’s

Liquidates

122

‘D’ Reorganizations – Cash – Rev. Rul. 70-240

P

X

Facts: P, X, and Y are corporations. P owns all of the stock of X and Y. X transfers all of its assets to Y in exchange for cash. X then liquidates into P.

Result: This transaction qualifies as a tax-free ‘D’ reorganization under section 368(a)(1)(D). A transfer by one corporation (X) substantially all of its assets to another corporation (Y) qualifies as a reorganization described in section 368(a)(1)(D) if, immediately after the transfer, one or more of its shareholders (P) is in control of the acquiring corporation (Y), and if stock or securities of the acquiring corporation (Y) are distributed in a transaction which qualifies under section 354, 355, or 356. See Section 354(b)(1).

Does the analysis in Coltec affect this result?

YAssets

Cash

Step One Step Two

P

X Y

Liquidation

123

All-Cash ‘D’ Reorganizations – Consolidation

Facts: P owns all of the stock of X and Y. X owns the stock of T. P, X, Y, and T are members of a consolidated group. T transfers its assets to Y in exchange for cash and immediately thereafter liquidates into X. Result: In the consolidated return context, the following events are deemed to occur: (i) Y is treated as issuing its stock to T in exchange for T’s assets; (ii) T is treated as distributing the Y stock to X in a liquidation; and (iii) Y is treated as redeeming its stock from X for cash. See Treas. Reg. § 1.1502-13(f) and (f)(7), ex. 3. The final D regulations confirm that the remaining basis or ELA in the Y stock treated as redeemed will shift to a “nominal share” issued by Y. See Treas. Reg. § 1.368-2(l). An ELA will give rise to a deferred gain when the nominal share is treated as distributed from X to P in order to reflect actual stock ownership. P may be able to avoid this result by having Y actually issue a single share of stock to T or by contributing a share of Y stock to X. Does the issuance of the one share have business purpose or economic substance?

X

T

(2)(1)

CashX Assets

Liquidation

P

Y

124

All-Cash ‘D’ Reorganizations – Foreign-to-Foreign

Facts: P owns all of the stock of CFC1 and CFC 2. CFC 1 and CFC 2 are foreign corporations. P has a basis in the stock of CFC1 equal to value. CFC 1 transfers its assets to CFC 2 in exchange for cash and immediately thereafter liquidates into P. Result: This transaction should be treated as a valid “D” reorganization. See Treas. Reg. § 1.368-2(l); but see Schering-Plough v. Corp. v. United States, No. 05-2575 (D. N.J. Aug. 28, 2009).

CFC1(1)Cash

CFC1 Assets

P

CFC2

(2)Liquidation

125

Roll-up Transaction

• Assume that a parent corporation converts several LLCs or partnerships into a corporation in a roll-up transaction. Is this transaction subject to review under the Federal Circuit’s analysis in Coltec if the roll-up was done in part to combine income and loss?

P

LLC1

LLC2

LLC3

Newco

Ownership interests in LLC1, LLC, and LLC3

A

B

C

126

Section 304 Cross-Border Transaction

Facts: P, a domestic corporation, owns all of the stock of F1 and F2, both of which are foreign corporations. F2 has excess foreign tax credits. P sells F1 stock to F2 in exchange for cash in a transaction the sole purpose of which is to pull foreign tax credits out of F2. Result: Section 304 applies to the transaction so that earnings are repatriated and foreign tax credits are pulled out of F2. However, does this transaction satisfy the economic substance and/or business purpose requirements in light of Coltec?

P

F1 F2

F1stock

cash

127

Debt Workout Issues with Tax Partnerships

128

Subtopics• Why important• General partnership principles

– Section 752 liability sharing rules• Generally applicable debt-related rules in partnership context

– COD and sale gain/loss• Liability characterization• Guarantees and releases

– Deemed exchange of debt instruments• Allocating inside debt-related income and outside basis effects• Outside gain from debt shifts• General planning tips• Exclusion of COD

– Various exceptions• As applied to various flow-through entities

– Attribute reduction– Other issues

• Purchase price adjustments• Related party acquisitions of debt

• Deferral of COD• Entrance of new partner to relieve debt stress• Reality: Should apply all of these rules (and more) in debt-workout planning

129

Why Important

• Tax partnership has been the entity of choice for some time– Tax partnerships used to raise non-public capital via equity and

debt offerings– A select number of tax partnerships are also used to raise public

capital – PTPs• Typical tax partnership deals use large amounts of

leverage• Economic downturn

– Value of assets (i.e., collateral/security) falling significantly• Credit crunch

– Sources for raising debt proceeds more limited– Even if find lender, cost of debt proceeds has increased

130

General Partnership Principles

• A partner owns an interest in a partnership– That partner’s interest generally split up into two

component parts• Interest in capital -- right to distribution of assets upon

liquidation• Interest in profits – mere right to participate in future earnings

of partnership

• A partner can acquire an interest in a partnership via– Contribution of assets to partnership– Provision of services to or, on behalf of, partnership– Acquisition from other partner (e.g., purchase)

131

General Partnership Principles

• Partner’s adjusted tax basis in its interest in partnership = “outside basis”– Outside basis adjusted generally to reduce

double inclusion of income and deductions

132

General Partnership Principles

• General Outside Basis Adjustment Rules• Increase by

– Distributive share of income (taxable and tax-exempt)– Tax basis of contributed property

• Decrease by– Distributive share of loss (deductible and non-deductible)– Cash– Tax basis of distributed property (generally)

• Cannot have negative “outside basis”– Instead, loss suspension, gain recognition, or

gain deferral (step-down of basis)

133

LLC

X

General Partnership Principles

PropertyV - $200MB - $100M

•Contribution of asset to partnership–Generally tax-free–Partner’s tax basis in contributed asset carries over to partnership’s tax basis in the asset

•Partnership’s adjusted tax basis in asset = “inside basis”–Partner’s outside basis increased by partner’s basis in asset

YOutside Basis$100M

Inside Basis$100M

134

LLC

X

General Partnership Principles

PropertyV - $200MB - $100M

•Distribution of asset from partnership–Generally tax-free–Partnership’s inside basis generally carries over to partner’s basis in asset (unless outside basis too low)–Partner’s outside basis reduced by inside basis of asset (to extent not below zero)

YOutside Basis$100M

($100M)$0

Inside Basis$0

135

LLC

X

General Partnership Principles

PropertyV - $200MB - $100M

•Distribution of asset from partnership–Generally tax-free–Exception: Cash distribution reduces outside basis first, and triggers gain recognition to the extent that cash would drive outside basis negative (i.e., cash in excess of outside basis)

YOutside Basis$100M

($200M)$100M Gain

Inside Basis$100M

$200M Cash

136

• O/B adjustments for distributive shares of income and loss generally done only at end of year

• O/B adjustment for distributions done at time of distribution• So, do partners have to wait until following year for tax-free

distributions?

Jan.1 July 1Dec. 31

O/B=$100 O/B=$100 O/B=$600

$500P/S Income

$500Distribution

$400Gain Recognition

$100P/S Income

General Partnership PrinciplesTiming of Allocations and Distributions

137

• “Advance” regulatory rule to alleviate timing problems– Distribution treated as advance against future profits at time of actual

distribution– Distribution later treated as actual distribution at end of partnership tax

year (after O/B increased for income but not loss)

Jan.1 July 1Dec. 31

O/B=$100 O/B=$100 O/B=$100Plus $600Less $500O/B=$200

$500P/S Income

$500Distribution

$0Gain Recognition

$100P/S Income

General Partnership PrinciplesTiming of Allocations and Distributions

138

General Partnership Principles

• Each partner has a capital account– Partnership-level account– generally tracks economic investment of partner in the

partnership– Partner has only one capital account even if owns more than one

type of interest in partnership

• Capital account adjusted in similar manner as outside basis– Significant differences from outside basis adjustments:

• Partnership liabilities not included (address later)• Can have negative balance

139

• Increase of partner’s “share” of partnership (entity-level) liability treated as deemed contribution of cash to partnership– Increases outside basis

• Decrease of partner’s “share” of partnership liability treated as deemed distribution of cash from partnership– Decreases outside basis– Important: can cause gain recognition under

section 731 for distribution of cash in excess of outside basis

Section 752 Liability Sharing Rules

140

Section 752 Liability Sharing Rules

• Why important?– Unlike S and C corporations, partner can increase its outside basis for its “share” of partnership (entity-level)

liabilities• Can increase ability to receive tax-free distributions and deductible losses

– Generally, not reflected in capital accounts• Causes capital accounts to diverge from outside basis• Rough rule of thumb: outside basis = capital account + share of partnership liabilities

LLC

X PropertyV - $200MB - $100M

YOutside Basis$100M$300M$400M

Inside Basis$100M

X Cap. Acct.$200M

LENDER

Loan$300M

141

Section 752 Liability Sharing Rules

X PropertyV - $200MB - $100M

YOutside Basis$100M$0M

$100M

Inside Basis$100M

LENDER

Loan$300M S Corp

• Why important?– Unlike S and C corporations, partner can increase its outside basis for its “share” of partnership (entity-level)

liabilities• Can increase ability to receive tax-free distributions and deductible losses

– Generally, not reflected in capital accounts• Causes capital accounts to diverge from outside basis• Rough rule of thumb: outside basis = capital account + share of partnership liabilities

– However, debt of S corporations from shareholder loans effectively increases shareholder outside basis (but not for loans from non-shareholders)

142

Section 752 Liability Sharing Rules

X PropertyV - $200MB - $100M

YOutside Basis$100M$0M

$100M

Inside Basis$100M

LENDER

Loan$300M C Corp

• Why important?– Unlike S and C corporations, partner can increase its outside basis for its “share” of partnership (entity-level)

liabilities• Can increase ability to receive tax-free distributions and deductible losses

– Generally, not reflected in capital accounts• Causes capital accounts to diverge from outside basis• Rough rule of thumb: outside basis = capital account + share of partnership liabilities

143

• Section 752 Liability Sharing Rules– Key: How determine partner’s “share” of partnership

(entity-level) liabilities?– Three general steps:

• First: Determine whether obligation rises to the level of a partnership liability

– Most obligations now constitute partnership liabilities

• Second: Economic risk of loss analysis– To extent partner’s share of partnership liability is determined

under this analysis, such portion of the liability is classified as “recourse”

• Third: Non-recourse liability sharing rules– To extent partner’s share of partnership liability is not

determined under economic risk of loss analysis, remaining portion of partnership liability is classified as “non-recourse”

Section 752 Liability Sharing Rules

144

• Section 752 Liability Sharing Rules– Second Step: Economic risk of loss analysis

• Focus: Whose assets, if any, are subject to an “economic risk of loss” under following scenario generally

– Partnership’s assets are worthless– All partnership liabilities are due– Partnership sells all assets for zero consideration (except for relief of

non-recourse debt) and then liquidates– Take all state-law and contract rights of partners and related parties

into account (whether or not memorialized in partnership agreement)» Guarantee» Indemnification agreement» Reimbursement agreement» Contribution agreement» General state partnership law

– So, generally, focus is on who OTHER THAN THE PARTNERSHIP could be liable for partnership liabilities

Section 752 Liability Sharing Rules

145

• Third Step: Non-recourse liability sharing rules– Apply to extent of portion of liability that no partner or

related person bears the economic risk of loss

– Underlying policy: since lender of non-recourse liability can seek payment only from specific assets, such liability should be shared among partners in way that income from such assets is allocated to partners

• It is the cash flow from such income that presumably would have been used to repay such liability

Section 752 Liability Sharing Rules

146

• Third Step: Non-recourse liability sharing rules– Partner’s share of partnership minimum gain

• Liability over book basis of property subject to liability = partnership minimum gain

– Partner’s share of section 704(c) minimum gain• Section 704(c) gain/”reverse section 704(c)” gain would recognize if

disposed of all property subject to liability in full satisfaction of such liability

– Partner’s interest in profits generally• Can state in partnership agreement as long as reasonably

consistent with other significant items of income or gain• Can tie to how deductions related to such liability will be shared

(e.g., loan proceeds used to acquire depreciable property)• Can first soak up remaining section 704(c) gain/”reverse section

704(c)” gain in asset subject to such liability

Section 752 Liability Sharing Rules

147

Section 752 Liability Sharing Rules

LimitedPartnership

X YOutside Basis$100M$300M$400M

LENDERState-law

Recourse Loan$300M

GP LP

Outside Basis$100M$0M

$100M

148

Section 752 Liability Sharing Rules

LimitedPartnership

X YOutside Basis$100M$300M$400M

LENDERState-law

Recourse Loan$300M

GP LP

Outside Basis$100M$0M

$100MGuarantee

149

Section 752 Liability Sharing Rules

LimitedPartnership

X YOutside Basis$100M$150M$250M

LENDERState-law

non-recourse loan$300M

GP LP

Outside Basis$100M$150M$250M

50% 50%

150

Section 752 Liability Sharing Rules

LLC

X YOutside Basis$100M$150M$250M

LENDERState-law

recourse loan$300M

Outside Basis$100M$150M$250M50% 50%

151

Section 752 Liability Sharing Rules

LLC

X YOutside Basis$100M$0M

$100M

LENDERState-law

recourse loan$300M

Outside Basis$100M$300M$400M

Guarantee

• Alternatives:– What if Y’s net worth is zero?– What if Y’s net worth is $30M?– What if Y received no consideration for the provision of the guarantee?

152

Section 752 Liability Sharing Rules

LLC

X YOutside Basis$100M$100M$200M

LENDERState-law

recourse loan$300M

Outside Basis$100M$200M$300M

$100M “Bottom-Dollar” Guarantee

• Y guarantees the repayment of the last $100M outstanding– If LLC can pay at least $100M of the loan, Y no longer has

secondary responsibility to pay

50% 50%

Inside Asset Value$500M

153

Section 752 Liability Sharing Rules

LimitedPartnership

X YOutside Basis$0M

$(300)M$300M Gain

LENDERState-law

recourse loan$300M

FORGIVEN

GP LP

Outside Basis$100M$0M

$100M

DepreciableProperty

$300MDeemed

Cash Distrib.

154

Section 752 Liability Sharing Rules

LLC

X YOutside Basis$100M$150M$250M

LENDERState-law

recourse loan$300M

Outside Basis$100M$150M$250M50% 50%

DepreciableProperty –

All Deductions to X

Year 1

155

Section 752 Liability Sharing Rules

LLC

X YOutside Basis$100M

$(150)M$50M Gain

LENDERState-law

recourse loan$300M

Outside Basis$100M$150M$150M$400MGuarantee

• Lender gets nervous; demands guarantee• Y’s guarantee converts $300M liability from non-recourse to recourse for section 752 purposes

Year 2

DepreciableProperty –

All Deductions to X

$150MDeemed

Cash Distrib.$150MDeemed

Cash Contrib.

156

Section 752 Liability Sharing Rules

LLC

X YOutside Basis$100M$300M$400M

LENDERState-law

recourse loan$300M

Outside Basis$100M$0M

$100M

Gua

rant

ee

Year 1

DepreciableProperty –

All Deductions to X

157

Gua

rant

ee

Section 752 Liability Sharing Rules

LLC

X YOutside Basis$50M

$(100M)$50M Gain

LENDERState-law

recourse loanrepaid

by $100M

Year 5

Z

$100M

$100MDepreciableProperty –

All Deductions to X

158

Section 752 Liability Sharing Rules

LLC

X YOutside Basis$100M$150M$250M

LENDERState-law

recourse loan$300M

Outside Basis$100M$150M$250M50% 50%

Year 1

DepreciableProperty –

All Deductions to X

159

Section 752 Liability Sharing Rules

LLC

X YOutside Basis$0M

$(30M)$30M Gain

LENDERState-law

recourse loan$300M

Year 5

Z

$60MDeemed

Cash Contrib.

40% 40% 20%

$30MDeemed

Cash Distrib.

DepreciableProperty –

All Deductions to X

160

Section 752 Liability Sharing Rules

LLC

X YOutside Basis$0M$(?)

Gain?

LENDERState-law

recourse loan$300M

Year 5

Z

40% 40% 20%

Gua

rant

ee

• Alternatives:– What if X guarantees $30M of loan?– What if X guarantees entire amount of loan?

DepreciableProperty –

All Deductions to X

161

Generally Applicable Debt-Related Rules in Partnership Context

• Cancellation of indebtedness income (“COD”)– A debtor recognizes COD income upon the satisfaction of

a debt instrument for an amount less than its issue price.• For publicly traded debt, the issue price is its trading price. • For non-publicly traded debt, the issue price is equal to its stated principal

amount if the instrument provides for interest that equals or exceeds the applicable federal rate.

– Exclusion of COD/attribute reduction– Deferral of COD– Deemed exchange of debt instruments

• Gain/Loss recognition– Deemed sale of assets/security– Deemed exchange of debt instruments

• OID/market discount/market premium

162

Sections 61 & 1001 Liability Rules

LLC

X Y

LENDER

$300M recourse loan

50% 50%

•Lender agrees to discharge debtor-partnership from responsibility for recourse liability in exchange for transfer of property–Debtor-partnership treated as selling property for FMV – Treas. Reg. 1.1001-2(c), ex. 8

•Gain/loss recognized–Debtor-partnership treated as having COD to extent debt cancelled exceeds FMV of transferred property – section 61(a)(12)–Makes sense:

•Transfer of property is payment of debt•But, obligation to repay not extinguished if FMV of property less than debt, because debt is recourse•If creditor decides to relieve excess debt, that is COD

PropertyV=$200MB=$100M

Debt Relief

Property

Any income recognized by LLC?If so, what type of income?

163

Sections 61 & 1001 Liability Rules

LLC

X Y

LENDER

$300M recourse loan

50% 50%

•Lender agrees to discharge debtor-partnership from responsibility for recourse liability without transfer of property–Debtor-partnership treated as having COD to extent debt cancelled – section 61(a)(12); 1.1001-2(c) ex. 8; Rev. Rul. 90-16–No sale gain/loss recognition – no property transferred–Makes sense - only action that occurs is the relief of obligation to repay

Debt Relief

Any income recognized by LLC?If so, what type of income?

164

Sections 61 & 1001 Liability Rules

LLC

X Y

LENDER

$300M non-recourse loan

50% 50%

Property SecurityV=$200MB=$100M

Debt Relief

Property Security

Any income recognized by LLC?If so, what type of income?

•Lender agrees to discharge debtor-partnership from responsibility for non-recourse liability in exchange for transfer of property securing such liability (foreclosure)

–Debtor-partnership treated as selling property for amount of debt forgiven – 1.1001-2(c), ex. 7•Gain/loss recognized

–No COD income •Debtor cannot be held liable for any deficiency judgment – non-recourse debt•So, no debt can be forgiven by the lender after the transfer of the security back to the lender

165

Sections 61 & 1001 Liability Rules

LLC

X Y

LENDER

$300M non-recourse loan

50% 50%

Property SecurityV=$200MB=$100M

Debt Relief

Any income recognized by LLC?If so, what type of income?

•Lender agrees to discharge debtor-partnership from responsibility for non-recourse liability without transfer of any property

–COD equal to amount of debt discharged – Section 61(a)(12); Rev. Rul. 91-31

166

• Key Issue: how determine if liability of partnership is recourse or non-recourse in this context?

– Does not appear that the general section 752 liability sharing rules apply

• Generally, these rules focus on whose assets could be subject to payment obligation if the partnership lost all value in its assets and it liquidated – an aggregate approach to partnerships

• Focus on state law and other creditor’s rights as if partnership was worthless and liquidated

Sections 61 & 1001 Liability Rules

167

• Key Issue: how determine if liability of partnership is recourse or non-recourse in this context?

– Appears that determination based on treating partnership as an entity separate from its partners

• Focus on state law and other creditor’s rights while also continuing to respect the existence of the partnership and the value of its assets – an entity approach to partnerships

Sections 61 & 1001 Liability Rules

168

• Treating partnership as an entity separate from its partners– Non-recourse liability = loan documents/state law limit lender’s

rights to specified collateral• Cannot pursue other assets of borrower • But what if borrow is an entity and an owner guarantees a portion of

borrower-entity’s liability – still, non-recourse?– Recourse liability = loan documents/state law do not limit

lender’s rights to specified collateral• Can pursue all assets of borrower

– But what if borrower is entity and only assets entity owns are assets acquired with creditor’s loan proceeds – still, recourse?

• State law may protect borrower’s assets (homestead exemption)• If borrower is an entity, state law may protect owners’ assets from

borrower’s creditor (e.g., LLC)

Sections 61 & 1001 Liability Rules

169

LLC

X YOutside Basis$100M$150M$250M

LENDERState-law

recourse loan$300M

Outside Basis$100M$150M$250M50% 50%

Liability Characterization

Sections 61/1001 Purposes: RecourseSection 752 Purposes: Non-recourse

170

LLC

X YOutside Basis$100M$300M$400M

LENDERState-law

recourse loan$300M

Outside Basis$100M$0M

$100M

Gua

rant

ee

Liability Characterization

Sections 61/1001 Purposes: RecourseSection 752 Purposes: Recourse to X

171

LLC

X YOutside Basis$100M$150M$250M

LENDERState-law

non-recourse loan$300M

Outside Basis$100M$150M$250M50% 50%

Liability Characterization

Sections 61/1001 Purposes: Non-recourseSection 752 Purposes: Non-recourse

172

LLC

X YOutside Basis$100M$300M$400M

LENDERState-law

non-recourse loan$300M

Outside Basis$100M$0M

$100M

Gua

rant

ee

Liability Characterization

Sections 61/1001 Purposes: Non-recourseSection 752 Purposes: Recourse to X

173

$300M state-law non-recourse loan

LLC

X YOutside Basis$100M$150M$250M

LENDER

Outside Basis$100M$150M$250M50% 50%

Bifurcated Liability Treatment

Sections 61/1001 Purposes: Recourse in part, Non-recourse in part

Section 752 Purposes: Non-recourse

•Liability may be, in part, recourse and, in part, non-recourse for state law purposes–Portion of otherwise state-law non-recourse liability guaranteed by debtor LLC

$200M guarantee

Year 1

Property SecurityFMV=$300M

174

$300M state-law non-recourse loan

LLC

X YOutside Basis$100M$150M$250M

LENDER

Outside Basis$100M$150M$250M50% 50%

Sections 61/1001 Purposes: Recourse in part, Non-recourse in part

Section 752 Purposes: Non-recourse

Property SecurityFMV=$150M (down

from $300M) AB=$10M

•If state-law part-recourse/part-non-recourse liability is settled (e.g., in foreclosure), do the section 61/1001 recourse or non-recourse rules take precedence or should a pro rata rule apply (i.e., what portions, if any, of property security should be treated as being transferred in connection with the discharge of the state-law recourse and non-recourse portions of the debtor LLC’s liability)? Does it matter?

$200M guarantee

Year 5

Bifurcated Liability Treatment

175

•If sections 61/1001 recourse rules take precedence (property security applied to recourse portion first), then results:$140 Gain and $50 COD = $190 total income

•If sections 61/1001 non-recourse rules take precedence (property security applied to non-recourse portion first), then results: $93.3 + $46.7=$140 Gain, and $150 COD = $290 total income

•If pro rata approach taken (2/3 recourse liability, so 2/3 of property security applied to recourse portion), then results: $93.3 + 96.7=$190 Gain + $100 COD = $290 total income

Year 5

Bifurcated Liability Treatment

$300M state-law non-recourse loan

LLC

X YOutside Basis$100M$150M$250M

LENDER

Outside Basis$100M$150M$250M50% 50%

Sections 61/1001 Purposes: Recourse in part, Non-recourse in

part

Section 752 Purposes: Non-recourse

$200M guarantee

Property SecurityFMV=$150M (down from

$300M) AB=$10M

176

•Some authority suggests that partial payments should apply to the non-recourse portion of liability first, which maximizes COD income generally

•Why? Debtor LLC should not be able to impair the lender’s rights to repayment by applying payments to recourse portion of liability first so that creditor is limited only to remaining (if any) collateral to discharge non-recourse portion (tax treatment should follow state creditor’s laws)

•If sections 61/1001 non-recourse rules take precedence (property security applied to non-recourse portion first), then results: $93.3 + $46.7=$140 Gain, and $150 COD = $290 total income

Year 5

Bifurcated Liability Treatment

$300M state-law non-recourse loan

LLC

X YOutside Basis$100M$150M$250M

LENDER

Outside Basis$100M$150M$250M50% 50%

Sections 61/1001 Purposes: Recourse in part, Non-recourse in part

Section 752 Purposes: Non-recourse

$200M guarantee

Property SecurityFMV=$150M (down

from $300M) AB=$10M

177

• However, what if the guarantee is a “bottom dollar” guarantee (i.e., debtor LLC agrees to pay only if property security value falls below $200)? State-law recourse portion will be eliminated upon the first payments on debt. So, could argue that property security should be applied to recourse portion first.•If sections 61/1001 recourse rules take precedence (property security applied to recourse portion first), then results:

$140 Gain and $50 COD = $190 total income

Bifurcated Liability Treatment

$300M state-law non-recourse loan

LLC

X YOutside Basis

$100M$150M$250M

LENDER

Outside Basis$100M$150M$250M50% 50%

Sections 61/1001 Purposes: Recourse in part, Non-recourse in

part

Section 752 Purposes: Non-recourse

$200M “bottom dollar” guarantee

Year 5

Property Security

FMV=$150M (down from

$300M) AB=$10M

178

LLC

X Y

LENDER

State-law non-recourse loan

$300M

Gua

rant

ee

Releases

Sections 61/1001 Purposes: Non-recourse

Section 752 Purposes: Recourse to X

Does a partner recognize income or gain under sections 61/1001 upon being released from a guarantee of a partnership liability?Does a partner recognize income or gain by reason of section 752 upon being released from a guarantee of a partnership liability? What are profit-sharing ratios? Anyone else on the hook? What is outside basis before release?

179

LLC

X Y

LENDER

State-law non-recourse loan

$300M

Gua

rant

ee

Releases

Sections 61/1001 Purposes: Non-recourse

Section 752 Purposes: Recourse to X

What if partner X has become primarily liable for the liability by reason of its guarantee?Is any resulting sections 61/1001 gain initially recognized at the partnership or partner level?Should gain result by reason of section 752 in this instance? Netting of deemed distributions (elimination of partnership liability) and deemed contributions (assumption of primary obligation to repay on liability)

180

Generally Applicable Debt-Related Rules in Partnership Context

• Deemed Exchanges of Debt Instruments– Certain modifications to the terms of a debt instrument held by a

partnership also can, by itself, trigger income or gain/loss – Deemed exchange of old debt instrument for new debt

instrument• Creditor perspective – gain/loss• Debtor perspective – COD• Other effects – OID/market discount/market premium

– Treas. Reg. 1.1001-3; Cottage Savings

181

After Determination of Partnership-Level, Debt-Discharge Issues

• After determining how much sale gain/loss and/or COD exists, two more steps…– Step 1: Allocate such items to partners

• Usually, partnership constrained on how can allocate such items under several rules

– Partnership minimum gain chargeback» Only for non-recourse liabilities for 1001 purposes

– Partner minimum gain chargeback» Only for non-recourse liabilities owed to

partner/related person for 1001 purposes– Section 704(c) gain/”reverse section 704(c) gain”– Substantial economic effect rules

– Step 2: Adjust “outside basis” for such items

182

LLC

X YOutside Basis$0M

$300M$300M

LENDERState-law

recourse loan$300M

-- Forgiven

Outside Basis$0M$0M$0M

Gua

rant

ee

Additional Gain Recognition Under Section 752?

Sections 61/1001 Purposes: Recourse

Section 752 Purposes: Recourse to X

–Foreclosure creates $300M COD and $300M of debt relief for section 752 purposes–Could X recognize additional gain by reason of section 752?

183

LLC

X YOutside Basis$0M

$300M$(300M)

$0M

LENDER$300M state-law

recourse loanForgiven - $300M COD

Outside Basis$0M$0M

$(0M)$0M

Sections 61/1001 Purposes: Recourse

Section 752 Purposes: Recourse to X

–If gain/COD allocated among partners same manner as how partners share discharged partnership liability, then likely no additional gain recognized by partners by reason of section 752

100%COD

0%COD

$300MDeemed CashDistribution

Additional Gain Recognition Under Section 752?

184

LLC

X YOutside Basis$0M

$150M$(300M)

$150M Gain

LENDER$300M state-law

recourse loanForgiven - $300M COD

Outside Basis$0M

$150M$(0M)$150M

Sections 61/1001 Purposes: Recourse

Section 752 Purposes: Recourse to X

–If gain/COD allocated among partners differently than how partners share discharged partnership liability, then likely additional gain recognized by partners by reason of section 752

50%COD

50%COD

$300MDeemed CashDistribution

Additional Gain Recognition Under Section 752?

185

$300MDeemed CashDistribution

LLC

X YOutside Basis$0M

$300M$(300M)

$0M

LENDER$300M state-law

recourse loanForgiven - $300M COD

Outside Basis$0M$0M

$(0M)$0M

Sections 61/1001 Purposes: Recourse

Section 752 Purposes: Recourse to X

100%COD

0%COD

• Gain Recognition Risk Regarding Timing: – distributive share of such items will not adjust outside basis until end of partnership year generally– related section 752 deemed distribution of cash occurs immediately generally– Big Exception: “Advance” regulatory rule helps avoid gain recognition trap from related section 752 deemed

distribution of cash in excess of outside basis (which has been unadjusted for related debt-discharge, partnership-level income)

Outside Basis$0M

$(300M)$300M Gain

$300M$300M

OR

Additional Gain Recognition Under Section 752?

186

LLC

X Y

LENDER$300M Loan

Additional Planning TipsMaximize Sale Gain/Reduce COD

PropertyFMV = $200M

AB = $100M

• COD is ordinary income, and sale gain could be capital– So, use of non-recourse debt can be more advantageous if want capital gain treatment upon discharge– E.g., partner may typically have unused capital losses (cannot use to absorb COD)

• If $300M loan is recourse for sections 61/1001 purposes, then upon discharge: $100M Gain and $100M COD• If $300M loan is non-recourse for sections 61/1001 purposes, then upon discharge: $200M Gain

187

LLC

X Y

LENDER

$300M state-law non-recourse loan

Additional Planning TipsMaximize COD/Reduce Gain

Property SecurityFMV = $50M

AB = $0M

• COD can be excluded (with or, sometimes, without attribute reductions) or deferred; but, what if non-recourse liability?• Negotiate reduction of non-recourse liability prior to foreclosure of property to generate COD income first and, possibly,

reduce the amount of subsequent gain if remaining liability less than FMV of secured property• If $300M loan is non-recourse for sections 61/1001 purposes, then upon discharge: $300M Gain (no COD)• If negotiate non-recourse loan down to $100M before foreclosure, then: $200M COD first and then $100M Gain

Year 5: Negotiate Partial Forgiveness

Year 8: Foreclosure

188

LLC

X Y

LENDER

$300M state-law non-recourse loan

Additional Planning TipsMaximize COD/Reduce Gain

Property SecurityFMV = $100M

AB = $0M

• COD can be excluded (with or, sometimes, without attribute reductions) or deferred; but, what if non-recourse liability?• If non-recourse liability for sections 61/1001 purposes, sell secured property to third party prior to foreclosure and use

sale proceeds to repay liability partially – remaining debt discharge creates COD• If $300M loan is non-recourse for sections 61/1001 purposes, then upon discharge: $300M Gain (no COD)• If sell security to third party and repay lender with cash proceeds, then: $100M Gain and $200M COD

1. Sell property security to third party for cash2. Use cash to repay loanas much as possible

3P

$100M

189

LLC

X Y

LENDER

$300M state-law non-recourse loan

Additional Planning TipsReduce Gain

Property SecurityFMV = $280M

AB = $0M

• If liability is non-recourse for sections 61/1001 purposes, foreclosure of secured property generates sale gain• Consider using other unsecured property with no built-in gain to repay liability• If $300M loan is non-recourse for sections 61/1001 purposes, then upon foreclosure: $300M Gain / LLC loses

$280M of value – really, economic loss overall of $280M+tax on $300M ($45M)=$325M• If $300M loan is non-recourse for sections 61/1001 purposes and $300M of unsecured property (with no BIG)

used to satisfy liability, then: $0 Gain and $0 COD / LLC economically loses only $300M of value

Unsecured PropertyFMV = $300M

AB = $300Mand

190

LLC

X Y

LENDER$300M Loan

Additional Planning TipsLosses

PropertyFMV = $200M

AB = $400M

• Foreclosure of secured property that has a built-in loss in state-law recourse or nonrecourse context can generate loss upon foreclosure

• If $300M loan is non-recourse for sections 61/1001 purposes, then upon discharge: $100M Loss and $0 COD• If $300M loan is recourse for sections 61/1001 purposes, then upon discharge: $200M Loss and $100M COD• Both scenarios generate a net $100M of loss, but character counts!

191

COD Exclusion RulesGeneral Rules

– To give debtor-taxpayer a “fresh start,” certain types of COD excluded from gross income

• Discharge of indebtedness of taxpayer occurs in a Title 11 case

• Discharge of indebtedness of taxpayer occurs when taxpayer is insolvent

• Indebtedness discharged is qualified farm indebtedness• Indebtedness discharged is qualified real property business

indebtedness• Indebtedness discharged is qualified principal residence

indebtedness discharged < January 1, 2013

192

COD Exclusion RulesGeneral Rules

– If partnership liability is discharged when the partnership is insolvent, can the partners exclude the resulting COD?

– If the partnership liability is discharged in Title 11 case, can the partners exclude the resulting COD?

193

– The COD exclusion rules generally are applied to partnership-level indebtedness at the partner level

COD Exclusion RulesGeneral Rules

194

– Certain types of COD excluded from gross income

• Discharge of indebtedness of taxpayer occurs in a Title 11 case

– Title 11 case = case under Title 11 of U.S. Code, but only if taxpayer is under jurisdiction of the court and discharge granted by court or pursuant to plan approved by court

COD Exclusion RulesBankruptcy

195

XCorp.

X and Y form XY LLC by contributing cash of $5M and XY LLC borrows $8M more. The business washes out, with XY LLC losing everything. XY LLC files for bankruptcy, triggering $8M of COD. How does section 108 apply? See section 108(d)(6).

YCorp.

XYLLC

COD Exclusion RulesBankruptcy of LLC

196

XCorp.

X and Y form XY LLC, make an S election, and contribute cash of $5M. XY LLC borrows $8M more. The business washes out, with XY LLC losing everything. XY LLC files for bankruptcy, triggering $8M of COD. How does section 108 apply? See section 108(d)(7).

YCorp.

XYLLC

COD Exclusion RulesBankruptcy of S Corporation

197

X and Y form XY LLC by X contributing cash of $5M and XY LLC borrowing $8M more. All profits and losses are allocated to and all distributions are made to X. Y is a member solely to prevent X from filing for bankruptcy regarding XY LLC on its own volition. Nonetheless, the business washes out, with XY LLC losing everything. After Y approves, XY LLC files for bankruptcy, triggering $8M of COD.

Is XY LLC a tax partnership?Does section 108(a)(1)(A) apply? See sections 108(d)(2), 7701(a)(1), (14).If section 108(a)(1)(A) applies, what tax attributes are reduced? See section 108(b)(1), (2).

COD Exclusion RulesBankruptcy of Disregarded Entity

XCorp.

YCorp.

XYLLC

198

– Certain types of COD excluded from gross income

• Discharge of indebtedness of taxpayer occurs when taxpayer is insolvent

– Insolvent = excess of liabilities over FMV of assets» Tested immediately before discharge

– Limit: amount excluded cannot exceed amount of insolvency

COD Exclusion RulesInsolvency

199

X and Y form XY LLC by contributing cash of $5M and XY LLC borrows $8M more. The business washes out. The lender forecloses on XY LLC’s assets triggering $8M COD. Prior to discharge, XY LLC’s liabilities exceed FMV of its assets by $5M. How does section 108 apply? See section 108(d)(6).What if FMV of X’s assets exceeds its liabilities, and Y’s liabilities exceed its FMV of its assets by $3M?

COD Exclusion RulesInsolvency of Tax Partnership

XCorp.

YCorp.

XYLLC

200

X and Y form XY LLC by contributing cash of $5M and make an S election for XY LLC. XY LLC borrows $8M more. The business washes out. The lender forecloses on XY LLC’s assets triggering $8M COD. Prior to discharge, XY LLC’s liabilities exceed FMV of its assets by $5M, and X and Y’s assets exceed their liabilities. How does section 108 apply? See section 108(d)(7).What if FMV of XY LLC’s assets exceed its liabilities at foreclosure, but X and Y’s liabilities exceed their assets at foreclosure –allocated COD is still COD in hands of X and Y?

COD Exclusion RulesInsolvency of S Corporation

XCorp.

YCorp.

XYLLC

201

X and Y form XY LLC by X contributing cash of $5M and XY LLC borrowing $8M more. All profits and losses are allocated to and all distributions are made to X. Y is a member solely to prevent X from declaring bankruptcy regarding XY LLC on its own volition. The business washes out, with XY LLC losing everything. The lender forecloses on XY LLC’s assets triggering $8M COD. Prior to discharge, XY LLC’s liabilities exceed its assets by $5M. Each of X and Y’s assets exceed their liabilities. Does section 108(a)(1)(B) apply? See sections 108(d)(2), 7701(a)(1), (14).If section 108(a)(1)(B) applies, what tax attributes are reduced? See section 108(b)(1), (2).

COD Exclusion RulesInsolvency of Disregarded Entity

XCorp.

YCorp.

XYLLC

202

– Planning Tip:• Discharge of indebtedness of taxpayer occurs

when taxpayer is insolvent, but only to the extent of such insolvency

• So, want to maximize insolvency to maximize exclusion

• What are the pressure points?

COD Exclusion RulesInsolvency

203

X and Y form XY LLC by contributing cash of $5M and XY LLC borrows $8M more. The business washes out. The lender forecloses on XY LLC’s assets triggering $8M COD. Prior to discharge, X had assets with FMV of $4M and liabilities of $6M. Can X exclude any portion of his distributive share of COD from XY LLC?

COD Exclusion RulesInsolvency

YCorp.

XYLLC

X IndividualInvestor

“Insolvency” of $2M

Assets - $4MHome - $1M401(k) - $0.5MProp. Z - $1.5M(Other P/S Int. – C/A - $1M)

Liabilities - $6MState-law, non-recourse loansecured by Prop. Z – $5MVery contingent liab. - $1M face

204

– Pressure Points:• Assets exempt from claims of creditors under state law are

still included for this purpose - homestead• What about contingent liabilities – all or nothing approach

based on 50% chance will have to pay (Merkel, 9th Circuit 1999) v. discount liability by probability of being called to pay (Merkel dissent)

• What about the amount of a state-law non-recourse liability that exceeds FMV of secured property – only include to extent such liability discharged (R-R 92-53)

• What about partnership interests as asset or liability?– Outside basis reflects partner’s share of partnership liabilities– Net value of partnership interest included as asset?– Partnership interest is asset to extent of positive capital account

after sale of all assets for FMV?– Partnership interest is liability to extent of negative capital

account after sale of all assets for FMV (to extent liable for negative capital account)?

COD Exclusion RulesInsolvency

205

– Often, since Title 11 and insolvency rules applied at partner level and partnership (but not partner) is bankrupt or insolvent, partner’s only option to exclude COD is via the exception for discharged qualified real property business indebtedness (“QRPBI”)

– QRPBI = indebtedness that• Was incurred/assumed by the taxpayer in connection with

real property used in a trade or business and is secured by such real property,

• Was incurred or assumed < 1/1/93 or was incurred/assumed after such date to acquire, construct, substantially improve such property, and

• Taxpayer makes election with respect to such debt

COD Exclusion RulesQualified Real Property Business Debt

206

• Two limits on COD exclusion for QRPBI– First Limit – no exclusion to extent discharge creates

equity in qualified real property• Excess of

– outstanding principal before discharge over – (net FMV of qualified real property securing such indebtedness-

all other QRPBI secured by such property)

– Second Limit – overall basis limitation• Excess of

– Aggregate adjusted basis of all depreciable real property that was held by taxpayer immediately before relevant discharge (but after general tax attribute reductions) over

– Depreciation claimed for year of discharge on such property

COD Exclusion RulesQualified Real Property Business Debt

207

X and Y form XY LLC by contributing cash of $5M and XY LLC borrows $11M more to construct an office complex. Due to downturn in local economy and real estate market overall, XY LLC and the lender agree to reduce to debt to $3M, which triggers $8M COD. Neither XY LLC, X, nor Y file for bankruptcy, and X and Y are solvent due to assets unrelated to their investments in XY LLC. Is there any way X and Y can exclude their distributive shares of COD from XY LLC?What if X and Y were not C corporations? At what level is the classification of debt as QRPBI made?What if net value of office complex of $3M? At what level is the equity limitation applied?What if X and Y each have $1M basis in their depreciable real property? At what level is the overall basis limit applied?

COD Exclusion RulesQualified Real Property Business Debt

XCorp.

YCorp.

XYLLC

$11M state-law, non-recourse loanUsed to construct office complexOffice complex serves as security

50% 50%

208

COD Exclusion RulesAttribute Reduction Rules

• COD exclusion rules do not provide as “fresh of a start” as possible

• Cost of COD exclusion = attribute reduction

• Attribute reduction occurs at beginning of tax year after tax year of discharge – helps preserve “fresh start”

209

• In partnership context, it is the partner’s attributes that are reduced generally

• General ordering rule for attribute reduction– NOL– General business credits– Minimum tax credits– Net capital losses– Basis reduction of all property – section 1017

• Certain exceptions, limitations, and ordering rules apply• All such property becomes subject to either section 1245 or

1250 recapture– Passive activity losses and credits– Foreign tax credits

COD Exclusion RulesAttribute Reduction Rules

210

• Exception to Ordering Rule: Taxpayer can elect to reduce basis of depreciable property first– Is it more valuable to taxpayer to prevent elimination of $1M NOL

(possibly use immediately) or to preserve $1M of depreciable basis (use later over time)?

– Outside Basis: Partner may (or, sometimes, must) treat partnership interest as depreciable property to extent of partner’s share of inside basis of partnership depreciable property

• Partner’s section 743(b) basis adjustments• Distributive share of reasonably expected depreciation deductions• Reduction of outside basis generally requires a reduction of inside

basis of depreciable property as well– Such inside basis adjustments are partner-specific – cf. section 743(b)

COD Exclusion RulesAttribute Reduction Rules

211

• Special attribute reduction rule for QRPBI exclusion– Must reduce basis of depreciable real property of

taxpayer (again, at partner level)• Depreciable real property securing QRPBI• Other depreciable real property

– Outside Basis: Partner may (or, sometimes, must) treat partnership interest as depreciable real property to extent of partner’s share of inside basis of partnership depreciable real property

COD Exclusion RulesAttribute Reduction Rules

212

Other COD-Related RulesPurchase Price Adjustment

3P sells property to XY LLC for $100M. XY LLC pays with its note. XY LLC takes $100M basis in property. One year later, 3P forgives $10M of note due to discovery of condition that existed at time of sale that reduced FMV to $90M. Ordinarily, forgiveness would trigger $10M of COD for XY LLC. Neither X, Y, or XY LLC qualify under any of the exclusions for COD. So, are X and Y stuck with $10M COD? Since note arose out of the purchase of Property and adjustment relates back to original sale, the purchase price adjustment exception should apply. XY LLC must reduce its inside basis in the Property by $10M, but it does not recognize any COD.

XCorp.

YCorp.

XYLLC

3PProperty

Year 1: $100M NoteYear 2: $90M Note

213

Other COD-Related RulesSection 108 Related Party Rules

XY LLC owes $100M to Lender. XY LLC business is in rough patch. XY LLC cannot meet monthly payments. Lender will not work with XY LLC to get XY LLC through rough patch. XY LLC finds party (“Friendly Investor”) to purchase note from Lender for $80M with the understanding that it will work with XY LLC in getting through rough patch without foreclosing.Lender may be willing to do b/c thinks XY LLC will get worse – so, $80M is more than they will ever collectFriendly Investor willing to do it b/c its hoping that XY LLC will turn it around and repay full $100M eventually – profit of up to $20MXY LLC wants to do this to give them time to turn things around with the use of the assets subject to the $100M liabilityDid XY LLC recognize any COD at time Friendly Investor purchased $100M note from Lender?

XCorp.

YCorp.

XYLLC

Lender$100M Liability

FriendlyInvestor

$100M Note $80M

$100M Liability

1

2

2

214

Other COD-Related RulesSection 108 Related Party Rules

Tax obstacle: Section 108(e)(4): XY LLC treated as acquiring $100M liability for $80M, resulting in $20M COD if (i) Lender is notrelated to XY LLC and (ii) Friendly Investor is related to XY LLC at time of acquisition (or even becomes related later – e.g., other investors redeemed).Relatedness is very broad (constructive ownership rules apply) – sections 267(b) and 707(b) applied (generally >50% thresholds).If applies, liability treated as reissued to Friendly Investor at $80M issue price (could create $20M OID for Friendly Investor).

XCorp.

YCorp.

XYLLC

Lender $100M Liability

FriendlyInvestor

$100M Note

$80M $100M Liability

1

2 2

215

Other COD-Related RulesSection 108 Related Party Rules

XY LLC forms Sub LLC with Institutional Investor. Sub LLC issues $80M new debt to acquire $100M outstanding debt of XY LLC, which may cause liability to vanish for accounting purposes. Does XY LLC recognize COD? Section 108(e)(4) relatedness rules may not be tripped due to XY LLC’s 50% or less interest in both capital and profits interests in Sub LLC.

XCorp.

YCorp.

XYLLC

Lender $100M Liability

$100M Note

$80M $100M Liability

1

3 3

Institutional Investor

SubLLC

OtherLender

$80M Loan

2

50% 50%

216

Section 108(i)Legislative Change• Section 1231 of the 2009 Recovery Act added subsection (i) to section 108.

Deferral of COD Income • A taxpayer may elect under section 108(i) to include COD income from the reacquisition of

an “applicable debt instrument” in gross income ratably over a 5-year period (rather than including the entire COD income in the year of the reacquisition).

• The five-year period for recognition of COD income begins with the fifth tax year following the tax year in which the reacquisition occurs if the reacquisition occurs in 2009.

– If the reacquisition occurs in 2010, the five-year period begins with the fourth tax year following the tax year in which the reacquisition occurs.

– Thus, for calendar year taxpayers, the five years of inclusion would be 2014-2018 regardless of whether COD income is realized in 2009 or 2010 (assuming no short-period returns).

• Section 108(i) applies only to reacquisitions occurring in 2009 or 2010.

Section 163(e)(5)(F)• Section 163(e)(5)(F) was added in connection with section 108(i) to prevent section

163(e)(5) from deferring or disallowing OID on applicable high yield discount obligations.

217

Section 108(i)Interaction with Section 108(a)• An election under section 108(i) precludes the taxpayer from excluding the COD

income under section 108(a) (with a potential reduction of attributes under section 108(b)) for the year of reacquisition as well as any subsequent year. – Thus, for example, a taxpayer cannot exclude the COD income under section

108(a) after deferring recognition of the income until 2014.

Election to defer COD income• A taxpayer makes an election to defer COD income under section 108(i) by

including a statement that clearly identifies the instrument and the amount of the deferred income, and any other information the IRS requires.– The election generally is made on an instrument-by-instrument basis. However,

aggregation is permitted under certain conditions. See Rev. Proc. 2009-37. – Can an election be made in respect of a portion of the COD income recognized on

an instrument? Yes, see Rev. Proc. 2009-37.– Protective elections? Yes, see Rev. Proc. 2009-37.– Taxpayers may receive an automatic 12-month extension subject to Treas. Reg. §

301.9100-2(a). See Rev. Proc. 2009-37.

218

Section 108(i)Election to defer COD income (cont.)• The section 108(i) election is irrevocable. • Information returns are required each year until all of the COD income has

been recognized. See Rev. Proc. 2009-37. • Note that the election is made by the entity for partnerships, S corporations, or

other pass through entities, rather than the partners, shareholders, or members.– However, a partnership has the ability to choose which portion of each

partner’s distributive share of COD income (i.e., each partner’s “COD income amount”) will be deferred (i.e., each partner’s “deferred amount”) and which portion will not be deferred (i.e., each partner’s “included amount”). See Rev. Proc. 2009-37.

– Should there be a similar election rule for S corporations and their shareholders?

• An election to defer COD income does not affect a taxpayer’s earnings and profits (except for RICs and REITs). See Rev. Proc. 2009-37.

219

Definition of termsSection 108(i) applies to “reacquisitions” of “applicable debt instruments.”

Applicable Debt Instruments• An “applicable debt instrument” is defined as any debt instrument that was issued

by –

– a C corporation, or

– any other person in connection with the conduct of a trade or business by that person.

• A “debt instrument” is defined broadly to include –

– a bond,

– a debenture,

– a note,

– a certificate, or

– any other instrument or contractual arrangement constituting indebtedness within the meaning of section 1275(a)(1).

220

Definition of termsReacquisition• A “reacquisition” is defined as any acquisition of an applicable debt instrument by

the debtor that issued the debt instrument, or is otherwise the obligor, or a person related to that debtor.

– A “related person” is defined by reference to section 108(e)(4).

• An “acquisition” is defined to include --

– a “debt for cash” exchange;

– a “debt for debt” exchange (including an exchange resulting from a modification of a debt instrument);

– a “debt for stock” exchange (including debt exchanged for a partnership interest);

– the contribution of debt to capital;

– the complete forgiveness of the indebtedness by the holder of the debt instrument; and

– a “debt for property” exchange (see Rev. Proc. 2009-37).

221

Section 108(i) – Other Rules

OID Deferral• Section 108(i)(2) defers deductions related to OID in debt-for-debt exchanges

(including exchanges resulting from significant modifications) to match the deferral of income when a debtor makes a section 108(i) election.– OID may be at issue, for example, where existing debt is restructured to

defer the payment of interest on the new debt or to increase the interest rate on the new debt instrument.

Acceleration of Deferred Items• Any item of income or deduction deferred under section 108(i) must be taken

into account at the time the taxpayer dies, liquidates, or sells substantially all of its assets (including in a Title 11 or similar case).– The deferred items will not be accelerated if the taxpayer reorganizes and

emerges from the Title 11 case. See Conference Report, H.R. Report 111-16 (2009).

• The acceleration rule applies to the sale or exchange or redemption of an interest in a partnership, S corporation, or other pass-through entity by a partner, shareholder, or other person holding an ownership interest in the entity.

• The IRS has been granted authority to apply acceleration rules “in circumstances where appropriate.”

222

Section 108(i) – Other RulesPartnership Allocations

• In the case of a partnership, any deferred COD income is allocated to the partners immediately before the discharge in the manner those amounts would have been included in their distributive shares if the income or deduction were recognized at that time.

• Any decrease in a partner's share of partnership liabilities as a result of the discharge is not taken into account for purposes of section 752 partnership liability rules to the extent it would cause the partner to recognize gain under section 731. – Thus, the deemed distribution under section 752 is deferred for a partner to

the extent it exceeds the partner's basis.

• Any decrease in partnership liabilities that is deferred under section 108(i) will be taken into account by the partner at the same time, and to the same extent, as the deferred income is recognized.

223

Example 1 – Section 108(i) in Corporate Context

P

D

$100 D Note

X$70

$100 D Note

Facts: P wholly owns D. X holds an outstanding note issued by D with a $100 face amount. D acquires the $100 note for $70 and realizes $30 COD income.

Alternate Facts: D does not acquire its note. Instead, an election is made tocause D to be disregarded as an entity separate from P.

224

Example 2 – Section 108(i) in Partnership Context

P

$100 D Note

X$70

$100 D Note

Facts: P, Q, and R own equal interests in D, a limited liability company treated as a partnership for Federal tax purposes. X holds an outstanding note issued by D with a $100 face amount. D acquires the $100 note for $70 and realizes $30 COD income.

D

Q R

Insolvent &$23 O/B

Bankrupt &$23 O/B $0 O/B

225

Entrance of New Partner to Relieve Debt Stress on Partnership

• Struggling partnership can work out debt problems by admitting additional partners– Increasing assets – outside investor– Decreasing liabilities – lender becomes new investor

• But, there are significant tax issues to consider

226

LLC

X YOutside Basis$100M$300M$400M

LENDERState-law

non-recourse loan$600M

Outside Basis$100M$300M$400M50% 50%

Entrance of New Equity Partner

Sections 61/1001 Purposes: Non-recourseSection 752 Purposes: Non-recourse

Year 1

227

LLC

X Y

O/B($200M)$300M$100M

LENDERState-law

non-recourse loan$600M

O/B($200M)$300M$100M

20% 20%

Year 5

Entrance of New Equity Partner

Z

O/B$0M

$100M$100M

60%

$100M & Control

Could X and Y recognize gain by reason of section 752?

228

LLC

X Y

O/B($200M)$300M

($180M)$80M Gain

LENDERState-law

non-recourse loan$600M

O/B($200M)$300M

($180M)$80M Gain

20% 20%

Year 5

Entrance of New Equity Partner

Z

O/B$0M

$100M$360M$460M60%

$100M & Control$180 Deemed Cash Distributions

Could this gain from the $360M debt shift from X and Y to Z be prevented?

229

Entrance of New Equity Partner

LLC

X YO/B

($200M)$300M$100M

LENDERState-law

non-recourse loan$600M

O/B($200M)$300M$100M20% 20%

Year 5

Z

O/B$0M

$100M$100M

60%

$100M & ControlGuarantees

Absent the guarantees, note also that such debt shift may not occur by reason of X and Y’s share of partnership minimum gain converting to reverse section 704(c) minimum gain due to a “book-up” occurring upon entrance of Z. However, as depreciation/amortization taken on secured LLC property, debt generally will shift from X and Y to Z (due to decrease of such reverse section 704(c) minimum gain).

Note also that “book-up” alone should not trigger partnership minimum gain chargeback.

230

Entrance of New Equity Partner

Z likely will want to invest in a “fresh” vehicle that does not have any hidden tax/other skeletons. Many of the issues are the same. However, there are lurking issues regarding contributions of assets with essentially “net negative value” (good tax-free section 721 for LLC?), and issues surrounding how much non-recourse liability is treated as assumed by Sub LLC under section 752(c) rules when such liability exceeds FMV of secured property contributed (what is LLC’s outside basis?).

LLC

X YO/B

($200M)$300M$100M

LENDER

State-law non-recourse loan

$600M

O/B($200M)$300M$100M

50% 50%

Year 5

Z

O/B$0M

$100M$100M

$100M & Control

SubLLC

Assets &Liab.

231

LLC

X YOutside Basis$100M$300M$400M

LENDERState-law

non-recourse loan$600M

Outside Basis$100M$300M$400M50% 50%

Entrance of Lender as New Partner

Sections 61/1001 Purposes: Non-recourseSection 752 Purposes: Non-recourse

Year 1

232

LLC

X Y

O/B($200M)$300M

($300M)$200M Gain

LENDER

O/B($200M)$300M

($300M)$200M Gain

20% 20%

Year 5O/B$0M

$600M$600M

60%

$600M Note & Control

Does the Lender’s contribution of $600M note qualify for tax-free treatment under section 721? Is the note “property”? Look to what was originally transferred by Lender to LLC? What are consequences of the elimination of the $600M liability? See sections 108(e)(8), 731, 752. What if $600M note is exchanged for partnership interest with FMV of $400? If COD, can some of the COD be allocated to the new lender/partner?

Entrance of Lender as New Partner

233

Using Flow-through Entities, Including Disregarded Entities, in Acquisition

Transactions

234

Overview -- Using Flow-through Entities, Including Disregarded Entities, in Acquisition

Transactions

• Basic Structuring Transactions Involving Disregarded Entities

• Mergers and Other Reorganizations Involving Disregarded Entities

• Mixing-Bowl Transactions and Issues

• Leveraged Mixing-Bowl Transactions and Additional Issues

• Other Strategies to Keep in Mind with Mixing-Bowl Transactions

• Other Partnership Structuring Issues

• Common Business Considerations in Mixing-Bowl Transactions

235

Multiple Disregarded Entities

Facts: Corporation P is the sole member of LLC-1 and LLC-2. LLC-1 and LLC-2 form LLC-3, with each taking a 50% membership interest.

Results: The assets of LLC-1, LLC-2, and LLC-3 are treated as owned directly by P. See Rev. Rul. 2004-77.

LLC-3

P

LLC-2LLC-1

50%50%

100%100%

236

Merger of CorporationInto Single-Member LLC

Facts: Corporation P owns all of the stock of Corporation S and all of the membership interests in LLC. S is merged into LLC pursuant to Delaware Law.

Results: Although this transaction could be treated as an upstream merger, S should be treated ultimately as liquidating into P under section 332. See Treas. Reg. §§ 1.332-2(d), (e) ex., 1.368-2(b)(1)(ii); see, e.g., PLR 9822037.

LLC

100%

P

100%

MergerS

237

Facts: P owns all of the outstanding interests in LLC, which is treated as a disregarded entity for tax purposes. P sells all of the outstanding membership interests in LLC to X, an unrelated party.

Results: Because P is treated as owning all of the assets of LLC rather than LLC interests, P is treated as selling all of the assets of LLC to X.

LLC

P

100%

CashX

100% of LLC

Sale of All of theMembership Interests

238

Sale of Less than All ofthe Membership Interests

Facts: P owns all of the outstanding interests in LLC, which is treated as a disregarded entity for tax purposes. P sells 50% of the outstanding membership interests in LLC to X, an unrelated party.

Results: P is treated as having sold 50% of LLC’s assets to X, followed by a contribution by X of the purchased assets and by P of the retained assets to a newly formed partnership. Rev. Rul. 99-5 (Sit. 1).

What are the results if, instead of P’s selling the interests to X, X contributes cash to LLC in exchange for interests? See Rev. Rul. 99-5 (Sit. 2). What if the contributed cash is distributed to P within 2 years? See section 707(a)(2)(B). What if P sells 50% of the LLC’s interests in a public offering? See section 7704.

LLC

P

100%

CashX

50% of LLC

239

Sale of Less than All ofthe Membership Interests

Facts: S and B are members of a consolidated group. S owns all of the outstanding interests in LLC, which is treated as a disregarded entity for tax purposes. S sells 50% of the outstanding membership interests in LLC to B.

Results: S is treated as having sold 50% of LLC’s assets to B in an intercompany sale, followed by a contribution by B of the purchased assets and by S of the retained assets to a newly formed partnership. Rev. Rul. 99-5 (Sit. 1). Thus, gain on the sale from S to B is triggered under Treas. Reg. § 1.1502-13(d) upon the contribution of assets to LLC. A better result is obtained if B contributes cash directly to LLC, so that there is no sale between S and B. However, if that cash is distributed to S within 2 years, S may be treated as selling 50% of LLC’s assets to LLC in exchange for that cash under section 707(a)(2)(B).

LLC

100%Cash

50% of LLCS B

P

240

Overlap Between Automatic and Elective Changes In Classification

Facts: P owns all of the outstanding interests in LLC, which is treated as a disregarded entity for tax purposes. On January 1, 1998, P sells 50% of the outstanding membership interests in LLC to X, an unrelated party. P and X elect to treat the entity as an association effective January 1, 1998. Results: The elective classification changes preempt the automatic classification change resulting from the change in the number of owners. Thus, P is treated as contributing all of the assets and liabilities of LLC to Newco and selling 50% of the Newco stock to X. See Treas. Reg. § 301.7701-3(f)(2), (4) ex. 1.

LLC

P

100%

CashX

50% of LLCP

100%Stock

CashX

50% Newco

Newco

Assets &Liabilities

241

Sale of Membership Interests to Other Member

Facts: P and X each own a 50% interest in LLC. P sells its 50% LLC interest to X. After the sale, X is the sole owner of LLC, which is disregarded as an entity separate from X.

Results: The partnership terminates under section 708(b)(1)(A) when X purchases P’s interest. P treats the transaction as a sale of a partnership interest. However, for purposes of determining the consequences to X, LLC is deemed to make a liquidating distribution of all of its assets to P and X, and X is treated as acquiring the assets distributed to P. See Rev. Rul. 99-6. What if P and X are members of a consolidated group? See PLR 200334037.

50%

Cash

50% of LLC

50%

P X

LLC LLC

X

100%

242

Preparing for a Joint Venture

Facts: Corporation P owns all of the stock of Corporation S and wishes to admit X as a co-owner of the S business.

Step 1: P creates an intermediate corporation (Newco) between P and S.

P

S

Newco

243

Preparing for a Joint Venture

Step 2: S is converted into a single member LLC; that is, into a disregarded entity. Steps 1 and 2 should be combined into a single F reorganization (S reformed as Newco). See Prop. Reg. § 1.368-2(m)(3)(i), (m)(5) ex. 5.

P

S

Newco

LLC

244

Preparing for a Joint Venture

Step 3: X contributes assets to the LLC, converting it into a regarded partnership. This should be treated as a section 721 transaction for Newco as well as for X. See Prop. Reg. § 1.368-2(m)(3)(ii); Rev. Rul. 99-5 (Sit. 2).

P

Newco

LLC

X

245

Reorganizations Involving Disregarded Entities

246

Final Section 368 RegulationsMerger of Target into Disregarded Entity

Facts: P and T are domestic corporations and LLC is a domestic limited liability company. LLC is wholly owned by P. LLC is treated as a disregarded entity. P and T are combining entities. P and LLC comprise a combining unit, and T is a combining unit. T merges into LLC under state statutory merger law, with the T shareholders receiving consideration of 50% P voting stock and 50% cash.

LLC

P

100%

T

P Voting Stock and cash

Merger

247

Facts: P and T are domestic corporations and LLC is a domestic limited liability company. LLC is wholly owned by P. LLC is treated as a disregarded entity. P and LLC comprise a combining unit, and T is a combining entity and combining unit. LLC merges into T under state statutory merger law with shareholders of T receiving P stock and cash.

LLC

P

100%

T

Merger

Final Section 368 RegulationsMerger of Disregarded Entity into Corporation

248

On January 23, 2006, the IRS and Treasury issued final regulations defining the term “statutory merger or consolidation” as that term is used in the definition of an “A”reorganization under section 368(a)(1)(A) of the Code. These final regulations were the result of several iterations of proposed and temporary regulations and modifications made in response to comments.

The 2000 proposed regulations (May 16, 2000) provided that neither the merger of a disregarded entity into a corporation nor the merger of a target corporation into a disregarded entity could qualify as an A reorganization.

On November 15, 2001, the IRS and Treasury withdrew the 2000 proposed regulations and issued new proposed regulations that permitted certain statutory mergers involving disregarded entities to qualify as A reorganizations, if all of the assets and liabilities of the target are transferred to the acquiror and the target goes out of existence.

On January 24, 2003, the IRS and Treasury made certain minor clarifications to the proposed regulations and issued them as temporary regulations.

On January 5, 2005, the IRS and Treasury issued proposed regulations that would expand the temporary regulations to include mergers involving foreign entities and mergers effected pursuant to foreign laws within the scope of “statutory merger or consolidation.”

Final Section 368 RegulationsMergers and Consolidations

249

• A “statutory merger or consolidation” is defined as a transaction effected pursuant to the statute or statutes necessary to effect the merger or consolidation, in which transaction, as a result of the operation of such statute or statutes, the following events occur simultaneously at the effective time of the transaction in which:

– All of the assets (other than those distributed in the transaction) and liabilities (except to the extent such liabilities are satisfied or discharged in the transaction or are nonrecourse liabilities to which assets distributed in the transaction are subject) of each member of one or more combining units (each a transferor unit) become the assets and liabilities of one or more members of one other combining unit (transferee unit), and

– The combining entity of each transferor unit ceases its separate legal existence for all purposes.

• This requirement will be satisfied even if, under applicable law, after the effective time of the transaction, the combining entity of the transferor unit (or its officers, directors, or agents) may act or be acted against, or a member of the transferee unit (or its officers, directors, or agents) may act or be acted against in the name of the combining entity of the transferor unit, provided that such actions relate to assets or obligations of the combining entity of the transferor unit that arose, or relate to activities engaged in by such entity, prior to the effective time of the transaction, and such actions are not inconsistent with the combination requirement above.

• The final regulations adopt the change in the proposed regulations to permit mergers or consolidations involving foreign entities and mergers or consolidations pursuant to foreign laws.

Final Section 368 RegulationsDefinition of Terms

250

• The following terms are defined in the final regulations for purposes of defining statutory merger or consolidation:

• Disregarded entity - Business entity (as defined in Treas. Reg. §301.7701-2(a)) that is disregarded as an entity separate from its owner for federal income tax purposes. Examples include domestic single-member LLCs that do not elect to be treated as corporations, qualified REIT subsidiaries, and qualified subchapter S subsidiaries.

• Combining entity - Business entity that is a corporation that is not a disregarded entity.

• Combining unit - Comprised solely of a combining entity and all disregarded entities, if any, owned by the combining entity.

Final Section 368 RegulationsDefinition of Terms

251

Facts: P and T are domestic corporations and LLC is a domestic limited liability company. LLC is wholly owned by P. LLC is treated as a disregarded entity. P and T are combining entities. P and LLC comprise a combining unit, and T is a combining unit. T merges into LLC under state statutory merger law, with the T shareholders receiving consideration of 50% P voting stock and 50% cash.

Result: The transaction qualifies as a tax-free A reorganization under Treas. Reg. § 1.368-2(b)(1)(ii). See Treas. Reg. § 1.368-2(b)(1)(iii), ex. 2.

LLC

P

100%

T

P Voting Stock and cash

Merger

Final Section 368 RegulationsMerger of Target Into Disregarded Entity

252

Facts: P and T are domestic corporations and LLC is a domestic limited liability company. LLC is wholly owned by P. LLC is treated as a disregarded entity. P and LLC comprise a combining unit, and T is a combining entity and combining unit. LLC merges into T under state statutory merger law with shareholders of T receiving P stock and cash.

Result: The transaction does not qualify as a tax-free A reorganization under Treas. Reg. § 1.368-2(b)(1)(ii) because all of assets and liabilities of the combining unit of P and LLC do not become assets of T, and LLC is not a combining entity. See Treas. Reg. § 1.368-2(b)(1)(iii), ex. 6.

Notes: If LLC is a transitory merger subsidiary, is a recast under Rev. Rul. 67-448 available if only P shares are used?If LLC is not a transitory merger subsidiary, could the transaction be viewed as a section 351 transaction tothe extent of the LLC assets (and possibly a “B” reorganization with respect to the rest)?

LLC

P

100%

T

Merger

Final Section 368 RegulationsMerger of Disregarded Entity Into Corporation

253

Facts: P and T are domestic corporations and LLC1, LLC2, and LLC3 are domestic limited liability companies. LLC1and LLC2 are wholly owned by P. LLC3 is wholly owned by T. The LLCs are treated as disregarded entities. P, LLC1, and LLC2 comprise a combining unit, and T and LLC3 comprise a combining unit. T merges into LLC1 under state statutory merger law, with the T shareholders receiving consideration consisting of 50% P voting stock and 50% cash. LLC3 merges into LLC2 under state statutory merger law.

Result: The transaction qualifies as a tax-free A reorganization under Treas. Reg. § 1.368-2(b)(1)(ii). See Treas. Reg. § 1.368-2(b)(1)(iii), ex. 2.

LLC1

P

100%

T

P Voting Stock and cash

MergerLLC3

100%

LLC2

100%

Final Section 368 RegulationsMerger of Target and LLC Into Separate DE’s

254

ZForeign

YForeign

Merger

Z SHs Y SHs

Y Shares and cash

Facts: Z and Y are entities organized under the laws of Country Q and classified as corporations for Federal tax purposes. Z merges into Y under Country Q law. Pursuant to statutes of Country Q the following events occur simultaneously: (i) all of the assets and liabilities of Z become the assets and liabilities of Y, (ii) Z’s separate legal existence ceases for all purposes, and (iii) Z shareholders receive consideration consisting of 50% Y voting stock and 50% cash.

Result: Under the final regulations, this transaction qualifies as an “A” reorganization. See Treas. Reg. § 1.368-2(b)(1)(ii), -2(b)(1)(iii) Ex. 13.

Final Section 368 RegulationsMerger of Foreign Entities Under Foreign Law

255

TConsolidation

P

P SHs

Newco

T SHs P SHsT SHs

Facts: Under state W law, T and P consolidate. Pursuant to such law, the following events occur at the effective time of the transaction: all of the assets and liabilities of T and P become the assets and liabilities of Newco, an entity that is created in the transaction, and the existence of T and P continues in Newco. In the consolidation, the T and P shareholders exchange their stock of T and P, respectively, for stock of Newco.

Result: Under the final regulations, the consolidation qualifies as an “A” reorganization, because it is a transaction effected pursuant to the statute or statutes necessary to effect the merger or consolidation (i.e., State W consolidation law), all of the assets and liabilities of each member of one or more combining units (i.e., P and T) become the assets and liabilities of one or more members of another combining unit (i.e., Newco). See Treas. Reg. § 1.368-2(b)(1)(ii). The fact that the existence of the consolidating corporations (T and P) continues in Newco under State W law will not prevent the consolidation from qualifying as a statutory merger or consolidation. See Preamble to Treas. Reg. § 1.368-2(b); Treas. Reg. § 1.368-2(b)(1)(iii), Ex. 12.

Final Section 368 RegulationsState Law Consolidation

256

Facts: T, a Country Q Limited Company with a single US shareholder (SH), amalgamates with P, also a Country Q Limited Company, pursuant to the law of Country Q. By operation of law, the assets of T and P become assets of a new entity (“Amalco”), P and T cease their separate existence, and SH and the P shareholders receive shares of Amalco stock as consideration. SH receives 30% of Amalco’s outstanding shares.

Result: Under the final regulations, the amalgamation qualifies as an “A” reorganization, because it is a transaction effected pursuant to the statute or statutes necessary to effect the merger or consolidation (i.e., Country Q amalgamation law), all of the assets and liabilities of each member of one or more combining units (i.e., P and T) become the assets and liabilities of one or more members of another combining unit (i.e., Amalco). See Treas. Reg. § 1.368-2(b). The fact that the existence of the amalgamating corporations (T and P) continues in Amalco under Country Q law will not prevent the amalgamation from qualifying under the final regulations as a statutory merger or consolidation. SeePreamble to Treas. Reg. § 1.368-2(b); Treas. Reg. § 1.368-2(b)(1)(iii), Ex. 14.

TAmalgamation

SH

P

P SHs

Amalco

SH P SHs

Final Section 368 RegulationsAmalgamation Under Foreign Law

257

Facts: P and T are domestic corporations and LLC is a domestic limited liability company. LLC is wholly owned by P. LLC is treated as a disregarded entity. T merges into LLC under state statutory merger law, with the T shareholders receiving interests in LLC. After merger, LLC is not disregarded as an entity separate from P and is treated as a partnership for federal income tax purposes.

Result: The transaction does not qualify as a tax-free A reorganization because assets of T do not become assets of a combining unit. LLC cannot be a combining entity as a partnership and, thus, is not part of a combining unit. See Treas. Reg. §1.368-2(b)(1)(iii), ex. 7.

Note: What if LLC elects to be taxed as a corporation effective at the time of the merger? See Rev. Rul. 76-123; Rev. Rul. 68-349; Rev. Rul. 68-357.

LLC

P

100% TInterests in LLC

Merger

T SHsPT SHs

LLC

Final Section 368 RegulationsMerger of Corporation Into DE in Exchange

for DE Interests

258

TP

Merger

P

X

Facts: P and T, both corporations, together own all of the membership interests in X, a limited liability company that is treated as a partnership for federal income tax purposes. Under State W law, T merges into X. Pursuant to such law, the following events occur simultaneously at the time of the transaction: all of the assets and liabilities of T become the assets and liabilities of X, and T ceases its separate legal existence for all purposes. In the merger, the shareholders of T exchange their T stock for consideration consisting of 50% P stock and 50% cash. As a result of the merger, X becomes an entity that is disregarded as an entity separate from P.

Result: Under the final regulations, the transaction satisfies the requirements of a statutory merger or consolidation because the transaction is effected pursuant to State W law and the following events occur simultaneously at the effective time of the transaction: all of the assets and liabilities of T, the combining entity and sole member of the transferor unit, become the assets and liabilities of one or more members of the transferee unit that is comprised of P, the combining entity of the transferee unit, and X, a disregarded entity the assets of which P is treated as owning for tax purposes immediately after the transaction, and T ceases its separate legal existence for all purposes. See Treas. Reg. § 1.368-2(b)(1)(iii), ex. 11. The existence and composition of the transferee unit are determined immediately after (but not immediately before) the merger. See Preamble to Treas. Reg. § 1.368-2(b)(1).

X P stock an

d cash

Final Section 368 RegulationsMerger of Corporate Partner Into Partnership

259

TP P

X

Issues: In this transaction, X terminates as a partnership under section 708(b)(1)(A). The preamble to Treas. Reg. § 1.368-2(b)(1) notes that this transaction “raises questions as to the tax consequences of the transaction to the parties, including whether gain or loss may be recognized under the partnership rules...as a result of the termination of” X. The preamble also inquires whether the principles of Rev. Rul. 99-6 should apply to this transaction.

X

Merger

P stock an

d cash

Final Section 368 RegulationsMerger of Corporate Partner Into Partnership (Cont.)

260

Facts: P and T each own a 50% interest in X. T merges into P in an “A” reorganization. Afterward, P is the sole owner of X, which is disregarded as an entity separate from P.

Results: The partnership terminates under section 708(b)(1)(A) when P acquires T’s interest in X by operation of law. Does Rev. Rul. 99-6 apply to this type of partnership termination? Rev. Rul. 99-6 involved a taxable sale of a partnership interest from T to P. All the authorities cited in Rev. Rul. 99-6 involve taxable sales of partnership interests. See Rev. Rul. 67-65; Rev. Rul. 55-68; McCauslen v. Comm’r, 45 T.C. 588. Nonetheless, Rev. Rul. 84-111 (Sit. 3) appears to apply McCauslen in the context of a tax-free section 351 transaction. Treasury and the IRS have requested comments on whether “the principles of Revenue Ruling 99-6” apply to these facts. T.D. 9242 (Jan. 23, 2006).

50% 50%

P T

X X

P

100%

Merge

Final Section 368 RegulationsMerger of Corporate Partner Into Other Partner

261

T

P

LLC

100%

T Stock

50% P Stock50% Cash

T

P

LLC

T SHs

Facts: P and T are domestic corporations. P owns all of the interests in LLC, a domestic limited liability company that is disregarded for federal tax purposes. T’s shareholders transfer their T stock to P in exchange for 50% P stock and 50% cash. Immediately after the acquisition, T engages in one of the following alternative transactions.(1) T merges into P = A reorganization(2) T merges into LLC = A reorganization(3) T files a form in Delaware to become an LLC = Not an A reorganization (4) T checks the box to be treated as a disregarded entity = Not an A reorganization(5) T liquidates into P = Not an A reorganization(6) T dissolves = Not an A reorganization if remaining property does not vest in parent upon dissolution

Does the form of the second step determine the characterization of the transaction? Under what circumstances could a state law liquidation be treated as a consolidation treated as an A reorganization?See King Enterprises, Inc. v. United States, 418 F. 2d 511 (Ct. Cl. 1969); Rev. Rul. 67-274; Rev. Rul. 72-405; Rev. Rul. 2008-25; Rev. Rul. 2001-46; Rev. Rul. 90-95; PLR 9539018; Preamble to Treas. Reg. § 1.368-2(b)(1).

Final Section 368 RegulationsStep Transaction Issues

262

Facts: P owns all of the stock of two corporations, T and A. P contributes all of its T stock to A. Immediately thereafter, A forms a wholly owned LLC, and T merges into LLC.

Result: The contribution of T stock and the subsequent merger of T into LLC should be integrated and treated as if T transferred all of its assets directly to A in exchange for A stock and then distributed the A stock to P in complete liquidation. The transaction, as recharacterized, should qualify as a tax-free acquisitive D reorganization. See PLR 200445016; see also Rev. Rul. 2004-83 (taxable sale of subsidiary stock to another subsidiary followed by an actual liquidation treated as a D reorganization); PLR 200430025 (transfer of stock followed by a QSub election treated as a D reorganization).Note that, as a result of the AJCA, section 357(c) no longer applies when T’s liabilities exceed T’s aggregate basis in its assets as long as the D reorganization is acquisitive. See section 357(c)(1)(B).

D Reorganization D Reorganization

100% 100%

LLC

T Stock

Merger

P

T A

100%

A

P

T

100%

263

Facts: T conducts two businesses, Business A and Business B. P would like to acquire Business A in a tax-free reorganization in exchange for 80% P stock and 20% cash. T has contingent liabilities that P wants to leave behind. Further, assume for simplicity that the Business B assets have little or no built-in gain and T has a single shareholder. Accordingly, T forms a new corporation, HC, which in turn forms a wholly owned LLC treated as a disregarded entity. T transfers Business A to HC and then merges into LLC. HC then distributes the LLC interests to its shareholder in a taxable distribution. HC then merges into P, with the T shareholder receiving P stock and cash.

Result: Steps 1 and 2 should qualify as a tax-free F reorganization; step 3 should be treated as a taxable distribution of LLC’s assets to T’s shareholder; step 4 should qualify as a tax-free A reorganization. See Prop. Reg. § 1.368-2(m)(3)(ii); Rev. Rul. 96-29; PLRs 199902004, 199939017. What if, instead of a merger, the T shareholder sells the HC stock to P? See Prop. Reg. § 1.368-2(m)(2).

F Reorganization F Reorganization

100%

4) P Voting Stock & Cash

2) M

erge

r

T

HC

T Shareholder

1) Business A

100%

HCBus. A

T Shareholder

P

3) LLCInterests

4) Merger

LLCLLC

Bus. B/Cont. Liab.

264

A B

Bus. A Bus. B

Mixing-Bowl Transactions and Issues

A would like to dispose of Bus. A, which is appreciated A wants to acquire Bus. B (or cash) B would like to dispose of Bus. B, which may or may not be appreciated B wants to acquire Bus. A A and B wish to defer any built-in gain in their businesses as long as possible Section 1031 is not available since Bus. A and Bus. B assets are not “like-kind” Combining the businesses in corporate form would introduce an additional

layer of tax since no party will have an 80%+ interest in the corporate joint venture

265

P

A B

Bus. A Bus. B

P

A B

Bus. B Bus. A

7+ Years Pass

Mixing-Bowl Transactions and Issues

Bus. A profits, losses, and cash flow: A:25% B:75% Bus. B profits, losses, and cash flow: A:75% B:25% Daily operations of Bus. A managed by B/Daily operations of Bus. B managed by

A Liquidate in accordance with capital accounts

To extent available, A receives Bus. B assets/B receives Bus. A assets

266

• Typical Issues– Section 704(c)(1)(A) – built-in gain or loss in section

704(c) property taken into account by contributing partner via allocation of depreciation/amortization or disposition gain or loss at partnership level

– Section 704(c)(1)(B) – distribution of section 704(c) property to noncontributing partner w/in 7 years

• Mechanical provision

– Section 737 – distribution of property to partner who contributed other section 704(c) property w/in 7 years

• Mechanical provision• Applies to nonliquidating distributions as well, but may be overkill

since section 704(c) continues to apply

Mixing-Bowl Transactions and Issues

267

Mixing-Bowl Transactions and Issues• Typical Issues

– Section 707• Disguised sale of property between partner and partnership – final regulations• Disguised sale of partnership interest between partners – proposed regulations

recently withdrawn (case law and legislative history still apply)– General rules to treat as disguised sale:

• Simultaneous transfers: second transfer would not have been made “but for” first transfer

• Nonsimultaneous transfers: same “but for” test + subsequent transfer not dependent on “entrepreneurial risks of partnership operations”

– Presumptions:• Transfers w/in 2 years presumed disguised sales unless facts “clearly establish”

otherwise• Transfers not w/in 2 years presumed not disguised sales unless facts “clearly

establish” otherwise– “Clearly establish” appears to be high standard – can help & hinder partners– Illustration of mixing-bowl transaction involving disguised sale of property –

Treas. Reg. 1.707-3(f) ex. 8– Although no regulations for disguised sales of partnership interests, section

707 should be viewed as self-enforcing in this regard

268

Mixing-Bowl Transactions and Issues

• Disguised sale treated as occurring at the time of the earliest transfer

• Seems to make sense, since sale deemed to occur between same parties that did the transactions that caused disguised sale treatment

269

Mixing-Bowl Transactions and Issues

• Keep an eye on liabilities of Bus. A and Bus. B– Could create disguised sale of property at contribution

• Is transferred liability a “qualified liability” of partner?– Includes unsecured ordinary business liabilities where all material assets of

business contributed– If Bus. A is only a line of overall business conducted by A, have all material

assets been transferred? -- Could section 355 guidance provide comfort?– If B wants only a portion of Bus. A assets, then ordinary business liabilities of

Bus. A transferred to P will not be “qualified liabilities”• If not, does the contributing partner retain a large enough share of the

liability after the contribution?– Every dollar of non-”qualified liability” of partner for which partner does not

remain on the hook treated as disguised sale consideration – Normal recourse liability rules apply– Only profit-sharing rule of nonrecourse liability rules apply– Consider guarantees, indemnifications, etc. to preserve risk of loss

270

Mixing-Bowl Transactions and Issues

• Keep an eye on liabilities of Bus. A and Bus. B (cont.)– Even if no disguised sale, could recognize gain at contribution

under section 731– Particularly if businesses disproportionately leveraged – Consider guarantees, indemnifications, etc. to prevent shift of

liabilities and resulting deemed distribution of cash in excess of outside basis

• No nontax business purpose needed – Treas. Reg. 1.752-2(b), 1.737-4(b) ex. 2

– Relying on nonrecourse rules may provide only temporary comfort

• Outside basis from Tier 1 (p/s min. gain) rule decreases as P pays debt• Outside basis from Tier 2 (section 704(c) min. gain) rule decreases as P

depreciates assets– Consider paying down portion of debt prior to transfers to P so

as to eliminate disproportionate leverage

271

• Keep an eye on liabilities of Bus. A and Bus. B (cont.)– Could recognize gain as debt is paid down over time under

section 731– Income of partnership increases outside basis of partners at

end of partnership year only– Deemed distribution of cash due to debt payment taken into

account immediately– Gain recognition under section 731 if deemed distribution of

cash exceeds outside basis (unadjusted for current year income)

– Exception: treat deemed distribution of cash as “draw” against partner’s distributive share of income and take into account at end of partnership year

• Allows income to increase outside basis before testing for gain recognition under section 731

• However, rule seems to apply only if partnership has income and only to the extent of partner’s distributive share thereof

• See Treas. Reg. 1.731-1(a)(1)(ii); Rev. Rul. 94-4

Mixing-Bowl Transactions and Issues

272

• Watch out for section 721(b)– Section 721 nonrecognition rule overridden if P

viewed as “investment company” under section 351(e) rules

– TRA of 1997 significantly broadened rules – Two requirements for “investment company”

status:• 1. Diversification of A’s and B’s interests in

transferred assets– Generally need transfer of non-identical assets

• 2. >80% of gross value of assets of P are (i) “bad assets” and (ii) held for investment

– “Held for investment” broadly defined: all assets other than inventory and assets used in financial services businesses

Mixing-Bowl Transactions and Issues

273

• Watch out for section 721(b) (cont.)– Could have section 721(b) issue when

• B is contributing cash or other financial assets (rather than Bus. B)

– Such contribution apparently disregarded if plan for P to use such assets to acquire Bus. B assets

• Business contributed consists of large amount of working capital for future expansion

• Business contributed includes interests in other entities where other entities essentially hold cash or cash-equivalents equal to proceeds of sales of valuable assets

• B contributes a personal note• Any combination of the above circumstances

Mixing-Bowl Transactions and Issues

274

• Watch out for section 721(b) (cont.)– “Bad assets” include

• Money and foreign currency• All forms of equity in corporations (no active trade req’t)• All forms of indebtedness in corporations (no active trade req’t)• All other equity interests if can convert or exchange into any other

“bad asset”• Any interest in any entity if “substantially all” assets of entity are

“bad assets”– “Substantially all” not defined – but see Treas. Reg. 1.731-2(c)(3)

(adopts 90% gross value test for similar purpose)• Any interest in any entity if not “substantially all” assets of entity

are bad assets, but only to extent value of interest attributable to “bad assets” of entity

– No floor – but see Treas. Reg. 1.731-2(c)(3) (adopts a 20% gross value floor for similar purpose)

Mixing-Bowl Transactions and Issues

275

• Section 731(c)– “Marketable securities” treated as cash to extent of FMV– Could cause gain recognition upon distribution if exceed

outside basis– “Marketable security” has broad meaning

• Unlike section 721(b), no >80% gross value requirement• Actively traded financial instruments and currencies (broadly

defined)• Interests in any entity if substantially all of the assets of such

entity consist (directly or indirectly) of marketable securities, money, or both

– “Substantially all” means “90 percent or more of the assets of the entity (by value) at the time of the distribution of an interest in the entity consist (directly or indirectly) of marketable securities, money, or both.” Treas. Reg. 1.731-2(c)(3)(i)

Mixing-Bowl Transactions and Issues

276

• Section 731(c)– “Marketable security” has broad meaning (cont.)

• Any interest in an entity not described above but only to the extent of the value of such interest which is attributable to marketable securities, money, or both.”

– Exception: “[A]n interest in an entity is a marketable security to the extent that the value of the interest is attributable (directly or indirectly) to marketable securities, money, or both, if less than 90 percent but 20 percent or more of the assets of the entity (by value) at the time of the distribution of an interest in the entity consist (directly or indirectly) of marketable securities, money, or both.” Treas. Reg. 1.731-2(c)(3)(ii).

– Section 731(c)(6) could convert resulting capital gain under section 731 into ordinary income if “marketable security” is “unrealized receivable” or “inventory” item

• Unlike section 751(b), inventory need not be “substantially appreciated” to convert capital gain to ordinary income

Mixing-Bowl Transactions and Issues

277

• Other section 704(c) considerations– Section 704(c) method should not be overlooked when negotiating

terms of partnership agreement– Instead of economically owning 75% of Bus. A through P, B could have

purchased 75% of Bus. A assets from A• Direct purchase would have given B a full cost basis from which to generate

depreciation deductions• Generally, section 704(c) attempts to preserve the amount of depreciation

deductions that noncontributing partners would have taken into account if the property had a cost basis

• However, “ceiling rule” under section 704(c) may limit amount of depreciation deductions allocable to B from Bus. A assets if inside basis of Bus. A is low enough

• Can remedy with curative allocations or remedial allocations– Curative allocations helpful only if expect to have other similar property

generating depreciation deductions– If no similar property, use remedial allocations (creating tax items)– Curative or remedial allocations of additional depreciation to B will cause

additional income to be allocated to A» Traditional method would not have allocated additional income to A

Mixing-Bowl Transactions and Issues

278

• Section 751(b)– Section 751(b) – overrides section 731 nonrecognition rule upon

distribution if shift in partner’s share of “hot assets”• Section 751(b) could apply since not making liquidating distributions

consisting of pro rata portion of value of each asset of P• “Hot assets” include assets generally not considered “substantially

appreciated inventory” or “unrealized receivables,” such as depreciation recapture

• Even though accounts receivable may not qualify as “unrealized receivables,” can be treated as “inventory”

– If included, reduces likelihood that inventory will be “substantially appreciated” as long as P on accrual method

– Reduce section 751(b) exposure • Do not contribute “hot assets” (e.g., A/R and inventory) to extent

possible (depreciation recapture cannot be separated from its underlying property)

• Enter into agreement stating which “cold assets” deemed exchanged for disproportionate distribution of “hot assets” – cannot do reverse agreement

– Watch out: Must test for section 751(b) when have deemed distributions of cash due to debt shifts under section 752 as well

Mixing-Bowl Transactions and Issues

279

• Anti-Abuse Rules– Treas. Reg. 1.701-2 (general anti-abuse rule), 1.704-4(f)

(section 704(c)(1)(B) anti-abuse rule), 1.737-4 (section 737 anti-abuse rule)

• Would not seem to apply since– 75:25 disproportionate allocations do not seem inconsistent with the

intent of subchapter K – still significant joint investment and entrepreneurial risk sharing

» 90:10 may be too aggressive – Treas. Reg. 1.707-3(f) ex. 8» “Substantially all” may be too aggressive – Treas. Reg. 1.704-

4(f)(2) ex. 1– A and B have continuing interest in assets for significant period of

time (7+ years)– Congress already has addressed any perceived abuse by enacting

section 704(c)(1)(B) and 737, which has clear 7-year cut-off» Treas. Reg. 1.704-4(f)(2) ex. 1 blesses delay of distribution to

period outside 7-year period for “principal purpose of avoiding”section 704(c)(1)(B)

Mixing-Bowl Transactions and Issues

280

• Anti-Abuse Rules (cont.)– Unhelpful circumstances to avoid

• 90:10 allocations• Investment banking and in-house materials giving the

appearance that the parties intended from the start to liquidatethe partnership immediately after 7 years

– Partnership agreement should not require liquidation after 7 years –rather, agreement should provide that partnership shall not be liquidated within 7 years without consent of A and B

• Lack of any discussion/substantiation of the potential synergistic effects of combining Bus. A with Bus. B

• Mechanisms designed to undo the apparent economic deal between the parties (e.g., fixed price call option on certain partnership property or long-term leases of certain partnership property)

Mixing-Bowl Transactions and Issues

281

• Preferred Interests– Structure could be modified so that A receives 25% preferred

interest with respect to Bus. A assets and B receives 25% preferred interest with respect to Bus. B assets

• Technique used to substantially freeze A’s continuing interest in Bus. A to 25% of its FMV at contribution and B’s continuing interest in Bus. B to 25% of its FMV at contribution

– Risk is that preferred interest will be treated as debt of P• If treated as debt of P, portion (or all) of contributed property

could be viewed as being sold to P• Dearth of authority on treating preferred interests as debt• Commonplace for preferred stock to be treated as equity

– Risk might be reduced by combining preferred interest with common interest – “participating preferred interest”

Mixing-Bowl Transactions and Issues

282

• Preferred Interests (cont.)– Partners may wish to monetize their preferred interests as well– A could borrow 90% of value of its 25% preferred interest– Monetizing creates risks

• Preferred interest sold to lender• Preferred interest disregarded and treated as sale of assets to

lender– How reduce risk?

• Involve third-party lender with arm’s-length lending terms– Since preferred interest non-marketable, likely lender is B

• Secure the note with unrelated substantial assets of A• Make repayment terms of note and terms of preferred interest

materially different

Mixing-Bowl Transactions and Issues

283

• Puts and Calls on Interests in P– Circumstance: Usually when B has contributed non-

business assets– Purposes:

• Liquidation of P can be vetoed by either partner• A’s put option on its interest gives A some unilateral power

to force exit from partnership under certain conditions– May further insulate A from downside of Bus. A in P

• B’s call option on A’s interest gives B some unilateral power to remove A from partnership under certain conditions

– May further transfer to B upside of Bus. A in P• Options also can be viewed as injecting liquidity into an

otherwise non-marketable interest

Mixing-Bowl Transactions and Issues

284

• Puts and Calls on Interests in P (cont.)– Risks:

• Cause current sale of interest in P• Increase risk of disguised sale of property since could

evidence intent of parties that A not share in entrepreneurial risks of Bus. A from formation date of P

• Increase risk of anti-abuse rules applying

Mixing-Bowl Transactions and Issues

285

• Puts and Calls on Interests in P (cont.)– How reduce risks?

• Overall guiding principle: make sure that, at time of entering into options, “more than remote possibility” that options will not be exercised during relevant exercise periods

– See Penn-Dixie, 69 T.C. 837 (1978), Kwiat, 64 T.C.M. 327 (1992), Griffin Paper, 74 T.C.M. 559 (1997), Rev. Rul. 72-543, F.S.A. 1998 WL 1984538

– Function of volatility of price of businesses within P -- Penn-Dixie (steel business, very volatile – no sale), Kwiat (industrial metal shelving not as volatile -- sale)

– Function of expected financial ability of optionholder to exercise in future - Griffin• Delay exercise periods until period of years after grant

– Penn-Dixie (3 & 4 years after grant), Griffin (8 years after grant) • Vary exercise periods of put and call

– Coinciding exercise dates fatal in Rev. Rul. 72-543, 1 day gap o.k. in Penn-Dixie, complete overlap of exercise period o.k. in Griffin but court focused more on potential financial inability of optionholder to exercise

• Exercise prices=FMV of interest at time of exercise – Exercise prices not tied to FMV was one of fatal facts in Kwiat

Mixing-Bowl Transactions and Issues

286

P

A B

Bus. A Bus. B

P

A B

LLCBus. B

LLCBus. A

7+ Years Pass

LLCBus. A

LLCBus. B

LLCBus. A

LLCBus. B

Variant: Place businesses in separate disregarded LLCs to shield assets of one business from the liabilities of the other business in a tax transparent manner

Mixing-Bowl Transactions and Issues

287

• Could the transfer of Bus. A and Bus. B into separate disregarded LLCs impact the disguised sale analysis?– Disguised sale analysis focuses on whether subsequent

transfer of property is dependent on entrepreneurial risks of partnership operations

• More likely that subsequent distribution is not dependent on risks of partnership operations, more likely a disguised sale

• Placing businesses in separate LLCs effectively insulates assetsof each segment of partnership operations from liabilities of the other

• However, the separate income and loss of each business are stillshared between the parties

– See also Treas. Reg. 1.707-3(b)(2)(viii) (fact that may prove existence of sale): “That partnership distributions, allocations, or control of partnership operations is designed to effect an exchange of the burdens and benefits of property.”

Mixing-Bowl Transactions and Issues

288

P

A B

Bus. A Cash

P

A B

Bus. B Bus. A

7+ Years Pass

Variant: B contributes cash, and P acquires Bus. B from a third party with such cash

3PBus. B

Cash

Mixing-Bowl Transactions and Issues

289

• Bus. B assets are not subject to section 704(c), section 707, or section 737

• Bus. A assets are subject to such provisions• If distribute Bus. B to A during 7-year period, section 737

issue for A?– A nonliquidating distribution of Bus. B to A could avoid section

737 if A’s outside basis equals or exceeds FMV of Bus. B• Can accomplish via A’s guarantee of sufficient amount of P debt• See Treas. Reg. 1.737-4(b) ex. 2

– A liquidating distribution of Bus. B to A could avoid section 737 if A’s outside basis equals or exceeds FMV of Bus. B

• Apparently could accomplish by A assuming or taking subject to a sufficient amount of P debt

• As discussed above, section 721(b) apparently should not be issue since plan is for cash to be used to acquire Bus. B assets

Mixing-Bowl Transactions and Issues

290

P

A B

Bus. A Cash

P

A B

P Sub stock

Bus. A

7+ Years Pass

Variant: B contributes cash, P contributes cash to P Sub, P Sub acquires Bus. B, A receives P Sub stock, A liquidates P Sub

3PBus. B

Cash

P Sub

Cash

P Sub

Liquidation

Mixing-Bowl Transactions and Issues

291

• P Sub stock not subject to section 704(c), section 707, or section 737• Bus. A assets are subject to such provisions• Under section 334(b), A takes basis in Bus. B assets equal to inside

cost basis of Bus. B assets rather than outside low basis of P Sub stock– Apparently eliminating A’s built-in gain from Bus. A assets via tax-free

liquidation of P Sub• However, section 732(f) requires a basis step-down of P Sub assets

(or gain recognition) upon P’s distribution of P Sub stock to A– Reduction amount = lower of (i) actual basis step-down of P Sub stock upon

distribution to A and (ii) aggregate basis of P Sub assets over A’s basis in P Sub stock

– If required basis reduction > basis of P Sub property, excess = capital gain to A

– Thus, A’s built-in gain from Bus. A assets continues in Bus. B assets to extent Bus. B assets have sufficient initial basis to reflect such built-in gain; A recognizes capital gain otherwise

• As discussed above, section 721(b) apparently should not be issue since plan is for cash to be used to acquire Bus. B assets

Mixing-Bowl Transactions and Issues

292

P

A B

Bus. A Cash

P

A B

A stock Bus. A

7+ Years Pass

Variant: B contributes cash, and P acquires A stock from a third party with such cash

3PA stock

Cash

Mixing-Bowl Transactions and Issues

293

• Current Law Treatment– Effectively, A disposed of its appreciated business assets in

exchange for its own stock in a manner that permanently eliminates the built-in gain in its business assets

– Upon liquidation, A’s low outside basis transfers to its stock– Subsequently, built-in gain in the stock should not be recognized

under section 1032 – But see section 721(b) – cash contributed to acquire A stock still

“bad asset”– But see section 731(c) – stock could be “marketable security”

• Prop. Treas. Reg. 1.337(d)-3– Would treat the liquidating distribution to A as a redemption of A’s

stock with A’s interest in P under section 311, rather than section 731 (i.e., built-in gain in A’s interest in P would be recognized)

• Would apply to stock of A and A’s affiliates• Would apply to options, warrants, and similar interests as well

– Proposed in 1992, but not finalized yet– When finalized, could have retroactive effective date back to 1989

Mixing-Bowl Transactions and Issues

294

P

A B

Bus. A Cash

P

A B

A debt Bus. A

7+ Years Pass

Variant: B contributes cash, and P acquires A debt from a third party with such cash

3PA debt

Cash

Mixing-Bowl Transactions and Issues

295

• Proposed Treas. Reg. 1.337(d)-3 does not apply to debt instruments

• Effectively, A disposed of its appreciated business assets in exchange for its debt in a manner that permanently eliminates the built-in gain in its business assets– Upon liquidation, A’s outside basis transfers to its debt if

section 731 applies• Section 731 may not apply if do not view debt as “property”

– Debtor position and creditor position merge– But see section 731(c) – debt could be “marketable security”

• However, Rev. Rul. 93-7: A must recognize gain to extent FMV of debt exceeds basis of debt following distribution

• A also could recognize COD income to extent adjusted issue price>FMV

• Do not overlook section 721(b) – cash contributed to acquire A debt still “bad asset”

Mixing-Bowl Transactions and Issues

296

P

A C

Bus. A Cash

4 Years PassP

A C B

Cash

P

A C B

3+ Years Pass

Bus. A

consolidated consolidated consolidated

A and C are members of consolidated group A wants to dispose of Bus. A but wants to minimize time that it has to

remain a partner with potential acquirer (B)

Mixing-Bowl Transactions and Issues

297

• Does acquirer partner have to be a partner with selling partner for at least 7 years in order to avoid section 704(c)(1)(B)?– Although the statute does not impose such a

requirement, it appears that Service would challenge such a transaction if P “formed pursuant to a plan the principal purpose of which is to minimize period of time that A would have to remain a partner with a potential acquirer” of Bus. A

– See Treas. Reg. 1.704-4(f)(2) ex. 2– However, such a transaction should work if P is

formed for other non-tax business reasons

Mixing-Bowl Transactions and Issues

298

P

A B

Bus. A Bus. B

Cash

Leveraged Mixing-Bowl Transactions and Additional Issues

Bank N/R Loan

A wants to reduce its ownership in Bus. A in exchange for cash immediately but defer gain recognition

Bus. A profits, losses, and cash flow: A:25% B:75% Bus. B profits, losses, and cash flow: A:75% B:25% Bus. A managed by B/Bus. B managed by A Nonliquidating distribution of loan proceeds to A=90% FMV of Bus. A assets Liquidate in accordance with capital accounts

To extent available, A receives Bus. B assets/B receives Bus. A assets

P

A B

Bus. B& Bank Loan

Bus. A

7+ Years Pass

299

• Section 707 – Treas. Reg. 1.707-5(b) – A must receive distribution of loan proceeds (or other consideration

traceable to loan proceeds) w/in 90 days of P incurring bank loan to avoid disguised sale

• If (i) cash also contributed by B or (ii) P already has other cash from operations or unrelated borrowings, how avoid argument that cashdistribution did not come from bank loan proceeds? – cash is fungible

• P should (i) direct Bank to transfer loan proceeds to A, (ii) receive loan proceeds and immediately transfer to A, or (iii) deposit into new bank account and distribute to A w/in 90 days

• See Treas. Reg. 1.163-8T(c) – If receive loan proceeds in cash and transfer any cash w/in 15 days of

receipt of loan proceeds, then P can treat the transfer of cash as allocable to such loan proceeds

– If receive and deposit loan proceeds in bank account, P may treat anytransfer of cash out of account w/in 15 days of deposit of loan proceeds as transfer of loan proceeds

– Otherwise, if receive and deposit loan proceeds in bank account, any transfer of cash out of account treated as such loan proceeds before treated as (i) any unborrowed amounts deposited at time loan proceeds deposited or (ii) any amounts deposited after loan proceeds deposited

– Rules applied separately to separate bank accounts of P

Leveraged Mixing-Bowl Transactions and Additional Issues

300

• Section 707 – Treas. Reg. 1.707-5(b) (cont.)– A also must have sufficient share of loan under section

752 to avoid disguised sale• Sufficient share=(modified section 752 share x percentage of

total liability proceeds distributed to A)– Tier 1 (p/s min. gain) and Tier 2 (section 704(c) min. gain) rules of

nonrecourse liability rules do not apply for this purpose– Must rely on recourse liability rules and general Tier 3 rule (profit-

sharing ratios) of nonrecourse liability rules– Since profit-sharing ratios usually not enough, focus falls on

recourse liability rules» In this example, A could have only a 75% share of bank loan

under Tier 3 rule (and it might be lower)• Thus, A having share of bank loan merely equal to amount

distributed to A may not be sufficient if P retains some loan proceeds

Leveraged Mixing-Bowl Transactions and Additional Issues

301

• Section 731– Even if avoid disguised sale, A must have

enough share of bank loan under normal section 752 rules to avoid distribution of loan proceeds in excess of outside basis

Leveraged Mixing-Bowl Transactions and Additional Issues

302

• For purposes of section 707 and 731 issues, how make otherwise non-recourse liability a recourse liability allocable to A? Treas. Reg. 1.752-2– A guarantees portion (or all of) bank loan

• Guarantee of portion of bank loan can be “bottom-dollar” –Treas. Reg. 1.704-2(m) ex. 1(vii), 1.752-2(b)

• Guarantee must be enforceable under state law– Notice of guarantee to creditor

• Guarantee with amount guaranteed floating from year-to-year appears to be valid – Treas. Reg. 1.705-1(a), 1.752-4(d)

• Guarantee with limited term appears to be valid– All of A’s rights of contribution, reimbursement, and

subrogation from B, P, and all related parties must be waived

Leveraged Mixing-Bowl Transactions and Additional Issues

303

• Necessary capitalization of A to support guarantee obligation– Presumption that A will satisfy guarantee regardless of net worth

• Treas. Reg. 1.752-2(b)(6)– However, anti-abuse rules could apply to disregard A’s guarantee

• Treas. Reg. 1.752-2(j)– No bright-line rule for appropriate level of net worth

• Do not need net worth equal to debt guaranteed• 50%?• 10%? Rev. Proc. 89-12 (former entity classification ruling guideline)• 0%?

– Rules suggest that lack of net worth alone is not sufficient to disregard guarantee – Treas. Reg. 1.752-2(j) ex.; CCA 200246014

• Types of assets to create net worth• Liquid assets v. illiquid assets• Business assets v. investment assets • Note receivable from affiliate that has deep pocket• Not interest in the relevant partnership

Leveraged Mixing-Bowl Transactions and Additional Issues

304

• Use of interposed shell entities– Same net worth considerations apply if A interposes a

shell corporate subsidiary– If A interposes a shell disregarded LLC, lose presumption

of satisfaction under Treas. Reg. 1.752-2(b)(6)• Under Treas. Reg. 1.752-2(k), payment obligation of a

disregarded LLC is treated as a payment obligation of its owner only to the extent of the net worth of the LLC

– Regulations did not extend net worth limit to shell corporate subsidiaries

– Interposing shell corporate subsidiaries seems preferable to shell disregarded LLCs

Leveraged Mixing-Bowl Transactions and Additional Issues

305

• Appears that A could vary the level of its net worth as the required level of guarantee varied over time – Treas. Reg. 1.705-1(a), 1.752-4(d)

• As bank loan is paid down, A will recognize the gain that it deferred by reason of the guarantee at contribution– Structure bank loan as balloon payment debt so as to push this event

far into the future• Partnership could retain profits in special debt amortization fund

so as to insure that funds would be available to pay down debt when it became due

• Use of contribution agreements to force B to make cash contributions to P in case P lacks funds to service bank loan creates risk that A’s guarantee would be disregarded – Treas. Reg. 1.752-2(j)– Such contribution agreements could be viewed as insulating A from

having to pay under its guarantee• Existence of other senior guarantees or pledged assets increases

risk that A’s guarantee will be disregarded -- Treas. Reg. 1.752-2(j); CCA 200246014

Leveraged Mixing-Bowl Transactions and Additional Issues

306

P

A B

Bus. A& Bank Loan

Bus. B

CashRetainedBank

N/RLoan

P

A B

Bus. B& Bank Loan

Bus. A

7+ Years Pass

Variant: A borrows against Bus. A assets and contributes assets

Leveraged Mixing-Bowl Transactions and Additional Issues

307

• Issues regarding incurrence of bank loan at P level exist in this structure as well

• However, there are certain disguised sale rules that could eliminate the need for A to guarantee the bank loan when it is transferred to P– If bank loan is treated as “qualified liability,” then the deemed distribution of

cash to A upon the loan’s transfer from A to P is disregarded for disguised sale of property rules

– “Qualified liability” includes• Liability incurred more than 2 years prior to contribution that has encumbered

contributed property for 2-year period leading up to contribution• Liability the proceeds from which are allocable to capital expenditures with

respect to contributed property• Ordinary business liabilities where all material business assets contributed• Liability incurred within 2 years prior to contribution but not incurred in anticipation

of contribution of property – must “clearly establish”

Leveraged Mixing-Bowl Transactions and Additional Issues

308

• Even if bank loan is “qualified liability,” guarantee of bank loan may be needed to avoid gain recognition under section 731

• However, may not need to guarantee as much to avoid section 731 risk as would have had to guarantee to avoid section 707 risk if bank loan incurred at P level– Section 707: Every dollar of bank loan distributed to A

that A does not bear under modified section 752 rules is treated as disguised sale consideration to A

– Section 731: Only need to guarantee enough to avoid a deemed distribution of cash in excess of outside basis

Leveraged Mixing-Bowl Transactions and Additional Issues

309

Other Strategies to Keep in Mind with Mixing-Bowl Transactions

P

A B

Asset X Asset YV 10MB 1M

V 10MB 10M

C

49% 49%2%

V 10MB 10M

V 10MB 1M

Asset X

Prior to AJCA, Asset X takes stepped-up basis in B’s hands of 10M, and, if no section 754 election, basis of Asset Y is not reduced. Basis “stripped” from B’s interest in P and

transferred to Asset X P’s sale of Asset Y later yields no gain, but

distribution of sale proceeds would trigger gain to A of 9M

After AJCA, Asset X still takes a stepped-up basis in B’s hands, but, even if no section 754 election, Asset Y must be stepped down by 9M. no mandatory step down if Asset X’s basis

step-up <= 250,000 may be able to stagger distributions of

property to avoid 250,000 threshold

See amended section 734 (“substantial basis reduction” > 250,000).

310

P

A B

Asset X Asset YV 10MB 1M

V 10MB 10M

C

49% 49%2%

V 10MB 10M

V 10MB 1M

Asset Y

Prior to AJCA, Asset Y takes stepped-down basis in A’s hands of 1M, and, if section 754 election, basis of Asset X is increased by 9M. Basis “stripped” from Asset Y and

transferred to Asset X A has gained control of when to

recognize its built-in 9M gain prior to distribution, A may not

have had control over P’s sales of assets

Advantageous to A if Asset Y is nondepreciable

P’s sale of Asset X later yields no gain and distribution of sale proceeds to B should trigger no gain

After AJCA, no apparent change.

Other Strategies to Keep in Mind with Mixing-Bowl Transactions

311

P

A B

Asset X CashV 10MB 20M

V 10MB 10M

C

49% 49%2%

V 10MB 10M

V 10MB 20M

Cash

Prior to AJCA, A recognizes 10M loss, and, if no section 754 election, basis of Asset X remains 20M. P’s sale of Asset X later yields another 10M

loss, but any distribution of sale proceeds would trigger offsetting gain to B

After AJCA, A still recognizes 10M loss, and, even if no section 754 election, basis of Asset X reduced by 10M. See amended section 734(b). P’s sale of Asset X later yields no gain or loss,

and distribution of sale proceeds would yield no gain or loss to B

Amended section 704(c)(1)(C) overkill? Assuming Asset X was contributed by A with

the 10M built-in loss, amended section 704(c)(1)(C) would have prohibited B from taking into account the second 10M loss in the absence of amended section 734(b)

But what about loss arising after contribution?

Other Strategies to Keep in Mind with Mixing-Bowl Transactions

312

P

A B

Asset X CashV 10MB 20M

V 10MB 10M

C

49% 49%2%

V 10MB 10M

V 10MB 20M

1231Asset

3PCash

1231Asset

Instead of P distributing cash to A, P uses the cash to acquire an asset that is used in P’s trade or business for more than one year

P later distributes that asset to A A uses that asset in its trade or business for

more than one year A sells that asset when A does not recognize

any gain from other section 1231 property

If A would have received a cash distribution or sold its interest in P, it would have recognized a 10M capital loss

However, since A received a section 1231 asset, A can recognize an ordinary loss under section 1231(a) – but see section 1231(c) (5-year recapture period)

Other Strategies to Keep in Mind with Mixing-Bowl Transactions

313

P

A B

Asset X CashV 10MB 20M

V 10MB 10M

C

49% 49%2%

V 10MB 10M

V 10MB 20M

Prior to AJCA, A recognizes 10M loss, and, if no section 754 election, basis of Asset X unchanged. P’s sale of Asset X later yields another 10M

loss, but any distribution of sale proceeds would trigger offsetting gain to 3P

After AJCA, A still recognizes 10M loss, and, even if no section 754 election, basis of Asset X reduced by 10M. See amended section 743(b) (“substantial built-in loss”>250,000). P’s sale of Asset X later yields no gain or

loss, and distribution of sale proceeds would yield no gain or loss to 3P

“Substantial built-in loss” determined on aggregate basis – avoid with built-in gain property

3P

Other Strategies to Keep in Mind with Mixing-Bowl Transactions

314

P

A B

Asset X CashV 10MB 20M

V 10MB 10M

C

49% 49%2%

V 10MB 10M

V 10MB 20M

Amended section 704(c)(1)(C) overkill? Assuming Asset X was contributed by A with

the 10M built-in loss, amended section 704(c)(1)(C) would have prohibited 3P from taking into account the second 10M loss in the absence of amended section 743(b)

But what about loss arising after A’s contribution of Asset X?

3P

Other Strategies to Keep in Mind with Mixing-Bowl Transactions

315

P

A B

Asset X A stockV 10MB 1M

V 10MB 10M

C

49% 49%2%

V 10MB 10M

V 10MB 1M

Asset X

Prior to AJCA, Asset X takes stepped-up basis in B’s hands of 10M, and, if no section 754 election, basis of A stock is not reduced Basis “stripped” from B’s interest in P and

transferred to Asset X P’s sale of A stock later yields no gain, but

distribution of sale proceeds would trigger gain to A of 9M

After AJCA, Asset X still takes a stepped-up basis in B’s hands, but, even if no section 754 election, A stock must be stepped down by 9M But irrelevant since section 1032 protects A

from gain recognition However, after AJCA, since basis step down

normally would be made to A stock, amended section 755(c) requires that basis step down be made to “other property” instead If no “other property,” P recognizes 9M gain

Other Strategies to Keep in Mind with Mixing-Bowl Transactions

316

P

A B

Bus. A Cash

3PBus. A

Other Partnership Structuring Issues

10M

50% 50%

Bus. A CashV 10MB 10M

V 10MB 10M

V 10MB 10M

V 7MB 10M

Bus. A appreciates in P from 7M to 10M, then P sells Bus. A to 3P for 10M

For purposes of determining A’s tax consequences, the basis of Bus. A is 10M – so no gain or loss

For purposes of determining B’s tax consequences, appears that the basis of Bus. A is 7M -- see amended section 704(c)(1)(C). B may have 50% of 3M gain

allocated to it – is this right? Since there was no economic/book

gain or loss, should there be an offsetting 1.5M tax loss allocated to A?

317

P

HoldCo

A SubPublic

Co

Public

A wants to take Bus. A public but realizes that it will not be able to retain an 80%+ interest in the business after the IPO and it also does not want to trigger section 357(c) gain A forms HoldCo, A Sub, and Public Co. A transfers Bus. A to A Sub via merger, A Sub contributes

Bus. A to P. Public Co contributes cash raised in the IPO to P

All transactions should be tax-free (but see section 721(b)) Permits A/HoldCo to retain significant portion of upside without

an additional level of tax If A/HoldCo wants to exchange its indirect interest in P in tax-

free transaction, A Sub can merge with Public Co If A/HoldCo wants to exchange its indirect interest in P in

taxable transaction, A Sub can exchange its interest in P for Public Co stock

Public Co can contribute additional assets to P later tax-free since no 80% control requirement

Structure similar to UPREIT -- Treas. Reg. 1.701-2(d) ex. 4

Bus. ACash

Cash

<80%

Merger

Stock

Bus. A: V 30ML 20MB 10M

AOtherProp.

Other Partnership Structuring Issues

318

Acquiror

Cash

1

NewLLC

New LLC Int.

Property

2

Facts:

1. X contributes property, and Acquiror contributes cash, to New LLC/Partnership in exchange for LLC interests

2. Acquiror issues an option to X to transfer its LLC interest to Acquiror in exchange for stock of Acquiror after a period of years

XOption

Issues:

1. Length and term of option should confirm that X is a partner

2. Whether option is taxed to X upon receipt

Other Partnership Structuring Issues

319

P

A

A Sub

B

A has operated Bus. A since 1990 and has built up a substantial amount of goodwill

How should B acquire a portion of Bus. A? Alt. 1: If B purchases a portion of Bus. A and then

contributes it to P, the anti-churning rules of section 197 will preclude B from taking amortization deductions for its portion of the Bus. A goodwill.

Alt. 2: If A (and A Sub.) form P with Bus. A first, B purchases an interest in P from A, and P has a section 754 election, the anti-churning rules of section 197 will not apply to B’s portion of the Bus. A goodwill that is stepped-up via section 743(b) How much time should pass between formation

of P and sale of interest to B? Cf. Rev. Rul. 70-140

B cannot be otherwise related to P or A See section 197(f)(9); Treas. Reg. 1.197-2(k) exs.

18, 19

GW: V 30MB 0 M

Other Partnership Structuring Issues

320

P

A B How should B acquire a portion of Bus. A? (cont.)

Alt. 3: If A contributes Bus. A and B contributes other property to P, P can make remedial allocations of amortization to B

However, if P distributes B’s assets to A shortly after formation of P, could have disguised sale of property between A and P

See Treas. Reg. 1.197-2(g)(4), (h)(12)(vii), (k) ex. 17

GW: V 30MB 0 M

Bus. A Cash

Other Partnership Structuring Issues

321

Common Business Considerations in Mixing-Bowl Transactions• Generally, as business risk decreases, tax risk increases

– 99:1 sharing of interests in income, loss, and cash-flow– Preferred Interests– Puts and Calls– Obligating one party to contribute cash to P to ensure enough

cash flow to meet current distribution requirements– Insulating Bus. A assets from liabilities of Bus. B– Retaining operational control over contributed business

• Note that, if B contributes only cash or cost-basis assets, B may not care about tax risks– Recast as sale of Bus. A to B may not hurt (may even help) B

from tax perspective– Consider using Tax Indemnity Agreement in favor of A to

make B care about tax risks

322

• Possible techniques to reduce business risk without increasing tax risk– Restrict B’s right to manage Bus. A– Permit A to take over management of Bus. A if financial

distress– Require P to hire trusted third-party managers for Bus. A– Give A control (or veto right) over P’s tax returns and audits –

control tax treatment (particularly in first year)– Give A control (or veto right) over selection of P tax elections

• E.g., section 704(c) allocation method, section 754 election– Provide stated mechanism for determining FMV of contributed

assets for capital account and section 704(c) purposes– Prohibit P from disposing of Bus. A assets outside ordinary

course of business without approval of A (section 704(c)(1)(B))– Provide for tax liability distribution provision

Common Business Considerations in Mixing-Bowl Transactions

323

Carried Interest Legislative Proposal

324

Carried Interest Legislative Proposals

• On December 9, 2009, the House passed H.R. 4213 (the “Tax Extenders Act of 2009”).

• This extenders package included as a revenue offset a tax increase with respect to carried interests (and similar arrangements).

• This extenders package was referred to but not considered by the Senate Finance Committee.

• On December 22, 2009, Sen. Baucus (D-Mont) and Sen. Grassley (R-Iowa) sent a letter to the Senate Majority Leader and Minority Leader that conveyed a joint statement declaring their intent to address expiring tax provisions “as soon as possible” in the next year.

• Similar carried interest proposal included in Obama’s 2010 Budget Proposal• Similar carried interest proposals introduced and passed in 2007 and 2008

– Temporary Tax Relief Act of 2007– Alternative Minimum Tax Relief Act of 2008

325

Carried Interest Legislative Proposal

• Carried interest structures manifest themselves in different ways– Private equity funds– Venture capital funds– Hedge funds– Real estate development ventures– Natural resource ventures

• Following slides depict a private equity fund structure, but the same concepts and issues apply to the other carried interest structures as well

326

Simple Carried Interest Structure

Fund

MgmtCo.Investors

InvestmentManagers

U.S. individualsU.S. operating businessesFor. individualsFor. operating businessesPension plansEducation endowments

50%

50%

327

Simple Carried Interest Structure

Fund

MgmtCo.

Investors

InvestmentManagers

95% of Capital 5% of CapitalInv. Mgmt Agreement

328

Simple Carried Interest Structure

Fund

MgmtCo.

Investors

InvestmentManagers

Cash Investment Services

95% of Class A 5% of Class A100% of Class B

Interests in Fund illiquid

Holding for capital appreciation

329

Simple Carried Interest Structure

Fund

MgmtCo.

Investors

InvestmentManagers

Investment

XInvestment

YInvestment

Z

Inv. Mgmt Agreement

Investment management services used to invest contributed capital

330

Simple Carried Interest Structure

Years 1-61. Fund exercises control over companies2. Investments appreciate

MgmtCo.

Investors

InvestmentManagers

Investment

XInvestment

YInvestment

Z

Inv. Mgmt Agreement

Fund

331

Simple Carried Interest Structure

Year 7Fund closes out investments

and/or

InvestmentManagers

Investment

XInvestment

YInvestment

Z

PublicMarket

Investments liquidated via companies

Investments liquidated via public market

Investors MgmtCo.

Fund

332

Simple Carried Interest Structure

Fund

InvestmentManagers

End of Year 7Cash Proceeds& Taxable Gain

Cash Proceeds& Taxable Gain

Cash Proceeds& Taxable Gain

MgmtCo.

Investors

333

Current State of Play

• General economic expectation in Mgmt Co. market

– “2 and 20” (and moving toward “0 and 30”)

– No tax event upon issuance of Class B interests

– “2” taxed as ordinary income annually (35%)• Subject to self-employment taxes as well

– “20” taxed as long-term capital gain upon closing out investments/completing development (15%)

• Not subject to self-employment taxes

334

Statutory & Regulatory Framework

• Partner’s characterization of partnership profit– Entity theory prevails over aggregate theory

– Section 702(a)• Each partner takes into account distributive share of partnership’s

items of income, gain, loss, deduction, credit

– Section 702(b)• The partner’s character of any item of partnership income, gain, loss,

deduction, or credit “shall be determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership”

335

Statutory & Regulatory Framework

– Section 1402(a)• Partner’s distributive share of income that is capital gain excluded from

partner’s net earnings from self-employment– OASDI tax of 12.4% on first $106,800 of earnings– HI tax of 2.9% on all earnings

• This exception applies even for short-term capital gain (and most dividends and interest)

336

Statutory & Regulatory Framework

1. Fund recognizes gain when closes out its investments

2. Character of gain determined at partnership level

3. That gain allocated to partners

Current rules: Character of gain does notchange when partners take into account

Gain not subject to self-employment taxes if character is capital

Investors

InvestmentManagers

Investment

XInvestment

YInvestment

Z

Year 7Fund closes out investments

PublicMarket

Investments liquidated via companies

Investments liquidated via public market

and/or

MgmtCo.

Fund

337

Carried Interest Legislative Proposal

• Does address taxation of receipt of profits interest for services• Section 83 applies to (and default section 83(b) election made for) receipt of class B interest

– FMV = liquidation value (i.e., $0) : similar to current safe-harbor guidance and Prop. Reg. 1.721-1(b)

Fund

MgmtCo.

Investors

InvestmentManagers

95% of Class A 5% of Class A100% of Class B

Rangel bill – H.R. 4213 (Dec. 9, 2009)

Year 0

338

Year 7Fund closes out investments

Carried Interest Legislative Proposal

Primarily focuses on later point in structure -- when Fund recognizes capital gain upon liquidation of investments

InvestmentManagers

Investment

XInvestment

YInvestment

Z

PublicMarket

LTCG - sections 702, 703

LTCG - section 702

Investors MgmtCo.

Fund

Rangel bill – H.R. 4213 (Dec. 9, 2009)

339

Year 7Fund closes out investments

Carried Interest Legislative Proposal

Over-rides section 702 to convert long-term capital gain (15%) into ordinary compensation income (35%) for Mgmt Co.

InvestmentManagers

Investment

XInvestment

YInvestment

Z

PublicMarket

LTCG - sections 702, 703

Ordinary Income – H.R. 4213

Investors MgmtCo.

Fund

Rangel bill – H.R. 4213 (Dec. 9, 2009)

340

Carried Interest Legislative Proposal

• Main Rules – income tax– Net income regarding “investment services

partnership interest” (“ISPI”) = OI for performance of services

– Net loss regarding such interest = ordinary loss

• Only to extent of prior OI regarding same interest• Excess loss carried forward

Rangel bill – H.R. 4213 (Dec. 9, 2009)

341

Carried Interest Legislative Proposal

• Main Rules – self-employment tax (12.4%+2.9%)

– Net income regarding ISPI also treated as net earnings from self-employment (“NESE”)

– General exception from NESE for distributive share of “limited partner” overridden (huge expansion of tax base)

– General exception for capital-related income overridden (e.g., dividends, interest, and capital gain)

– Managers may already be subject to ordinary income tax rate on Fund income due to quick turnover of investments (s.t.c.g.), butthese managers likely have not been subject to self-employment taxes on such income (2.9% HI tax in play)

Rangel bill – H.R. 4213 (Dec. 9, 2009)

342

Carried Interest Legislative Proposal• Upon disposition of ISPI

– “any gain” recognized treated as OI for performance of services• Earlier proposal (H.R. 1935) even broader: all gain realized treated as OI upon any

disposition (e.g., 351, 721, 731 transactions)– loss treated as ordinary loss only to extent of aggregate net income over

aggregate net loss regarding such interest– suspended losses permanently lost upon disposition

• Distribution of appreciated property with respect to ISPI – BIG recognized– BIG treated as increase only to ISPI holder’s taxable income (not other partners)

• Earlier proposal (H.R. 2834) even broader: BIG recognized at entity level and allocable in accordance with partnership agreement (other partners could have taken portion of BIG into account upon distribution)

– FMV of such property treated as cash distribution for section 731 purposes (e.g., could trigger gain to ISPI partner if O/B insufficient)

– Basis of property adjusted to FMV in ISPI partner’s hands

Rangel bill – H.R. 4213 (Dec. 9, 2009)

343

Carried Interest Legislative Proposal

• Key Determination: To what extent is Mgmt Co.’s interest in Fund = ISPI?– ISPI defined broadly

• Administration’s 2010 budget proposal even broader –applies to “services partnership interest”

– Captures structures well beyond typical private equity (e.g., real estate structures)

Rangel bill – H.R. 4213 (Dec. 9, 2009)

344

Carried Interest Legislative Proposal

• Key Determination: To what extent is Mgmt Co.’s interest in Fund = ISPI?– ISPI =

• Any interest in partnership• Held by any person• Directly or indirectly• If was reasonably expected• Such person (or any related person) would provide• Directly or indirectly• “Substantial quantity” of any of following services to partnership with

respect to any specified asset held (directly or indirectly) by the partnership– Advising as to advisability of investing in, purchasing, or selling any “specified asset,”– “managing,” “acquiring,” or “disposing of” any “specified asset,”– Arranging financing with respect to acquiring a “specified asset,” or– Any “activity in support” of above activities

Rangel bill – H.R. 4213 (Dec. 9, 2009)

345

Carried Interest Legislative Proposal

– “Specified asset” =• Any security (very broad) -- section 475(c)(2)• Real estate held for rental or investment• Interest in a partnership• Commodities – section 475(e)(2)• Any option or derivative contract with respect to any of above

assets

Rangel bill – H.R. 4213 (Dec. 9, 2009)

346

Carried Interest Legislative Proposal

• ISPI exception for contributed capital (qualified capital interest - QCI)

– Exception: All tax items allocated to qualified capital interest (QCI) of ISPI not recast into ordinary income or loss if allocations to qualified capital interest of ISPI are

• Made in same manner as allocations made to other qualified capital interests held by unrelated partners who do not provide tainted services, and

• Allocations made to such other interests are “significant” compared to the allocations made to qualified capital interest at issue

Rangel bill – H.R. 4213 (Dec. 9, 2009)

347

Carried Interest Legislative Proposal

• ISPI exception for contributed capital (qualified capital interest - QCI)

– Qualified capital interest = portion of ISPI equal to• Increases:

– FMV of contributed property– Amounts included under section 83 upon issuance of ISPI– Net income allocated to partner attributable to qualified capital interest

• Decreases:– Distributions with respect to qualified capital interest– Net loss allocated to partner attributable to qualified capital interest

Rangel bill – H.R. 4213 (Dec. 9, 2009)

348

Carried Interest Legislative Proposal

– What is not excepted?• Allocate greater portion of income to invested capital

than any non-service partner would have been allocated for same amount of contributed capital

• E.g., Mgmt Co. cannot contribute small amount of capital and have Fund allocate majority of Fund capital gain to capital portion of Mgmt Co.’s interest to avoid recharacterization of capital gain to OI

Rangel bill – H.R. 4213 (Dec. 9, 2009)

349

Carried Interest Legislative Proposal

• ISPI exception for contributed capital (qualified capital interest)– Dispositions of Qualified Capital Interests: Proportional

amount of disposition gain regarding ISPI attributable to qualified capital interest not recast as ordinary income (or loss)

– Practical Issue: May be easier to demonstrate to IRS that particular portion of partnership interest is QCI if interest split into separate classes (e.g., class B unit in exchange for services (ISPI) and class A unit in exchange for capital (QCI))

Rangel bill – H.R. 4213 (Dec. 9, 2009)

350

Carried Interest Legislative Proposal

• Effective Date:– Generally, taxable years ending after 12/31/09

• Revenue estimate: $25B over 10 years– Estimate has remained fairly constant since

original introduction in 2007– ES codification = less than $10B over 10 years

Rangel bill – H.R. 4213 (Dec. 9, 2009)

351

Carried Interest Legislative Proposal

• Positions in favor

– “The man of great wealth owes a peculiar obligation to the State, because he derives special advantages from the …existence of government. Not only should he recognize this obligation in the way … he earns and spends his money, but it should also be recognized by the way in which he pays for the protection the State gives him. … [H]e should assume his full and proper share of the burden of taxation ….” (President Theodore Roosevelt, 1906 message to Congress)

• Opening statement of Senator Max Baucus for carried interest congressional hearing on July 11, 2007

352

Carried Interest Legislative Proposal

– Distributive share of Mgmt Co. from Fund (and related distribution rights) are disguised OI compensation for services

• Not a return on financial capital invested by Mgmt Co.• If purpose of lower capital gains rates is to encourage investors to put

financial capital at risk, does not appear much reason to make such preference available to Mgmt Co., since risk involves Mgmt Co.’s time and effort rather than financial capital

– Eliminate inequity: performance-based income of most managers taxed as OI and subject to self-employment taxes

353

Carried Interest Legislative Proposal

• Positions in opposition

– Would stifle innovation in U.S. (e.g., venture capital funds usesame structure)

– Would push more capital to foreign markets

– Would inhibit companies from expanding• Unemployment would increase

– Would further aggravate “credit crunch” since acceptable risk level for private equity investments would decrease

354

Carried Interest Legislative Proposal

– Typical private equity investors (such as pension funds and education endowments) would suffer

– “20” is not wholly a return on labor• A mixture of return on capital (know-how, IP, contacts, implicit

compensation reinvested, debt responsibility) and return on labor• Economically and administratively difficult to determine what portion of

income relates to capital and what portion relates to labor– Model treating Mgmt Co. as having interest-free use of 20% of Investors’ capital

» Could be used as alternative to carried interest proposals, but complex– “2” represents return on labor already

355

Carried Interest Legislative Proposal• Positions in opposition

– OI compensation paid generally without regard to success of business (minimal risk), investment manager can enjoy “20” only if and to extent business is successful (entrepreneurial risk-taking/clawback)

– Too broad – e.g., captures typical real estate structures used for decades (cash equity + sweat equity)

• “[T]he most sweeping and potentially most destructive tax increase on real estate since the modification of passive loss rules of the 1986 Tax Reform Act” -- Int’l Council of Shopping Centers & The Real Estate Roundtable (July 31, 2007)

• Impact greatest for developments in underserved communities

356

Carried Interest Legislative Proposal

– Just unprincipled “revenue grab” from easy political targets

– Can structure around -- “20” increased to “35”

– Will not generate significant revenue

357

Fund

InvestmentManagers

Carried Interest Legislative Proposal

Loan of 20%of Target Capital Level

Capital Contributions

80% of Class A 20% of Class A

Planning around Rangel bill?

OI for Mgmt Co. for section 707(c) guaranteed payment for investment services (offset by interest expense for Mgmt Co.)

Interest income for Investors (offset by allocation of deduction for section 707(c) guaranteed payment to Mgmt Co.)

Mgmt Co. repays loan upon liquidation of Fund’s investments

What interest rate will Investors demand on loan?

Do Mgmt Co.’s Class A interests qualify as a qualified capital interest, thereby avoiding the carried interest recast to OI?

Investors MgmtCo.

Rangel bill – H.R. 4213 (Dec. 9, 2009)

358

Fund

InvestmentManagers

Carried Interest Legislative Proposal

80% of Class A 20% of Class A

Planning around Rangel bill?

Bank

Loan of 20%of Target Capital Level

Capital Contributions

MgmtCo.

Investors

Rangel bill – H.R. 4213 (Dec. 9, 2009)

Do Mgmt Co.’s Class A interests qualify as a qualified capital interest, thereby avoiding the carried interest recast to OI?

359

Carried Interest Legislative Proposal

• Can businesses transfer functions and income to offshore tax haven to avoid carried interest proposals?

• Can businesses issue convertible/contingent debt (instead of pure equity) to avoid carried interest proposals?

• If they do either of the above, could they be subject to heightened penalty regime?

Rangel bill – H.R. 4213 (Dec. 9, 2009)

360

Carried Interest Legislative Proposal

• The Future– House has passed carried interest twice in past 2

years– Obama administration’s 2010 budget includes a

carried interest proposal– Revenue estimate is 2 and ½ times larger than

current economic substance codification proposals

361

Application of Sections 267 and 707 in Partnership Transactions Involving Loss Property –

Can I Recognize the Loss?

362

Recognizing Tax Benefits from Economic Downturns -- Loss Recognition & Section 707(b)

What if X has a 50% capital interest and a 60% profits interest in LLC?What if X has a 50% capital interest and profits interest in LLC?What if X has a 50% capital interest and profits interest in LLC, except for a contingent right to 51% of certain profits?What if X has a right to reacquire the Property for FMV after a period of 2 years?

LLCDevelopmentJoint Venture

XInvestor

(Unrelated to X)

PropertyV - $150MB - $200M

$100M

$50M

X is managing member

363

Appendix

364

List of Anti-Abuse RulesCode ProvisionsSection 197(f)(9)(F)Section 269Section 269ASection 336(d)(2)(B)Section 355(a)(1)(D)Section 357(b)Section 382(l)(1)(A)Section 467(b)(4)(B)Section 482Section 542(c)(8)Section 751(b)(3)(B)Section 845(b)Section 864(f)(5)(B)Section 953(e)(7)(C)Section 954(h)(7)Section 1298(d)(3)(B)Section 7872(c)(1)(D)Section 7874(c)(4)

Treasury RegulationsTreas. Reg. § 1.43-4(e)(1)Treas. Reg. § 1.45D-1(g)(1)Treas. Reg. § 1.56-1(c)(5)(i)(D)Treas. Reg. § 1.62-2(k)Treas. Reg. § 1.105-4(a)(3)(i)(B)Treas. Reg. § 1.141-14Treas. Reg. § 1.142(a)(5)-

1(b)(2)(ii)Treas. Reg. § 1.148-10Treas. Reg. § 1.149(g)-1Treas. Reg. § 1.150-1(c)(5)Treas. Reg. § 1.150-2(h)Treas. Reg. § 1.168(i)-1(e)(3)(vi)Treas. Reg. § 1.197-2(j)Treas. Reg. § 1.246-5(c)(1)(vi)Treas. Reg. § 1.263A-1(j)(4)Treas. Reg. § 1.263A-7(c)(4)Treas. Reg. § 1.263A-15(c)Treas. Reg. § 1.269B-1(b)(2)Treas. Reg. § 1.337(d)-4(a)(3)(iii)Treas. Reg. § 1.338-1(c)Treas. Reg. § 1.367(a)-

3(d)(2)(vi)(D)Treas. Reg. § 1.367(a)-6T(h)Treas. Reg. § 1.367(d)-1T(g)(6)

Treas. Reg. § 1.367(e)-1(b)(6)Treas. Reg. § 1.367(e)-2(d)Treas. Reg. § 1.401(k)-1(b)(3)Treas. Reg. § 1.414(c)-5(f)Treas. Reg. § 1.444-1T(b)(5)(iii)Treas. Reg. § 1.444-2T(b)(3)Treas. Reg. § 1.446-3(i)Treas. Reg. § 1.460-4(k)(4)Treas. Reg. § 1.460-6(d)(3)Treas. Reg. § 1.461-4(d)(5)(iii)Treas. Reg. § 1.468A-6(g)(1)Treas. Reg. § 1.468B-3(a)(2)Treas. Reg. § 1.513-4(d)(2)Treas. Reg. § 1.597-3(g)Treas. Reg. § 1.701-2Treas. Reg. § 1.701-3(a)(10)Treas. Reg. § 1.704-4(f)Treas. Reg. § 1.731-2(h)Treas. Reg. § 1.737-4Treas. Reg. § 1.752-2(j)Treas. Reg. § 1.761-2(d)(3)(iv)Treas. Reg. § 1.846-2(c)Treas. Reg. § 1.863-3(c)(1)(iii)Treas. Reg. § 1.865-1(c)(6)Treas. Reg. § 1.881-3

Treas. Reg. § 1.883-2(d)(4)Treas. Reg. § 1.884-5(d)(4)(iv)Treas. Reg. § 1.897-1(o)(2)(iv)Treas. Reg. § 1.897-3(e)Treas. Reg. § 1.897-9T(d)(1)(iii)Treas. Reg. § 1.954-1(b)(4)Treas. Reg. § 1.954-

2(a)(3)(ii)(A)Treas. Reg. § 1.988-2(e)(2)(v)Treas. Reg. § 1.1221-2(g)(2)(iii)Treas. Reg. § 1.1275-2(g)Treas. Reg. § 1.1275-6(d)(1)(iii)Treas. Reg. § 1.1296-2(b)(3)Treas. Reg. § 1.1374-4(i)(5)(iii)Treas. Reg. § 1.1441-3(b)(2)(ii)Treas. Reg. § 1.1445-1(c)(2)(ii)Treas. Reg. § 1.1445-5(b)(5)(ii)Treas. Reg. § 1.1502-13(h)Treas. Reg. § 1.1502-32(e)Treas. Reg. § 1.1502-

95(e)(2)(vi)Treas. Reg. § 1.4958-7(b)(2)