Many taxpayers have been able to reduce their taxes in transactions involving contingent liabilities, leading Congress to change subchapter C and the Treasury Department to change the regulations under IRC section 752. In July 2006, a district court reviewed the definition of a liability and Treasury’s ability to make regulations retroactive and ruled in favor of the taxpayer.
St. Croix Ventures and Rogue Ventures, single-member LLCs, each borrowed $41.7 million from a bank at 17.97% interest. They each received the principal and a $25 million “loan premium” in exchange for the above-market interest rate. The loans required interest for seven years and repayment of principal at the end of the period. The LLCs agreed to pay a declining penalty if they repaid the loans early. Each LLC invested its total amount, $66.7 million, in Klamath LLC and Kinabalu LLC, respectively, for 90% partnership interests. The partnerships assumed the debt. Several months later, St. Croix and Rogue withdrew from the partnerships. The partnerships repaid the debt and distributed cash to the LLCs. The IRS classified the $25 million loan premium as a liability; the taxpayer disagreed.
Result. The court first decided whether the loan premium was a liability for purposes of IRC section 752. At the time of this transaction, in 2000, the regulation did not define a liability. Prior cases—Helmer v. Commissioner and Long v. Commissioner—held that contingent liabilities are not liabilities for purposes of section 752. A contingent liability is one that is not fixed; it does not become a liability until it becomes fixed or liquidated. Since the loan premium was not repayable unless the loan was prepaid, and that event was not certain to occur, the loan premium was contingent and not a liability.
The government also argued the contingent amounts had to be classified as liabilities to maintain the equality of inside and outside basis. The court acknowledged that much of partnership taxation is designed to maintain this equality. However, it does not always exist. In fact, the government has argued against equality when it was in its interest to do so. Therefore, the court rejected the need for equality when a disparity served the taxpayer’s interest.
The final issue was whether Treasury Regulation section 1.752-6, issued June 24, 2003, could be applied retroactively to affect the outcome of the case. Regulations are not generally applied retroactively, but they can be. Before examining the general rules for retroactive regulations, the court said the level of deference accorded an interpretive regulation was less than for a statutory regulation. Since the court ruled the regulation was interpretive, it considered the general rules for retroactive regulations. The court listed four items that affected the decision: (1) whether the taxpayer was reasonable in relying on prior law or policy; (2) whether Congress implicitly approved the prior law by re-enactment of relevant code sections; (3) whether retroactive application would cause equal taxpayers to be taxed differently; and (4) whether retroactive application would result in a harsh outcome. The court concluded that factors 1, 2 and 4 favored the taxpayer and 3 was neutral and denied retroactive application of the regulation.
In May 2005, the Treasury Department issued final regulation section 1.752-7, which approaches contingent obligations differently than the regulation in question in this case and the approach taken for corporate taxpayers. This case is still relevant for the definition of liabilities and the retroactivity of regulations.
Klamath Strategic Investment Fund LLC v. United States, 440 F. Supp.2d 608; 98 AFTR2d 2006-5495 (DC Tex., 2006).
Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.