Step Right Up

BY EDWARD J. SCHNEE

The Tax Court upheld as having economic substance a partnership’s nearly $12 million distribution of notes to redeem partners’ interests in real estate on which the partnership claimed a step-up in basis. The IRS had denied the partners’ resulting nonrecognition of gain on grounds that the distribution consisted of either cash or marketable securities and that the partnership was not entitled to step up its basis.

The partnership, Countryside Limited Partnership, was owned by Arthur M. Winn, Lawrence H. Curtis and others. Countryside owned a 448-unit residential property in New Hampshire that it planned to sell at a gain. Before the sale, Countryside and a limited liability corporation it indirectly owned borrowed a total of $11.9 million at the London Interbank Offered Rate (LIBOR) plus 175 basis points. The LLC used the cash to purchase four privately issued notes paying interest at LIBOR minus 55 basis points. The partnership distributed its interest in another LLC indirectly holding the notes to redeem the partnership interests of Winn and ­Curtis. The partnership made a section 754 election and increased the basis of the real estate, eliminating the gain on its sale. The Service concluded, however, in a final partnership administrative adjustment that the distribution created taxable gain to Winn and Curtis. Winn sought a partial summary judgment on that issue, which the Tax Court granted and issued a memorandum opinion.

Section 731 generally provides for nonrecognition of gain or loss on partnership distributions that don’t exceed a partner’s outside basis. One method previously used to avoid excess gain was to purchase and distribute marketable securities instead of cash. In response, Congress enacted section 731(c), which treats marketable securities as cash for purposes of section 731.

The government argued that the notes were marketable. To be marketable securities, notes must either be traded on an exchange or subject to an arrangement to convert them into marketable securities. These notes were not traded on an exchange, and the fact that their terms could be modified wasn’t sufficient to ­constitute an arrangement for conversion to marketability, the court said.

The government secondarily argued that the distribution lacked economic substance. It stated that the interest expense on the borrowed funds would always exceed the interest income on the notes purchased with those funds. But the Tax Court said the Service was evaluating the wrong transaction. The distribution, not the loan, was at issue. Since the distribution of the notes terminated the partners’ interests in the partnership and the real estate, it had economic substance and could not be disregarded.

In similar cases, courts have ruled against taxpayers (see, for example, ACM Partnership v. Commissioner, TC Memo 1997-115, on contingent installment sales). This case awaits a final decision, and it was unclear whether the IRS will file an appeal, which would be to the District of Columbia Circuit.

n Countryside Limited Partnership v. Commissioner, TC Memo 2008-3

Prepared by Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

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