Leveraged Partnership a Disguised Sale


In a recent ruling, the Tax Court found that a transfer of assets to an LLC constituted a disguised sale. The court also determined that the taxpayer was liable for an accuracy-related penalty in excess of $36 million for substantial understatement of income tax. The petitioner, Canal Corp. & Subsidiaries, formerly Chesapeake Corp. & Subsidiaries (Chesapeake), disputed the IRS claim of a $524 million gain and resulting deficiency of more than $183 million related to a series of transactions in 1999.


In the late 1990s, Chesapeake sought to sell its largest subsidiary, Wisconsin Tissue Mills Inc. (WISCO), but ruled out a direct sale because of WISCO’s low tax basis. Instead, in 1999, it entered into a leveraged partnership structure with Georgia Pacific (GP) that required the two companies to transfer certain business assets to a joint venture, Georgia-Pacific Tissue LLC, which would then borrow funds from a third party and distribute the proceeds to Chesapeake as a special distribution. GP guaranteed the third-party debt, and Chesapeake agreed to indemnify the joint venture’s debt. GP agreed to reimburse WISCO for any tax cost it might incur in a buyout by GP of WISCO’s interest in the joint venture. Chesapeake’s indemnity agreement limited its obligation to only the principal of the joint venture’s debt, which was due in 30 years. It also required GP to first seek indemnification from the joint venture’s assets. WISCO’s transfer of assets to the LLC gave it a 5% ownership interest. In 2001, WISCO sold its LLC interest to GP, and GP sold its entire interest in the LLC to an unrelated third party. Chesapeake reported the gain from the sale on its consolidated return in 2001.


Under IRC §§ 721 and 731, partners may contribute capital to a partnership and receive distributions of previously taxed profits without recognizing gain or loss. However, under section 707(a)(2)(B) such treatment is not available for mutual transfers between a partner and partnership of money or property that, when viewed together, are properly characterized as a sale or exchange of property (“disguised sale”). When such contributions and distributions occur within two years of each other, they generally are presumed to be a disguised sale. However, Treas. Reg. § 1.707-5(b)(1) provides an exception for an allocable share of the partner’s liability in certain debt-financed transfers.


The IRS determined that the gain should have been reported in 1999, when WISCO contributed its assets to the LLC, and that the transaction was a disguised sale. Chesapeake argued that the exception to the disguised sale rules for debt-financed transfer of consideration limited the applicability of the disguised sale rules and the two-year presumption.


The court found that WISCO had no economic risk of loss and should not be allocated any part of the debt incurred by the LLC. Consequently, the distribution of cash to WISCO did not fit within the debt-financed-transfer exception to the disguised sale rules. As a result, the Tax Court held, WISCO’s transfer of its assets to the LLC was a disguised sale under section 707(a)(2)(B) resulting in a gain that should have been recognized by Chesapeake on its consolidated return in 1999.


The court also upheld the IRS’ assessment of the substantial understatement penalty under section 6662(a). Chesapeake contended that no penalty should be imposed because it relied in good faith on a “should” opinion from its adviser (a partner in an accounting firm). Stating that the “should” opinion from the adviser “looks more like a quid pro quo arrangement than a true tax advisory opinion,” the court agreed with the IRS that the taxpayer did not act in good faith in relying on the opinion.


  Canal Corp. & Subsidiaries v. Commissioner , 135 TC no. 9


By Alice A. Upshaw, CPA, MPA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., McCray Professor of Business and Professor of Accounting, both of the College of Business, West Texas A&M University, Canyon, Texas.


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