In 2016, the IRS and Treasury Department issued temporary regulations under the section 707 disguised sale rules that effectively turned off the debt-financed distribution exception by providing that all liabilities would be allocated for disguised sale purposes in accordance with a partner’s interest in partnership profits, regardless of whether the liability was a recourse or non-recourse liability. In 2018, proposed regulations were published that repealed the temporary regulations and reinstated the prior rules, including the debt-financed distribution exception, with retroactive effect.
In particular, section 12 of the Discussion Draft contains a proposal to require “all debt [to] be shared between the partners in accordance with partnership profits,” a proposal that would effectively revive the approach of the 2016 proposed regulations. Just a month after, in October 2021, the Tax Court decided which involved a disguised sale transaction and the debt-financed distribution exception.
This article provides an overview of the disguised sale rules and the debt-financed distribution exception. Part I provides background of subchapter K rules. Part II explains the disguised sale rules under section 707(a)(2)(B) and discusses Tribune Media as an illustrative example. Continuing the discussion of Tribune Media, Part III analyzes the debt-financed distribution exception and introduces the concept of “economic risk of loss.”
I. Subchapter K Background and Otey
Several provisions in subchapter K work in tandem to execute this policy goal. Under section 721(a), a partner generally does not recognize gain or loss upon contribution of property to a partnership in exchange for an interest in the partnership, and any precontribution gain or loss is preserved until a future recognition event. Under section 731(a), a partner generally does not recognize loss on non-liquidating distribution, nor gain on the receipt of a distribution from a partnership, except to the extent a cash distribution exceeds the partner’s basis in its partnership interest. Thus, the amount of a partner’s basis in the partner’s partnership interest determines the extent to which gain is recognized by the partner upon receipt of a cash distribution from the partnership.
The taxpayer-friendly rules allow taxpayers to structure transactions that are otherwise taxable as related tax-free contributions and tax-free distributions. For instance, a “disguised sale” occurs when a taxpayer transfers property to a partnership in exchange for an interest in the partnership and receives cash or property from the partnership in a way that renders the transaction a sale. Otey involved a taxpayer from Nashville, Tennessee who wanted to sell the land he inherited from his uncle to a real estate developer. The partners treated the taxpayer’s transfer of the land to the partnership as a contribution of capital under section 721. The partnership subsequently took out a construction loan of approximately $870,000 and, pursuant to the partnership agreement, distributed one-half of the loan proceeds to the taxpayer. The taxpayer argued that the distribution of cash by the partnership was tax free under section 731 because his basis in the partnership ($18,500 plus his one-half share of the partnership’s construction loan under section 752) exceeded the amount of cash distributed to him. The IRS, on the other hand, contended that the contribution and distribution of cash functioned in substance as a taxable sale of his land to the partnership.
II. Section 707(a)(2)(B) Disguised Sale Rules
Section 707(a)(2)(B) gives the Treasury Secretary the authority to prescribe regulations and establish criteria to determine whether related contributions and distributions are, in substance, a sale of property. Under section 707(a)(2)(B), a transaction is a taxable sale if: (i) there is a direct or indirect transfer of money or other property by a partner to a partnership, (ii) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and (iii) the transfers, when viewed together, are properly characterized as a sale or exchange of property.
Tribune Media provides a clear example of a disguised sale under section 707(a)(2)(B). That case involved the sale (the Cubs transaction) of the Chicago Cubs Major League Baseball team (the Cubs assets) by Tribune Media Co. (Tribune) to the Ricketts family.Tribune and the Ricketts family agreed to form a partnership, with Tribune contributing the Cubs assets in exchange for a 5 percent interest and the Ricketts family contributing $150 million in exchange for a 95 percent interest. As required by the formation agreement, the partnership made a special distribution to Tribune on the closing date of approximately $705 million, financed by a combination of the equity contribution by the Ricketts family and the partnership’s debt. Tribune did not dispute that nature of the Cubs transaction; in fact, it reported the Cubs transaction on its 2009 tax return as a disguised sale.
III. Section 707 Debt-Financed Distributions Exception and Economic Risk of Loss
One exception to the disguised sale rules is the debt-financed distribution exception.To determine a partner’s “allocable share” of the partnership’s debt, subchapter K adopts a concept of economic risk of loss (EROL). As noted in Part I, how partnership liabilities are allocated is fundamental to subchapter K, and EROL is the key mechanism by which partnership liabilities are allocated under subchapter K.
This EROL test considers the worst-case scenario: all partnership assets, including cash, become worthless, all of the partnership’s liabilities become payable in full, and the partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditor is limited solely to particular assets of the partnership), after which it liquidates. To the extent that a partner is “on the hook” for the partnership’s debt in this scenario, the liabilities are recourse and allocated to the partner.
Partnerships and partners have used various arrangements, such as guaranties, assumptions, and indemnity agreements, to influence the manner in which partners share the EROL with respect to partnership debts. If the arrangement is valid and sufficiently obligates the partner under the doomsday scenario, the debt is respected as a recourse debt.
In Tribune Media, Tribune conceded that the Cubs transaction – the contribution of Cubs assets worth $735 million followed by a special cash distribution to Tribune of approximately $705 million – was a disguised sale but argued that it should be allowed to offset a portion of the taxable gain on the special cash distribution, under the debt-financed distribution exception, to the extent it guaranteed collection of the partnership’s debt.
The Tax Court emphasized that under the doomsday scenario, the low probability of Tribune’s fulfillment of its obligation is “irrelevant” because the test assumes a worst-case scenario under which everything, including the “buffers,” is rendered worthless and the debt guaranty is called. The regulation asks who, in this worst-case scenario, the creditors would look to for payment of the debt.
President Biden signed the Act on August 16, 2022. The bill does not modify subchapter K, leaving debt-financed distributions, as still, the name of the subchapter K game. Given recent congressional focus on subchapter K reform and the lively debate taking place in the tax community, however, it may be too early for 'team maximum flexibility' to declare victory. Subchapter K reform may still be on Congress’s radar.