Government Appeals Tax Court Decision on Leveraged Partnership Transactions, Anti-Abuse Rules
Government Appeals Tax Court Decision on Leveraged Partnership Transactions, Anti-Abuse Rules
On May 12, the Department of Justice (DOJ) filed its opening brief in its appeal to the Seventh Circuit of the Tax Court’s decision in Tribune Media Co. v. Commissioner (T.C. Memo 2021-122). The government views the Tax Court’s ruling as paving the way for inappropriate income tax planning, potentially enabling taxpayers to follow the roadmap created by the taxpayer in Tribune Media to implement leveraged partnership transactions without triggering taxable gain while avoiding incurring meaningful economic risk.
The appeal is primarily focused on perceived errors by the Tax Court in applying a liability allocation anti-abuse rule under Treas. Reg. §1.752-2(j) and the general partnership anti-abuse rule under Treas. Reg. §1.701-2. If successful on appeal, the case would likely be remanded to the Tax Court for a determination regarding applicability of the liability allocation and general anti-abuse rules. It is unclear whether the Tax Court would reach a different conclusion upon remand.
The initial brief submitted by DOJ contains a discussion of factors determined to be relevant in concluding the taxpayer’s guarantee was without substance. Consideration should be given to these factors – summarized in the conclusion of this alert – when structuring or evaluating transactions.
Summary of Relevant Facts
In 2009, Tribune Media Company completed a transaction in which it contributed the Chicago Cubs baseball team to a partnership in exchange for an interest in the partnership plus a $714 million cash distribution. Under the disguised sale of property rules in section 707(a)(2)(B), the $714 million would be viewed as a consideration received in connection with a partial sale of the Chicago Cubs baseball team. However, through use of liability guarantees, a significant portion of the debt used to fund the cash distribution was allocated to Tribune Media. Under an exception to the disguised sale rules, distributions funded by debt allocated to the distributee are not treated as disguised sale consideration.
Based on rules described in Treas. Reg. §1.752-2, to the extent a partner bears economic risk of loss (EROL) with respect to a liability, the liability will be allocated to the partner. For purposes of determining whether a taxpayer has EROL with respect to a particular liability, the regulations provide for an analysis relying on hypothetical facts. Under Treas. Reg. §1.752-2(b), a partner bears EROL with respect to a liability to the extent that, if the partnership constructively liquidated, the partner or a related person would be obligated to make a payment with respect to the liability. For purposes of this analysis, regulations require the constructive liquidation to be determined under all the following hypothetical facts:
- All the partnership’s liabilities become payable in full.
- With the exception of property contributed to secure a partnership liability (see Treas. Reg. §1.752-2(h)(2)), all the partnership’s assets, including cash, have a value of zero.
- The partnership disposes of all its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditors’ right to repayment is limited solely to one or more assets of the partnership).
- All items of income, gain, loss or deduction are allocated among the partners.
- The partnership liquidates.
To benefit from the debt financed distribution exception to the disguised sale rules, Tribune Media agreed to guarantee a portion of the debt used to fund the distribution. The objective of this guarantee was to create EROL resulting in an allocation of the liability to Tribune Media. Based on the terms of the executed agreements and the general rules described in Treas. Reg. §1.752-2, Tribune Media properly bore EROL. As shown on applicable income tax returns, partnership liabilities were allocated to Tribune Media and reflected its EROL.
Liability Allocation Anti-Abuse Rule
Upon examination, the IRS concluded that the parties’ attempt to create EROL violated the anti-abuse rule under Treas. Reg. §1.752-2(j), which generally provides that an obligation of a partner to make a payment may be disregarded if facts and circumstances indicate that a principal purpose of the arrangement is to eliminate the partner’s EROL with respect to that obligation.
As discussed in both the Tax Court’s opinion and DOJ’s opening appeals brief, the parties structured an arrangement that met the literal requirements to create EROL under Treas. Reg. §1.752-2. However, under the government’s view of the facts, Tribune Media did not bear meaningful risk of loss. The government noted that that “[t]he Tax Court and Tribune itself concluded that Tribune had no more than a ‘remote’ risk under the Senior Guarantee” with “myriad protections in place that all but assured Tribune would never be called upon to repay any portion of the Senior Debt.”
It appears that, in evaluating applicability of the section 752 anti-abuse rule, the Tax Court focused on the fiction that is deemed to occur for purposes of determining EROL under Treas. Reg. §1.752-2. Consequently, the Tax Court assumed the debt became due and all relevant assets became worthless. Under this interpretation, Tribune Media would be called upon to satisfy the outstanding liability. Consequently, the Tax Court concluded that the actual and remote risk to Tribune Media wasn’t relevant to the anti-abuse rule under Treas. Reg. §1.752-2(j). With this ruling the Tax Court would significantly limit the potential effectiveness of the anti-abuse rule.
The government views the reference in Treas. Reg. §1.752-2(j) to “facts and circumstances” to mean a required analysis of the actual economic arrangement of the parties. This contrasts with the view apparently taken by the Tax Court. In the Tax Court’s analysis, the anti-abuse analysis was conducted under the lens of the hypothetical factual assumptions required under the general rule of Treas. Reg. §1.752-2(b). The different views, of course, could have dramatic results in terms of whether and when the anti-abuse rule may apply.
General Partnership Anti-Abuse Rule
In addition to the liability allocation anti-abuse rule under Treas. Reg. §1.752-2(j), the government has also taken issue with the Tax Court’s application of the general partnership anti-abuse rule under Treas. Reg. §1.701-2. In its decision, the Tax Court noted that the Treas. Reg. §1.701-2 anti-abuse rules apply only “to the function of the partnership as a whole.” The government, on the other hand, points out that Treas. Reg. §1.701-2(a)(2) requires that “[t]he form of each partnership transaction must be respected under substance over form principles.”
Ultimately, DOJ believes the Tax Court has misapplied the general anti-abuse rule. Acknowledging that the totality of the transaction may have had a business purpose, analyzing specific aspects under the general anti-abuse rule is appropriate. Similar to the discussion around the liability allocation anti-abuse rule, a recharacterization of the loan guarantee could have a significant impact on the tax consequences to the parties involved.
Based on the status of the Tribune Media case and the government’s appeal, there are a few important factors for consideration and reasonably drawn conclusions.
The government disagrees with the manner in which the Tax Court applied both the liability allocation anti-abuse rule and the general anti-abuse rule. It is reasonable to conclude that, if faced with a similar fact pattern, the IRS will challenge application of the debt-financed distribution exception to the disguised sale rules. In its brief, DOJ described the following factors as critical in its determination that the loan guarantee was without economic substance:
- The Cubs’ baseball club had strong revenue flow and structural protections built into the transaction ensuring the ability of the Cubs to meet its financial obligations. In particular, the Cubs had stable and growing cash flow streams from long-term media rights agreements along with strong ticket sale revenue. Debt service arrangements were structured to pull from these cash flow streams.
- As part of obtaining approval from Major League Baseball to complete the transaction, several parties to the transaction executed an operating support agreement intended to provide a “financial safety net” to the Cubs in times of economic uncertainty.
- To prevent potential creditor seizure of the Cubs baseball team, the Commissioner of Major League Baseball had the authority to take significant actions, including requiring funding additional equity contributions, the sale of the team and the provision of a super-senior loan to fund operating expenses.
- There is unique value to the collateral associated with a major league baseball team. Based on S&P valuations, upon a distressed asset sale, a 40% reduction in the value of the collateral would still yield significant value.
- Tribune Media documented its belief that the possibility of its guarantees would be called upon was remote. On its financial statements, Tribune Media disclosed the guarantees in the notes but did not record a liability, create a reserve, or report any value associated with the guarantees.
The Tax Court evaluated application of both the liability allocation anti-abuse rule and the general anti-abuse rule. The Tax Court concluded that the liability allocation anti-abuse rule was inapplicable. This conclusion was premised on application of the hypothetical transactions described in Treas. Reg. §1.752-2(b), i.e., the loan becomes due and payable, and the obligor has no assets with which to satisfy the obligation. Under this assumption, the Tax Court concluded that the remoteness of the guarantor’s obligation is not relevant. If this approach is accurate, application of the liability allocation anti-abuse rule would certainly seem to be significantly limited. If appropriate to analyze this anti-abuse rule under actual facts, it’s unclear whether the Tax Court would have reached a different end result.
Until resolved on appeal, taxpayers should be able to rely on the Tax Court’s ruling in Tribune Media to structure transactions involving debt-financed distributions. However, taxpayers should likewise be prepared for IRS challenge if audited.