Tax Court Respects Steps in Deferral Transaction

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January 31, 2008

In Countryside v. Commissioner, TC Memo 2008-3 (filed Jan. 2. 2008), the Tax Court ruled favorably for a partner on an economic substance challenge by the IRS where a parent partnership incurred debt, formed lower-tier partnerships (which purchased non-marketable securities) and made a liquidating distribution to the partner of interests in the lower-tier partnerships. The decision was filed in response to the partner's partial summary judgment motion.

The transaction was intended to provide the distributee partner with deferral on his gain in the parent partnership interest while providing the parent partnership with a positive basis adjustment in property it sold shortly after the distribution. The parent partnership, Countryside LP, was owned by individuals A, B and C, and a corporation owned by A and B. CLP owned residential property (the Manchester Property).

In October of 2000, the following steps occurred:

  1. CLP borrowed $8.5 million from a bank (Bank),
  2. CLP contributed the $8.5 million to a federal tax partnership (CLPP) in exchange for a 99 percent interest (a corporation owned by A owned a one percent interest in CLPP),
  3. CLPP contributed $8.5 million to another federal tax partnership (MP) in exchange for a 99 percent interest (another corporation owned by A owned a one percent interest in MP),
  4. MP borrowed $3.4 million from Bank, and
  5. MP used the $8.5 million and the $3.4 million to buy four privately issued notes from a financial institution (Notes).

On Dec. 26, 2000, CLP distributed its 99 percent interest in CLPP to A and B in complete liquidation of their interests in CLP, leaving C and a corporation as the only federal tax partners in CLP. On Jan. 26, 2001, CLP executed a sales agreement for the Manchester Property, closing the sale in April 2001. During the time at hand, CLPP apparently owned only its interest in MP and a small amount of money, and MP apparently owned only the Notes and some money.

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The parties treated the distribution on Dec. 26, 2000, as a distribution by CLP of property to a partner in liquidation of the partner's interest in CLP. A, B and CLP treated the distribution as not giving rise to gain under section 731. CLP and CLPP each had a section 754 election in effect at that time. MP did not have a section 754 election in effect. A's and B's outside basis in CLP was less than CLP's basis in the CLPP interests distributed to them. CLP claimed a positive basis adjustment to the Manchester Property under section 734(b)(1)(B).

The IRS argued that the liquidating distribution to A and B should be disregarded under economic substance grounds in part because CLP could not have made a profit on the incurrence of the debt and the acquisition of the Notes. The interest rate on the debt exceeded the interest return on the Notes. The IRS apparently argued that CLP should be treated as having (indirectly) distributed money to A and B. Citing Coltec, ACM and other economic substance and business purpose cases, the court found that the transactions at hand accomplished the non-tax business purpose of converting A's and B's interest in the Manchester Property into an interest in the Notes, causing the two remaining partners in CLP to bear 100 percent of the burdens and benefits associated with the Manchester Property.

The court had little difficulty rejecting the IRS's argument that the Notes were marketable securities within the meaning of section 731(c).

The next issue the court will likely face is whether CLP is allowed to increase the basis of the Manchester Property. The parties did not reduce the basis of the Notes, which MP owned. MP did not have a section 754 election in effect when CLP made the liquidating distribution of CLPP interests to A and B. The court did not rule on whether the lack of a section 754 election by MP, the partnership owned 99 percent by CLPP, prevents CLP from adjusting the tax basis of its property under the flush language of section 743(b).

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