Presenting a live 110 ‐ minute teleconference with interactive Q&A Leveraged Partnership Transactions and Tax Opinions Since Canal Corp. Structuring Transactions and Tax Advisor Engagements to Withstand IRS Scrutiny and Avoid Penalties WEDNES DAY, JUNE 22, 2011 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific Today’s faculty features: Jonathan M. Prokup, S Jonathan M Prokup S hareholder Chamberlain Hrdlicka West Conshohocken Pa hareholder, Chamberlain Hrdlicka , West Conshohocken, Pa. Robert Heller, Partner, Covington & Burling , New Y ork Attendees seeking CPE credit must listen to the audio over the telephone. Please refer to the instructions emailed to registrants for dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10 .
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Overview of the Presentation Overview of the Presentation • Introduction to Transaction, Technical Tax Issues and The Understatement Penalty Issues, and The Understatement Penalty • Leveraged Partnerships – Lessons of Canal g p • Tax Opinion Practice Following Canal 5
The taxpayer sought to dispose of a business in a tax-efficient manner. b i i t ffi i t Chesapeake Ch k 4 I d Indemnification for Debt ifi ti f D bt WISCO GP 1 1 2 2 4 3 LLC LLC Borrowed Funds Borrowed Funds 6
Leveraged partnerships raise basic questions about substance-over-form. ti b t b t f • Tax consequences generally apply to legal forms • Can lead to disparate treatment of transactions with the same substance transactions with the same substance • The tax law is replete with statutory/ regulatory anti-abuse rules and judicial doctrines 7
Canal Corp . highlights several technical t tax issues for leveraged partnerships. i f l d t hi • Allocation of recourse liabilities • Sufficiency of capital backing indemnity Sufficiency of capital backing indemnity – Quality vs. quantity • Subchapter K anti abuse rules • Subchapter K anti-abuse rules – Section 752 anti-abuse rule – General anti-abuse rule G l ti b l 8
Canal Corp . also illustrates increasing standards for protection from penalties. t d d f t ti f lti • I.R.C. § 6662(b)(2): 20-percent penalty on substantial understatement of income tax • Courts increasingly skeptical of taxpayer claims of reasonable cause and good faith claims of reasonable cause and good faith • After codification, conflation of judicial doctrines now more dangerous 9
Leveraged Partnerships – Leveraged Partnerships Lessons of Canal Robert Heller rheller@cov.com 212.841.1077
Basics Disguised Sales • Treas. Reg. § 1.707-3(a)(1): if a transfer of property by a partner to a partnership and one or more transfers of money or other consideration by the transfers of money or other consideration by the partnership to that partner [have the same economic effect as a sale], the transfers are treated as a sale of property, in whole or in part, to the partnership. – An exception to the return of basis first rule of partnership distributions 11 11
Basic Disguised Sale A B A B property x property x $$ LLC LLC property x $$ • A has property with • Related distribution of some amount of some amount of cash from LLC to A in h f LLC t A i basis that A would exchange for A’s like to monetize. property contribution • A contributes equal to A’s basis in q property x to LLC for the property an interest in the LLC 12 12
Basics Leveraged Disguised Sales • Treas. Reg. § 1.707-5(b)(1): If a partner transfers property to a partnership, and the partnership incurs a liability. . ., the transfer of money or other consideration to the partner is taken into account id ti t th t i t k i t t [under the disguised sale rules] only to the extent that the amount of money or the fair market value of the other consideration transferred exceeds that partner's other consideration transferred exceeds that partner s allocable share of the partnership liability . (emphasis added) • Leveraged partnership structures turn on liability Leveraged partnership structures turn on liability allocation 13 13
Basic Leveraged Disguised Sale Basic Leveraged Disguised Sale Structure A B A B A B $$ Bank $$ LLC LLC LLC property x • A contributes • LLC borrows from • Loan proceeds property x to LLC for property x to LLC for bank bank di t ib t d t A distributed to A an interest in the LLC • A guarantees debt or otherwise ensures 752 allocation 14
Liability Allocation • Recourse liabilities governed by Treas. Reg. § 1.752-2 – Who bears the economic risk of loss? • Assume partnership’s asset become worthless and all parties perform obligations (contractual or otherwise) • S bj Subject to the anti-abuse rule of Treas. Reg. § 1.752-2(j) t t th ti b l f T R § 1 752 2(j) • Special rule for disregarded entity under Treas. Reg. § 1.752-2(k) • Nonrecourse liabilities governed by the “third tier” allocation rule for “excess nonrecourse liabilities” of Treas Reg § 1 752-3(a)(3) excess nonrecourse liabilities of Treas. Reg. § 1.752 3(a)(3) – Partner’s share of partnership profits – Partnership agreement may specify if “reasonably consistent with allocations. . .of some other significant item of partnership income or gain” 15
What are the real issues in Canal • Allocation of recourse liabilities – Adequately capitalized guarantee • Retention of a significant economic interest vs. sale R t ti f i ifi t i i t t l • Financial statement impact – More than a remote chance of liability under the guarantee More than a remote chance of liability under the guarantee • Anti-abuse case (in more than just the 752 sense) 16
Nonrecourse Leveraged Nonrecourse Leveraged Partnerships - TAM 200436011 • Facts (simplified) – TP contributed assets to P; P borrowed and distributed proceeds to TP – TP received senior preferred interests in P entitling it to 100% of TP i d i f d i i P i li i 100% f gross income up to the coupon on the preferred – TP did not guarantee the P debt – Partnership agreement specified that 100% of the P borrowing was Partnership agreement specified that 100% of the P borrowing was allocated to TP under Treas. Reg. § 1.752-3(a)(3) relying on the gross income allocation • Financial statement issue solved because there is no TP guarantee t 17
TAM 200436011 • IRS disagreed with TP’s argument that the gross income allocation was a “significant item” of partnership income or gain – “Significant item” refers to a certain character or type – Gross income allocation does not reflect true economic sharing – Although not clear from TAM, TP likely retained a relatively small partnership interest • Easier to find abusive Easier to find abusive • But what if TP retained a significant economic ownership in the partnership? – Partial deferral 18
Partial Deferral and Dispositions • Example: LBO of privately-held business – Business held in flow-through form – Seller will roll-over significant equity (20%) – Buyer will finance 50% of purchase price • Assume $80m paid for 80% of company • Transaction can be structured as a leveraged partnership t hi – Seller achieves deferral on its rolled over equity and $8m of cash – Canal does not impact this transaction – Canal does not impact this transaction 19
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