A Leveraged Partnership

A leveraged partnership

December 12, 2002 | By Keith Martin in Washington, DC

A leveraged partnership transaction is under attack from the IRS.

With many power companies trying to sell assets to raise cash to make debt payments, there is a premium on finding a way to do so without triggering taxes on gains. Lower taxes mean more cash for the power company.

One approach some companies have considered using is to sell the assets through a leveraged partnership. The seller contributes the power plant to a partnership. The buyer contributes assets that generate cash. The partnership then borrows against the cash-generating assets and distributes the borrowed funds to the seller to redeem most of its partnership interest.

Under the IRS regulations, such a transaction will ordinarily be recharacterized as a “disguised sale” of the power plant if the seller contributes assets and is distributed cash within two years by the partnership. However, IRS regulations make an exception where the cash is money the partnership has just borrowed within the last 90 days, and the debt at the partnership level is “allocable” to the partner to whom the cash is distributed. Sellers make sure the debt is allocable to them by guaranteeing repayment of the partnership debt. This gets the assets off the seller’s hands and cash to the seller without an immediate income tax.

However, an internal IRS memorandum made public in November takes issue with the transaction. The IRS national office argues in the memorandum that the transaction in fact is a disguised sale. It suggests a number of grounds for attacking the transaction. One is that the guarantee of the partnership-level debt by the seller is a “sham” since the seller is a special-purpose entity that is too undercapitalized to make good on the guarantee.

The agency also suggests arguing that the transaction is in substance a sale of assets, despite the form. The IRS suggests this argument can be used where the seller announced an intention to sell assets and negotiated for such a sale before trying to structure the transaction to save on taxes. The IRS memorandum is ILM 200246014.