Leveraged partnerships continue to receive attention as a way to sell property without triggering a tax. This one failed, but not by much.
Company A had property it wanted to sell. It contributed the property to a partnership with other partners. The partnership borrowed on a nonrecourse basis against the property and distributed the cash to Company A.
The IRS is always on the lookout for disguised sales of property to partnerships. Such a sale will be assumed when one partner contributes property and receives back cash from the partnership within two years. However, IRS regulations make a number of exceptions. One exception is where the partnership borrows against the property and distributes the cash to the partner whose property it was within 90 days. The partner may have gotten back cash within two years of contributing property, but he will not be treated as having sold the property as long as the cash he received is no more than his share of the loan the partnership took out to pay the cash.
What is his share of the loan? Most nonrecourse debt at the partnership level is considered borne by partners in the same ratio as they divide up the taxable income of the partnership. However, partners are free to agree on a different percentage as long as that percentage is consistent with how they share in some “other significant item.”
In this case, the business deal among the partners is that Company A had a “senior preferred interest” in the partnership. It got cash equal to its preferred return each year before other partners were distributed any cash. It was also allocated an amount of “gross income” for tax purposes equal to the cash it was distributed each year before any income was allocated to anyone else.
The partners agreed on allocating 100% of the debt to Company A. This avoided a disguised sale. Company A argued that this was consistent with an “other significant item” — the fact that 100% of gross income was allocated to Company A each year up to a certain amount.
The IRS said no in a “technical advice memorandum.” A “technical advice memorandum” is a ruling by the IRS national office to settle a dispute between a taxpayer and an IRS agent arising from an audit.
The national office said a tranche of gross income or taxable income can never be a “significant item.” Rather, the phrase refers to partnership income of a certain character type, such as gains from the sale of property or tax-exempt income. The ruling is TAM 200436011. The IRS made it public in early September.