Did Canal Corp. sink the leveraged partnership transaction?

• Author: Weber, Neal A.

A recent decision by the Tax Court illustrates the limitations of the leveraged partnership exception to the disguised sale rules of Sec. 707(a)(2)(B). That provision requires sale or exchange treatment when (1) there is a direct or indirect transfer of money or other property by a partner to a partnership, (2) there is a related direct or indirect transfer of money or other property by the partnership to such partner (or another partner), and (3) the transfers described in (1) and (2), when viewed together, are properly characterized as a sale or exchange of property.

Facts of Canal Corp.

In Canal Corp., 135 T.C. No. 9 (2010), the taxpayer attempted to monetize an appreciated asset without triggering taxable gain, purporting to rely upon a regulatory exception from the disguised sale rules. The exception is intended to apply, essentially, when a partner is not truly cashing out of an asset--by contributing it and obtaining a cash distribution from the partnership--because the partner remains liable on partnership debt.

Canal Corporation contributed assets with an agreed-upon value of $775 million in exchange for a 5% interest in an LLC (taxed as a partnership) and a special cash distribution of $755.2 million. The other member of the LLC, Georgia Pacific, contributed assets with an agreed-upon value of $376.4 million. Georgia Pacific guaranteed the bank loan used to obtain the $755.2 million of cash distributed to Canal, but Canal partially indemnified Georgia Pacific as to that guarantee. Such an indemnification could in theory have resulted in Canal's being the ultimate obligor on the bank loan. However, the indemnification applied only to principal payments, required Georgia Pacific to proceed first against the assets of the LLC (of which it was a majority owner) before proceeding against Canal, and increased Canal's interest in the LLC to the extent it made payments under the indemnity.

Making matters ostensibly worse, Georgia Pacific did not insist on the indemnity as a business matter. Instead, Canal provided it, following the advice of its tax advisers, in order to ensure that it was considered to be ultimately liable on the bank loan and thus to ensure that it was not viewed as cashing out of its contributed asset in a disguised sale for tax purposes. Nevertheless, the transaction was characterized as a sale for financial accounting purposes, and Canal recorded no book liability for Canal's potential liability under the...