Chief counsel disregards indemnification agreements under anti-abuse rules in transactions that result in disguised sales.

• Author: Lipman, Benjamin

On June 14, 2013, the IRS issued Chief Counsel Advice (CCA) 201324013. The CCA focuses on the treatment of leveraged partnership transactions and the consequence of indemnity agreements in regard to disguised sales. In the CCA, the Office of Chief Counsel (OCC) advised that an indemnification agreement should be disregarded and, accordingly, the underlying partner contribution and distribution should be treated as a disguised sale under Sec. 707(a)(2)(B). The OCC based its conclusion on the precedents established in Canal Corp., 135 T.C. 199 (2010), and the anti-abuse rules under Regs. Sec. 1.752-2(j).

Background

Partnership taxation is renowned for its flexibility as well as its complexity. Two or more parties can decide to establish a business by contributing assets to the partnership in exchange for a partnership interest, and generally neither the partnership nor the partners recognize gain or loss (Sec. 721(a)). To forestall potential tax abuse, the IRS has an arsenal of weapons at its disposal for challenging a perversion of the partnership rules, including challenging the economic substance of a transaction and recharacterizing a partnership contribution of property as a disguised sale (Regs. Sec. 1.707-3), as well as applying the anti-abuse rules of Regs. Sec. 1.752-2(j).

In general, if a partner transfers property to a partnership and that partner receives one or more transfers of money or other consideration by the partnership, the transfer may be treated as a sale of property, in whole or in part, to the partnership (Regs. Sec. 1.707-3(a)(1)). Regs. Sec. 1.707-3(c)(1) states that transfers occurring within two years of a contribution to the partnership are assumed to be a sale of the property to the partnership unless the facts and circumstances clearly establish that a transfer does not constitute a sale.

Facts of the CCA

In year 2, A purchased Corporation X, which in year 1 had been a C corporation but converted to an S corporation effective date 1. Originally, A had planned for X to retain certain select assets while selling others. However, A changed his mind after X's business started to deteriorate. X began negotiations with several potential buyers for the sale of the contributed assets and decided upon Y as the purchaser. Y was willing to accept X's desired structure. Since X was an S corporation, there would be no corporate-level tax. However, X would potentially be subject to built-in gains tax under Sec. 1374(a) if the assets were disposed of within 10 years after date 1.

Corporation X had...