Partnership freezes after Castle Harbour.

• Author: Pope, Heidi

A closely held C corporation that is growing rapidly or plans to enter into a new line of business may consider the creation of a "frozen" limited liability company (LLC)/partnership (frozen partnership) to reduce its income tax liability and shift future appreciation out of the corporation. However, if the frozen partnership's existence is invalidated, there could be unintended income and/or gift tax consequences to the partners of the putative partnership. In light of recent IRS victories, these risks should be taken seriously.

Service Victories

Recently, the IRS was successful in invalidating the partnership form as a sham transaction; see Boca Investerings Partnership, 314 F3d 625 (DC Cir. 2003) (partnership form must be needed to accomplish a nontax business purpose, otherwise the partnership is a sham), and Asa Investerings Partnership, TC Memo 1998-305 (absence of a nontax business purpose is fatal to the legitimate existence of a partnership). The Service was also successful in attacking an "abusive" arrangement, arguing that a purported interest in a partnership constituted a debt, thus causing a reallocation of income to the other partners; see TIFD III-E, Inc., 2d Cir., 8/3/06, rev'g and rem'g TIFD III-E, Inc., 342 FSupp2d 94 (DC CT 2004) (Castle Harbour). These cases are largely viewed as tax-shelter cases; the tax benefit obtained by the shift of taxable income to a nontaxable entity appears to have greatly influenced the court's decision. Thus, it is unclear if the courts would rule the same absent the tax-shelter aspect.

What Is a Partnership Freeze?

Typically, a closely held C corporation establishes a separate LLC/partnership with its shareholders. The shareholders may be family members or highly valued employees of a C corporation that contributes the bulk of the capital or a portion of its fixed assets to the venture and acts as the LLC/ partnership's manager. In exchange, the C corporation receives a "preferred" interest, in that it is entitled to certain profit allocations and cash distributions before they are received by the other partners. Allocations/distributions in excess of this "preferred" amount are generally capped or disproportionately small compared to the corporation's capital contribution. The corporation's interest is known as a "frozen" interest.

Shareholders, on the other hand, contribute relatively little capital to the venture and generally act as limited partners, with minimal involvement in...