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Leveraged Partnership Transactions and Tax Opinions Since Canal Corp.Structuring Transactions and Tax Advisor Engagements to Withstand IRS Scrutiny and Avoid Penalties

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, JUNE 22, 2011

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Jonathan M Prokup Shareholder Chamberlain Hrdlicka West Conshohocken PaJonathan M. Prokup, Shareholder, Chamberlain Hrdlicka, West Conshohocken, Pa.

Robert Heller, Partner, Covington & Burling, New York

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Overview of the PresentationOverview of the Presentation

• Introduction to Transaction, Technical Tax Issues and The Understatement PenaltyIssues, and The Understatement Penalty

• Leveraged Partnerships – Lessons of Canalg p

• Tax Opinion Practice Following Canal

5

The taxpayer sought to dispose of a b i i t ffi i tbusiness in a tax-efficient manner.

Ch kChesapeake

I d ifi ti f D bt

4

WISCO GP

1 2

Indemnification for Debt

1 2

LLC Borrowed Funds

34

6

LLC Borrowed Funds

Leveraged partnerships raise basic ti b t b t fquestions about substance-over-form.

• Tax consequences generally apply to legal forms

• Can lead to disparate treatment of transactions with the same substancetransactions with the same substance

• The tax law is replete with statutory/ regulatory anti-abuse rules and judicial doctrines

7

Canal Corp. highlights several technical t i f l d t hitax issues for leveraged partnerships.

• Allocation of recourse liabilities• Sufficiency of capital backing indemnitySufficiency of capital backing indemnity

– Quality vs. quantity• Subchapter K anti abuse rules• Subchapter K anti-abuse rules

– Section 752 anti-abuse ruleG l ti b l– General anti-abuse rule

8

Canal Corp. also illustrates increasing t d d f t ti f ltistandards for protection from penalties.

• I.R.C. § 6662(b)(2): 20-percent penalty on substantial understatement of income tax

• Courts increasingly skeptical of taxpayer claims of reasonable cause and good faithclaims of reasonable cause and good faith

• After codification, conflation of judicial doctrines now more dangerous

9

Leveraged Partnerships –Leveraged Partnerships Lessons of Canal

Robert [email protected]

212.841.1077

Basics Disguised Sales

• Treas. Reg. §1.707-3(a)(1): if a transfer of property by a partner to a partnership and one or more transfers of money or other consideration by thetransfers of money or other consideration by the partnership to that partner [have the same economic effect as a sale], the transfers are treated as a sale of property, in whole or in part, to the partnership.– An exception to the return of basis first rule of partnership

distributions

1111

Basic Disguised Sale

A B A B

property x

LLC LLC

$$property x

• A has property with some amount of

• Related distribution of h f LLC t A i

property x$$

some amount of basis that A would like to monetize.

• A contributes

cash from LLC to A in exchange for A’s property contribution equal to A’s basis in

1212

property x to LLC for an interest in the LLC

qthe property

Basics Leveraged Disguised Sales

• Treas. Reg. § 1.707-5(b)(1): If a partner transfers property to a partnership, and the partnership incurs a liability. . ., the transfer of money or other

id ti t th t i t k i t tconsideration to the partner is taken into account [under the disguised sale rules] only to the extent that the amount of money or the fair market value of the other consideration transferred exceeds that partner'sother consideration transferred exceeds that partner s allocable share of the partnership liability. (emphasis added)

• Leveraged partnership structures turn on liabilityLeveraged partnership structures turn on liability allocation

1313

Basic Leveraged Disguised SaleBasic Leveraged Disguised Sale Structure

A BA B A B

LLCLLC LLC

$$Bank

$$

• LLC borrows from bank

• A contributes property x to LLC for

• Loan proceeds di t ib t d t A

property x

bank• A guarantees debt or

otherwise ensures 752 allocation

property x to LLC for an interest in the LLC

distributed to A

14

Liability Allocation

• Recourse liabilities governed by Treas. Reg. § 1.752-2– Who bears the economic risk of loss?

• Assume partnership’s asset become worthless and all parties perform obligations (contractual or otherwise)S bj t t th ti b l f T R § 1 752 2(j)• Subject to the anti-abuse rule of Treas. Reg. § 1.752-2(j)

• Special rule for disregarded entity under Treas. Reg. § 1.752-2(k)

• Nonrecourse liabilities governed by the “third tier” allocation rule for “excess nonrecourse liabilities” of Treas Reg § 1 752-3(a)(3)excess nonrecourse liabilities of Treas. Reg. § 1.752 3(a)(3)

– Partner’s share of partnership profits– Partnership agreement may specify if “reasonably consistent with

allocations. . .of some other significant item of partnership income or gain”

15

What are the real issues in Canal

• Allocation of recourse liabilities– Adequately capitalized guarantee

R t ti f i ifi t i i t t l• Retention of a significant economic interest vs. sale• Financial statement impact

– More than a remote chance of liability under the guaranteeMore than a remote chance of liability under the guarantee

• Anti-abuse case (in more than just the 752 sense)

16

Nonrecourse LeveragedNonrecourse Leveraged Partnerships - TAM 200436011• Facts (simplified)

– TP contributed assets to P; P borrowed and distributed proceeds to TPTP i d i f d i i P i li i 100% f– TP received senior preferred interests in P entitling it to 100% of gross income up to the coupon on the preferred

– TP did not guarantee the P debt– Partnership agreement specified that 100% of the P borrowing wasPartnership agreement specified that 100% of the P borrowing was

allocated to TP under Treas. Reg. § 1.752-3(a)(3) relying on the gross income allocation

• Financial statement issue solved because there is no TP tguarantee

17

TAM 200436011

• IRS disagreed with TP’s argument that the gross income allocation was a “significant item” of partnership income or gain– “Significant item” refers to a certain character or type– Gross income allocation does not reflect true economic sharing– Although not clear from TAM, TP likely retained a relatively small

partnership interest• Easier to find abusiveEasier to find abusive

• But what if TP retained a significant economic ownership in the partnership?– Partial deferral

18

Partial Deferral and Dispositions

• Example: LBO of privately-held business– Business held in flow-through form– Seller will roll-over significant equity (20%)– Buyer will finance 50% of purchase price

• Assume $80m paid for 80% of company• Transaction can be structured as a leveraged

t hipartnership– Seller achieves deferral on its rolled over equity and $8m of

cash– Canal does not impact this transaction– Canal does not impact this transaction

19

Loan Secured by Partnership Interest

• In Re: G-I Holdings, Inc., 105 AFTR 2d 2010-697– Contribution to a partnership coupled with a

partner-level borrowing that was recourse only to the partnership interestthe partnership interest

• $480m of assets contributed and $450m borrowed• Partnership also issued a preferred interest to service the

partner le el debtpartner-level debt

20

In Re: G-I Holdings, Inc.

• Court purports to apply a disguised sale analysis– Treats the partner-level borrowing as a partnership borrowing

• Legislative history supports this in appropriate cases where the partnership is in s bstance ser icing the debtpartnership is in substance servicing the debt

• But more of an anti-abuse case then a disguised sale case– Before promulgation of leveraged distribution regulations– Risk of loss and opportunity for gain minimized– Risk of loss and opportunity for gain minimized

• Very different case if taxpayer retained a greater economic interest– Intent of taxpayer to sell emphasized

• Analysis if Treas. Reg. § 1.707-5 appliedy g § pp

21

Pre-Canal Authority

• CCA 200246014 – classic leveraged partnership– Undercapitalized guarantee (when better credit available)

Guarantee only of principal– Guarantee only of principal– Lender must exhaust remedies first against partnership– Announced plan to sell or spin-off– Treas. Reg. § 1.752-2(j) anti-abuse rule applied

• Like Canal, very similar to the anti-abuse example– No guidance on what is undercapitalized– No guidance on what is undercapitalized

22

Disregarded Entity Net Value Rule

• Treas. Reg. § 1.752-2(k)– Economic risk loss only born to the extent of

DRE’s net value excluding partnership interest• More than a negative inference

– Preamble to -2(k) regulations explicit that a strict net value rule does not apply outside the DRE context

23

Canal Revisited

• Why was the indemnity considered undercapitalized?– Indemnitor’s net value

Quality of its assets– Quality of its assets– Counterparty considerations

• Ability of partnership to service debty p p– Can the § 1.752-2(j) anti-abuse rule trump the assumption

that partnership’s assets become worthless?

24

Partnership Assumptions of PartnerPartnership Assumptions of Partner Debt

• If only qualified liabilities assumed, no disguised sale• Treas. Reg. § 1.707-5(a)(1)

– Similar rule to debt-financed distributions – if the partnership assumes or takes property subject to a

liability of the partner other than a qualified liability, the partnership is treated as transferring consideration to the partner to the extent that the amount of the liability exceedspartner to the extent that the amount of the liability exceeds the partner's share of that liability immediately after the partnership assumes or takes subject to the liability. (emphasis added)

2525

PLR 201103018

• Contribution of property along with assumption of some nonqualified liabilities

T t d th t th lifi d– Taxpayer represented that the nonqualified liabilities would be allocated to it under Section 752

– Liabilities were not qualified for a technical reason and only for a moment in time

• No abuse = no disguised saleg

26

Partner Assumption of Partner Debt

• Facts same as PLR 201103018 except:– All liabilities assumed are qualified liabilities under Treas.

Reg § 1 707-5(a)(6)Reg. § 1.707-5(a)(6)– Partnership distributes back to contributing partner same

asset as contributed

T h i l l i• Technical analysis– No disguised sale because only qualified liabilities assumed– No §737 gain recognition under §737(d)§ g g § ( )

27

Partnership Anti-Abuse Rule

• Even where the specific 752 anti-abuse rule is avoided, the general partnership anti-abuse rule is relevant– Business purpose

I th i t ti t d t j i t b i– Is there an intention to conduct joint business activities?

28

Final Lessons

• Well capitalized guarantees– Both quality and quantity

• Try to stay out in front of client• Retention of a significant partnership interest• Partial deferral is valuable too

29

Tax Opinion Practice Following Canal C ti C i iCorporation v. Commissioner

Strafford Publications

Jonathan ProkupChamberlain [email protected] 772 2340 J 22 2011610.772.2340 June 22, 2011

www.taxblawg.net

IntroductionThe Tax Shelter Wars’ Latest Victim The Ta OpinionVictim – The Tax Opinion

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Chamberlain Hrdlicka 32

The tax shelters wars have undermined the use of opinions for penalty protection.

2004: Congress enacts I.R.C. § 6662A, imposing l i bl ipenalties on reportable transactions.

I.R.C. § 6664(d): reasonable cause defense for “reportable t ti ” i t b li th t t t itransaction” requires taxpayer believe the treatment is “more likely than not” proper.

2010: Congress codifies the economic substance 2010: Congress codifies the economic substance doctrine with its associated strict-liability penalty.

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Judicial skepticism of tax-advantaged transactions compounds the problem

Conflation of economic substance and other anti-b d iabuse doctrines: Schering-Plough Corp. v. United States, 651 F.Supp.2d

219 (D N J 2009)219 (D.N.J. 2009).

Canal Corp. avoided this confusion, but fell into th t ti d i tanother: treating advisors as promoters.

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Roadmap of presentation

Deconstructing Canal: bad facts or not, its influence is unlikely to be limited on that basis.unlikely to be limited on that basis.

Implications for Taxpayers: understand the distinction between risks that you can mitigate and those you cannot.

Implications for Practitioners: are courts trying to turn i i ti i t “ tt t ti ” i ?opinion practice into an “attestation” service?

The Future of Tax Opinions: they’re about more than just penalty protection; they have to be

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just penalty protection; they have to be.

Part OneDeconstructing Canal Corp. v. CommissionerCommissioner

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The court took a dim view of the taxpayer’s reliance on its advisor’s opinion.

Advisor’s advice was unreasonable: Did not think the work product justified the price tag.

Purportedly assumed away key facts .

Taxpayer did not act with good faith: Advisor's “interest” in closing the transaction created a g

conflict that rendered the opinion unreliable.

Equated advisor’s role with being a “promoter”.

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Was it really the advisor’s “unreasonable” factual assumptions that bothered the court?

“…the opinion was riddled with questionable conclusions and unreasonable assumptions ”conclusions and unreasonable assumptions. The only specific “assumption” identified was that WISCO

would maintain assets equal to 20 percent of the debt.q p

“We are also troubled by the number of times the draft opinion uses ‘it appears.’” “…assumed that the indemnity would be effective and that

WISCO would hold assets sufficient to avoid the anti-abuse rule ”

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abuse rule.


Will Canal Corp. be perceived simply as a “bad facts” case?

“Should” opinion without on-point authority.

B i b l i But reasoning by analogy is common.

Taxpayer submitted only a draft opinion into evidence.

Taxpayer, ratings agencies, stock analysts treated the transaction as a sale for financial accounting purposes.

B t diff b t b k d t t t t But differences between book and tax treatment are common.

Indemnity backed by assets with value equal to only 20 percent

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Indemnity backed by assets with value equal to only 20 percent of exposure.


Did the contingent nature of the engagement create a conflict?

Two views of the same facts:d d i d ld Taxpayer: company trusted advisor and would not

participate in the transaction without “should” opinion. Government: contingent fee gave advisor “a large stake Government: contingent fee gave advisor a large stake

in the outcome”.

Common to have the closing of transactions be contingent upon obtaining tax opinions.

Distinguish between contingency based on tax i d i b d l i

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savings and contingency based on closing.


The government’s position raises larger questions about the nature of tax planning.

Leveraged partnerships are a common form of tax l iplanning.

Government argued the case as a tax shelter: Argued for recharacterization under substance-over-form.

Most authorities cited in court filings arose from traditional "tax shelter" cases.

Consistent with “economic substance” challenges to h f i

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other types of common transactions.


Why didn’t the court conduct a “substantial authority” analysis?

Taxpayer never raised substantial authority defense.

Absence of analysis suggests the court was treating the transaction as a “tax shelter”. I.R.C. § 6662(d)(2)(C): exception for substantial

authority does not apply to “tax shelters” (i.e., an arrangement with a significant purpose of avoiding tax)arrangement with a significant purpose of avoiding tax)

The New Normal: for tax planning transactions – no matter how common substantial authority might

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matter how common – substantial authority might not be enough.

Part TwoNavigating the New Normal: Implications for Ta pa ersImplications for Taxpayers

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After the tax shelter wars, taxpayers face a new reality in tax penalty litigation.

Corporate taxpayers face higher standards for l i t d irelying on tax advisors.

In-house practitioners are sophisticated consumers of advice.

Did C l C h b d di " h ld" i i ? Did Canal Corp. overreach by demanding a "should" opinion?

Likewise, sophisticated transactions are subject to t tiextra scrutiny.

Not about everyday compliance with a complex system.

D lib l l i i h d k f h l

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Deliberately playing in the dark corners of the tax law.


Are second opinions the antidote to potential conflicts of interest?

Taxpayer: United States v. Boyle, 469 U.S. 241, 251 (1985) means that second opinions are not necessary(1985) means that second opinions are not necessary.

Boyle was a long way from Canal Corp.: i d i f d l i Not experienced in federal estate taxation.

Issue involved compliance with filing rules.

T C “I ff M Mill ’ j b i Tax Court: “In effect, Mr. Miller’s job was to review the transaction he helped structure.” Bifurcation of planning and opinion practices?

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Bifurcation of planning and opinion practices?


Fixed fee engagements are fine, so long as they are worth the money.

Notwithstanding the focus on the contingency, the i f th f d t t ffsize of the fee seemed to create more offense.

Implicit scolding: the advice (at least based on the d ft i i ) t th th tdraft opinion) was not worth the cost. Is this a proper determination for courts to make?

Corporate taxpayers can (and do) pay for the best advisors; but they should be getting the best advice.

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Contingent fee arrangements remain an area of uncertainty.

Court: tying the advisor’s fee to closing the t ti t th i titransaction creates the wrong incentives. Distinguish between contingencies based on closing and

contingencies based on tax treatment being sustainedcontingencies based on tax treatment being sustained.

Closing of a transaction is frequently contingent on obtaining desired level of tax adviceobtaining desired level of tax advice.

Taxpayers might consider partial contingencies.

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Credibility remains the most important part of the reasonable cause and good faith analysis

Advisor’s credibility is just as important as the taxpayer’staxpayer s. Recall court's skepticism about the amount of time PwC

claimed to have spent on the opinion.p p

Taxpayers may have to forego some more aggressive aspects of their transactions. Leveraged Partnerships: commit greater amount of assets

to back indemnity. C i I d i i i l

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Captive Insurance: reduce premiums, increase capital surplus.


Don’t wait until the damage is done to begin planning for potential controversies.

How would your advisors perform as witnesses?l d b d i i Court was “nonplused” by advisor’s testimony.

Do you know what your advisors are saying about your tax positions?your tax positions? Document/email policies for external advisors.R b h i f Remember the impact of non-tax sources. Ratings agencies/stock analysts.

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Financial statements/news articles/press releases.

Part ThreeNavigating the New Normal: Implications for PractitionersImplications for Practitioners

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Canal Corp. raises the importance of avoiding the “promoter” designation.

106, Ltd. v. Comm’r, 136 T.C. No. 3 (2011): Providing unsolicited advice.

Having a stake other than hourly billing.

Providing advice outside ordinary area of expertise.

One-off relationship.

Resemblance to economic substance analysis.

Practitioners may also need to rethink their

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Practitioners may also need to rethink their marketing strategies.


May practitioners rely on representations made taxpayers and non-legal advisors?

Circular 230, 10 C.F.R. § 10.35(c)(1):bl f l i / i i l d Unreasonable factual assumptions/representations include

assumptions/representations that the practitioner knows or should know are incorrect or incomplete.

Stobie Creek Invest., LLC v. United States, 82 Fed. Cl. 636 (2008): No investigation made into validity of representations,

which “were demonstrably false, a fact that could not have been doubted by any sentient person involved.”

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bee doubted by a y se t e t pe so vo ved.


How much investigation of client representations must be performed?

May tax practitioners rely on representations of non-legal advisors?legal advisors? Transfer-pricing experts. Scientific and technical consultants Scientific and technical consultants.

Must taxpayer be bound by legal commitments rather than mere representations?than mere representations?

Tension is more pronounced for transactions at risk of being recharacterized under anti-abuse doctrines.

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g


Does Canal Corp. suggest a move towards separating planning and opinion practices?

“It is unreasonable for a taxpayer to rely on a tax d i ti l i l d i l i th t tiadviser actively involved in planning the transaction

and tainted by an inherent conflict of interest.”

B t t ti thi iti i l But most cases supporting this proposition involve traditional tax shelters.

Recall the factors from 106, Ltd. v. Comm’r, 136 T.C. No. 3 (2011).

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Part FourNavigating the New Normal: The F t re of Ta OpinionsThe Future of Tax Opinions

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The value of opinions for penalty protection continues to diminish.

Codification of economic substance removes bl d freasonable cause defense:

Imposition of strict liability penalty.

Increasing breadth of assertion.

No relief for overlap of economic substance with other anti-abuse rules and doctrines.

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What other purposes do opinions serve?

Justify tax provision for financial reporting.

Provide support for corporate transactions.

Memorialize facts and analysis for anticipated y pcontroversy. Beware risks of disclosure.

Persuade IRS about merits of position. Less useful during examination

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Less useful during examination.


The diminishing use of opinions for penalty protection may have ancillary effects.

Changes calculus of deciding whether to disclose i i t ditopinions to auditors.

Work product doctrine: if an opinion can’t be used f lt t ti h it d?for penalty protection, why was it prepared? Note the implications of United States v. Deloitte, LLP,

610 F 3d 129 (D C Ci 2010)610 F.3d 129 (D.C. Cir. 2010).

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Does Code section 6694 obviate the need disqualify opinions of “conflicted” advisors?

Section 6694 and the “conflict of interest” doctrine t t i il l i ttarget a similar concern: overly aggressive tax advice.

B t ti d i C h l d By targeting advisors, Congress has placed incentives on the appropriate party.

Also, section 6694 operates irrespective of any potential conflict.

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Circular 230 Disclaimer

31 CFR Part 10, § 10.35, requires us to notify you th t t d i i thi t ti tthat any tax advice in this presentation was not intended or written to be used, and cannot be used, for the purpose of avoiding penaltiesfor the purpose of avoiding penalties.

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Documents

Presenting a live minute teleconference with interactive ...media.straffordpub.com/products/leveraged-partnership-transaction… · Basic Leveraged Disguised SaleBasic Leveraged Disguised