Disguised Sale Opportunities and Pitfalls with Partnership/LLC Acquisition Vehicles

M&AAlert 2007-5

Key points and opportunities
The single level of tax on distributed income, ability to avoidIRC § 197 anti-churning provisions, and flexibility in allocating income andequity make the partnership or LLC an attractive choice of entity as anacquisition vehicle. As a result,acquirers are increasingly utilizing partnerships and LLCs to facilitatemergers, acquisitions, and restructurings.

However, along with the flexibility comes complexity. One area of added complexity is theapplication of the disguised sale rules, which generally characterize cashreceived in the transaction as proceeds on the sale of the partnership’sunderlying assets or an interest in the partnership. The complexity increases substantially whenthe transfer includes property encumbered by liabilities and the assumption ofliabilities not encumbering transferred assets. Due to their expansive nature almost every acquisition utilizing apartnership or LLC will need to navigate the disguised sale rules.

Guidance
In the Tax Reform Act of 1984 (the “1984 Act”) Congressadded IRC § 707(a)(2)(B) to the Code to provide the Service with authority toidentify those transactions that, though structured as contributions anddistributions under IRC §§ 721 and 731, are more properly treated as sales orexchanges between the partnership and the partner.

Regulations providing guidance for disguised sales ofproperty to a partnership adopt a facts and circumstances analysis and includea two year presumption whereby, unless the facts clearly establish otherwise,distributions occurring within two years of a property transfer are presumed tobe a part of a disguised sale, while transfers outside of the two year windoware not presumed to be a part of a disguised sale. Treas. Reg. § 1.707-3(c)(1). To the extent a transaction results in adisguised sale, the partnership or other partners benefit from a stepped upbasis and potentially additional deductions as a result of the sale.

Proposed rules that were not included in the finalregulations would have required a ratable allocation of disguised sale proceedsand qualifying consideration to all of the assets transferred to thepartnership. Removal of this ruleprovides taxpayers some level of comfort that they may be able to “cherry pick”certain assets to sell and others to contribute to the partnership. However, careful consideration should begiven to the economic substance and business purpose of such an arrangement.

The regulations also provide safe harbors from the disguisedsale rules for certain reasonable distributions made during the two yearperiod. The regulations also include anexception for certain debt financed distributions to the extent of therecipient partner’s share of the liability. Treas. Reg. § 1.707-5(b).

With respect to liabilities assumed in conjunction with atransfer of property to a partnership, the regulations distinguish betweenqualified and unqualified liabilities. Unqualified liabilities are “bad” liabilities and assumption is treatedas a part of a disguised sale regardless of other factors, while assumption ofqualified liabilities is generally not treated as disguised saleconsideration.

In general, a liability incurred within the two years priorto the date of the transfer is an unqualified liability. Treas. Reg. 1.707-5(a)(7). However, as with almost every disguised sale rulethere are exceptions, in this case for the assumption of certain liabilitiessuch as operating trade payables. Treas.Reg. § 1.707-5(a)(6). Furthermore, rulesdetermining debt assumption offer numerous deferral opportunities.

In 2004 proposed rules (Prop. Reg. § 1.707-7) were issuedproviding guidance on the disguised sales of partnership interests with many ofthe same general rules as disguised sales of property. Recent comments by a high ranking Treasuryofficial indicate that the Treasury is considering withdrawing the proposedregulations and starting over.

Summary
When structuring an acquisition involving a partnership, itis essential to consider the impact of the disguised sale provisions. Failure to do so could create significant unintendedtax consequences; however, with the proper planning these same rules offersignificant deferral opportunities to targets and additional tax deductions toacquirers. In addition, special careshould be taken when transfers of property include assumption of liabilitiesand/or debt financed distributions.

This bulletin discusses certain general principles of taxlaw. This bulletin does not address all the specific requirements orexceptions that may apply, and it does not apply these general tax principlesto any particular transaction or situation. Accordingly, you should notrely upon the information in this bulletin for the purpose of implementing orreporting any particular transaction, and this bulletin may not be relied uponto provide any relief from any penalties under the Internal Revenue Code or anystate, local, or foreign tax law. Consult your tax advisor regarding theapplication of these general tax principles to your specific situation.

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