A not-so-brilliant disguise

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DEBT-FINANCED DISTRIBUTIONS

There are several exceptions to the application of section 707. A popular exception has been the "debt-financed distribution" under which, to the extent the partnership distributes cash that is the proceeds of partnership borrowing for which the contributor is considered indirectly liable, the distribution was not considered to be taxable consideration for a sale. It was possible for a partner to contribute built-in gain property (such as property that had been fully depreciated and is subject to recapture gain) to a partnership and for the partnership to borrow and distribute the proceeds to the partner. To the extent the partnership debt was allocated to the contributor partner, the distribution to the partner was not treated as taxable disguised sale proceeds.

The key determinant of the benefit is the amount of partnership debt that can be allocated to the contributing partner. Under prior rules, a guarantee of the partnership debt by a partner was sufficient to cause all the guaranteed debt to be allocated to the partner. Under the new rules, the IRS will no longer consider a partner's guarantee of the partnership debt sufficient to cause debt to be allocated to the partner to overcome the disguised sale treatment. Instead, the maximum amount of debt that may be allocated to a partner for purposes of overcoming sale treatment is the percentage of the debt that is equal to the contributing partner's percentage share of partnership profits.

Example: a partner ("Sponsor") has depreciated pipeline assets that have a book value of $1000 but a tax basis of $200. If Sponsor sold the assets it would have immediate taxable gain recognition of $800. If, instead, Sponsor contributed the assets to an MLP in which it has a 40% interest, the MLP could borrow $1000 and distribute the cash to the Sponsor.

Under prior rules, although Sponsor has only a 40% stake in the MLP, if it guaranteed the partnership debt, the entire amount of the debt would be allocated to Sponsor, the entire distribution would qualify for the debt-financed distribution exception and Sponsor would not have any taxable gain.

Under the new rules, however, the debt-financed distribution exception still exists but the share of debt allocated to the Sponsor is limited to its share of profits, which is 40% or $400, meaning that the remainder of $600 is considered Sponsor's sales proceeds. The proceeds are then reduced by a pro rata portion of the assets' tax basis (60% x $200 or $120), causing Sponsor to have $480 ($600 less $120) of taxable gain. Sponsor's taxable income has increased from zero to $480.

WHY THIS CHANGE NOW?

The IRS has been increasingly concerned about guarantees that do not give rise to real risk of loss. It has successfully challenged several high-profile leveraged partnerships in recent years under the theory that various guarantees entered into by the contributor did not confer a real risk of loss with respect to the partnership debt. In one high-profile deal, the Tribune Company disposed of Newsday to Cablevision through use of a leveraged partnership but it recently agreed to settle with the IRS by paying tax on a portion of the asserted gain. These new rules are a reflection of the IRS position in those matters.

QUALIFIED LIABILITIES - ANOTHER EXCEPTION TO DISGUISED SALE TREATMENT

In the world of partnership tax, the assumption by the partnership of debt of the partner is treated as though the partnership had distributed cash to the partner (and vice-versa, a partner's assumption of partnership debt is treated as a contribution of cash to the partnership). If a partner contributes assets to a partnership subject to debt for which the assets function as collateral, the partner is considered to have received cash from the partnership to the extent the partner is considered relieved of the debt.

The amount of the relief is equal to the debt assumed less the debt the partner is considered to remain on the hook for indirectly by virtue of its share of the partnership. Happily, the disguised sale rules exclude from sale proceeds certain types of debt, the relief of which will not be treated as a consideration for a sale, referred to as "Qualified Liabilities." For many years there have been four categories of Qualified Liabilities; the new rules add a fifth:

• "Old and cold" liabilities that have encumbered the transferred property for two years;
• Liabilities for which the proceeds were spent on and can be traced to capital expenditures;
• Liabilities incurred in the ordinary course of the trade or business in which the property was used;
• Recent (less than two-year-old) liabilities that were not incurred in anticipation of the transfer of the property to the partnership;
• A liability that is not incurred in anticipation of the transfer of the property to a partnership but that was incurred in connection with a trade or business in which property transferred to the partnership was used or held, but only if all the assets related to that trade or business are transferred (note absence of requirement that it be incurred in the ordinary course of business).

If levering at the partnership level followed by a distribution of cash will give rise to taxable gain recognition, then levering up at the partner level would be a way to keep debt proceeds in the hands of the partner, if the debt qualifies as one of the types listed above. However, to fit within the definition of Qualified Liability, there is a premium on planning ahead since "not in anticipation" of the transaction is a theme that runs through the definitions.

THE PREFORMATION CAPITAL EXPENDITURES EXCEPTIONS

A third exception to disguised sale treatment is for reimbursement of preformation capital expenditures ("PCEs"). Under this exception, to the extent that the distribution is to reimburse the contributor for its capital expenditures on the assets prior to the formation of the partnership, the distribution is not treated as consideration for a sale. This exception has been hugely helpful in the capitalization of MLPs pre-IPO with reimbursement to the partner using the public's money post-IPO. The exception has been so popular, however, the IRS has now tightened up use of the exception in two ways.

First, the new regulations make clear that when the preformation expense exception is applied, it must be applied on a property-by-property basis. The exception is limited to 20% of the fair market value of the contributed property at the time of the transfer but the 20% limitation is lifted if the value of the transferred property does not exceed 120% of the basis of the property contributed. In other words, if the property contributed had significant built-in gain, then at most 20% of the value of the property could be protected by the exception. By now applying these tests on a property-by-property basis, taxpayers cannot assert that assets contributed as a group had little built-in gain to allow isolated but expensive capital expenditures to be reimbursed in their entirety without sale treatment. The regulations do allow a limited aggregation of assets for purposes of applying the above thresholds.

Second, the new rules prevent "double dipping" by providing that, to the extent a liability of the contributor partner is assumed by the partnership (see Qualified Liability, Type 2 above) and that liability is traceable to capital expenditures, the PCE exception cannot be used because there has been no actual outlay by the partner to reimburse. In other words, a partner cannot exempt from sale proceeds both the assumption of a Qualified Liability and the reimbursement of PCEs financed with the same debt.

CHANGING TREATMENT OF PARTNER GUARANTEES OF PARTERSHIP DEBT

Even outside of the disguised sale rules, there have been changes to the allocation of debt among partners for tax purposes. Those changes matter because a partner can increase its tax basis in its partnership interest for its share of entity-level (partnership) debt. This increase in basis allows it to receive more regular distributions tax-free (not disguised sale distributions) and it permits the partner to take increased depreciation and interest deductions. A typical fix to bump up a partner's share of partnership debt for this purpose has been to have the partner execute a guarantee of the partnership's debt. A guarantee can still be effective for this purpose, but the IRS has signaled its intent to look much harder at whether the guarantee is merely window dressing without much likelihood it would ever result in a payment.

The new rules apply a facts and circumstances test using seven factors that weigh in favor of disregarding the guarantee:

• partner's obligation to pay is not subject to commercially reasonable contractual restrictions;
• absence of commercially reasonable documentation regarding the partner's financial condition;
• term of the payment obligation ends before term of the liability;
• partnership holds an unreasonable amount of cash exceeding foreseeable needs, so partner's payment obligation unlikely to be called upon;
• payment obligation does not permit creditor to promptly pursue payment;
• terms of the loan would have been substantially the same absent a guarantee; and
• creditor benefiting from guarantee did not receive documents at the time of execution.

Outside of the disguised sale context, if a partner wants to share in a debt amount by issuing a guarantee it can do so, it just has to be mindful of making the debt obligation real in compliance with the various factors set forth in the regulations.

One particular type of guarantee is now completely useless under the new rules: the "bottom dollar" guarantee. In a bottom-dollar guarantee if the partnership borrows, for example, $1000 from the bank and Sponsor gives a $200 bottom-dollar guarantee, the guarantee would not be triggered unless the bank recovers less than $200 from the partnership. Such a guarantee now will not give a share of debt to the partner.

HOW LEVERAGED PARTNERSHIPS MAY STILL WORK TO REDUCE TAX

Despite the new rules described above, with careful advance planning and patience, leveraged partnerships may still be useful in reducing tax. Consider the following:

• Contribute low-basis assets for equity. Consider a sponsor that has two pipelines of equal value that it wants to drop into an MLP: Pipeline A, with significant built-in gain and Pipeline B, with little book-tax differential. If both are contributed simultaneously in exchange for a combination of cash and units (equity) the IRS would assert that the cash proceeds were sale consideration for both pipelines and apply the aggregate tax basis of both pipelines against the cash (technically, an amount of the aggregate basis pro rata to the amount of cash relative to the value of the units plus cash) to determine the taxable gain amount. Since the receipt of equity (i.e. the units) is not treated as the receipt of sales proceeds, the sponsor would benefit by separating the transactions and contributing Pipeline A solely for equity while leaving Pipeline B for a later transaction (perhaps with a debt-financed distribution to further reduce sales proceeds). The key would be to make sure the two asset contributions aren't otherwise linked or could be construed as just two parts of the same transaction. For IRS purposes, the best evidence of separation is a time period of at least two years.
• Plan to use Qualified Liabilities. If the business sees an IPO in its future, even if it is one to three years off, considered putting assets that would be dropped into the MLP in connection with the future IPO into a special-purpose entity now, borrowing against those with a guarantee by the sponsor so that when the assets are contributed to the partnership, subject to the debt, the borrowed cash may stay back with the sponsor (assuming cash was not spent purchasing assets). In this case, the debt relief is not treated as sale proceeds to the extent it is a Qualified Liability. Moreover, after assumption of the debt by the partnership (which would then be, by definition, a leveraged partnership), the sponsor's share of the debt would be tested under the regular rules, meaning that a guarantee of the debt would be respected for purposes of determining the partner's basis in its interest, assuming it met the factors described above.
• Identify Pre-Formation Capex. To the extent the contributing partner can support that a cash distribution is a reimbursement of PCEs and they meet the threshold tests, then the cash distribution (even if from a leveraged partnership) will not be taxable sale proceeds.
• Like-Kind Exchange. A time-honored means of deferring gain recognition is the use of a section 1031 like-kind exchange, in which a party exposed to gain recognition identifies and purchases replacement property of a like-kind within a 180-day window, rolling over its basis in the relinquished property to the replacement property and deferring gain until the replacement property is sold. Partnership leverage, to the extent allocated to the sponsor, could be useful in reducing the deemed gain to be protected by the like-kind exchange. If a sponsor has acquisitions on its horizon that would be like-kind with the assets contributed to the partnership in a taxable disguised sale, deferral may the best solution.

In sum, with planning and forethought, contributions to leveraged partnerships, although less "brilliant," may still have some shine.

ABOUT THE AUTHORS

Barbara Spudis de Marigny and David L. Ronn are partners in the Houston office of Orrick, Herrington & Sutcliffe LLP, where De Marigny focuses on the taxation of energy-sector businesses, specializing in partnership taxation and Ronn focuses on capital markets, specializing in MLP transactions.