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Tuesday, August 08, 2006

DEBT VS. EQUITY IN THE PARTNERSHIP CONTEXT

In a recent tax shelter case, the 2nd Circuit Court of Appeals reversed the trial court and disallowed the allocation of income under a partnership to certain foreign entities that were effectively not subject to tax on the income. In its opinion, the Court recharacterized equity interests of the foreign partners as debt, and had some interesting observations and pronouncements in regard to the concept of debt vs equity when the purported equity interest is an interest in a partnership.

Usually, debt vs. equity considerations arise in regard to corporate stock, and relate to whether stock in a corporation or a loan to corporation will be respected as to its form, or whether the characteristics of the interest at issue and equity structure of the corporation warrant recharacterizing stock as debt, or debt as stock/equity. The Court noted that this issue usually arises in the corporate and not the partnership area, and further that in most cases involving the issue the taxpayer seeks debt treatment (usually to obtain an interest deduction for the corporation) but in this case the taxpayer is seeking equity treatment.

Some of the observations/conclusion made by the Court:

-The same debt vs. equity considerations apply in regard to partnerships as they do in the corporate area;

-The debt vs. equity examination should be conducted based on the "all-the-facts-and-circumstances" test of Culbertson, 337 U.S. 733, 742 (1949) (which it is easier for the IRS to prevail under) than applying the sham transaction doctrine (which requires the IRS to show that the taxpayer's characterization is altogether without economic substance);

-If a partner has an upside in the profits of the partnership, this is a factor in favor of equity. However, the inquiry does not end with examining the terms of the partnership agreement. Instead, the IRS and courts need to see if there is in fact a realistic possibility of such an upside. In the instant case, the Court found that as a practical matter, based on external factual considerations such as the ability to manipulate income among related entities and the ability to terminate the partnership, there was no such realistic possibility.

-If a partner's economic interest is not subordinated to creditors, this is indicative of equity. Again, however, the Court indicated that the inquiry does not end with examining the terms of the partnership agreement. In the instant case, the Court noted that the foreign partner's capital in the partnership was guaranteed by a third party, so this in effect kept such capital from being subordinated to creditors even though there was no express subordination in the partnership agreement.

-If a partner has the ability to terminate the partnership and thus obtain back their capital, this is a factor indicative of debt.

-The lack of management rights of a partner in the partnership is indicative of debt (even though this factor should not be given significant weight).

Case: TIFD III-E Inc v. U.S., 98 AFTR 2d 2006-XXX (2nd Cir 08/03/2006).

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