SHAM PARTNERSHIP STRIPS PARTNER OF DESIRED LOSSES

A recent case before the 5th Circuit Court of Appeals provides an instructive illustration of a sham partnership.

A condensed version of the facts are as follows (with some liberties taken to keep this simple):

1. LLC formed, with Chinese government-owned financial institution (Cinda) and  a 1% third party. Cinda contributes $1.1 billion portfolio of nonperforming loans. A U.S. investor (Beal) contributes $180 million of GNMA securities to the LLC and buys 90% of Cinda’s interest from Cinda for $19.4 million. Lots of strings are tied to the LLC’s ability and economic benefits from the GNMA securities, all running to the benefit of Beal.

2. The loans are carried on the LLC books at a tax-loss, since Cinda invested much more into them than current value. Normally, when these losses are realized by the LLC, they would be allocated back to Cinda under Section 704(c). However, by buying most of Cinda’s interest, Beal now gets the benefit of most of the losses when they arise. Since he obtained a large basis in the LLC via his investment of the GNMA securities, he has a large basis against which to use the losses.

3. The LLC operates, and losses are generated and allocated to Beal. Cinda, who is responsible for servicing the loans, does a terrible job, and in fact threatens to bring the matter to the IRS if the LLC and Beal don’t stop bothering it about its failure to properly service the loans. The LLC and Beal back down, and indeed do another deal with Cinda.

The IRS sought to challenge the losses taken by Beal. The court affirmed the lower court that the acquisition of the loans had economic substance. Unfortunately for the taxpayer, the court also affirmed a finding that the LLC was a sham partnership. Beal was instead treated as having bought the loans directly and receiving a tax basis equal to what he paid – and thus lost the ability to deduct Cinda’s losses (as successor partner to Cinda) on the loan portfolio.

Under the Supreme Court’s decision in Culbertson, whether a partnership will be respected for tax purposes depends on whether “the parties in good faith and acting with a business purpose” genuinely “intended to join together for the purpose of carrying on the business and sharing in the profits and losses.” This determination is made in light of all the relevant facts and circumstances. The appellate court focused on three particular aspects of this test.

LACK OF AN INTENT TO JOIN TOGETHER. At first, it does appear that the partners intended to operate a joint venture to make a profit on collecting the nonperforming loans. However, when the partners failed to force Cinda to fulfill its functions as loan servicer (after Cinda threatened to disclose the transaction to the IRS), the court determined that the tax benefit was the real purpose of the transaction, not the potential profits from loan collections. It also did not help that Cinda obtained regulatory approval for the transaction by indicating that its retained 10% LLC interest was only “symbolic” and characterizing its transaction as a “package sale of bad debts.”

LACK OF INTENT TO SHARE PROFITS AND LOSSES. Again it first, such an intent appears – Beal did after all contribute $180 million of GNMA securities to the LLC which were at risk of loss. However, by retaining the rights to income, and controlling the use and disposition of funds and the securities themselves, the court found that Beal personally received all of the potential benefits from those securities and retained all of the risks. Even though Cinda could benefit from appreciation in those securities, Beal’s ability to control any sales of the securities substantially diminished any chance of Cinda benefitting in this manner. Thus, there was a lack of intent to share profits and losses.

LACK OF A BUSINESS PURPOSE. This question focused on whether there was a non-tax need to form the LLC to profit from the nonperforming loans investment – or whether it was all about tax benefits. The taxpayer raised six reasons why an LLC was needed, but the court did not buy into any of them.

Thus, the court found that Beal directly purchased the loans from Cinda. The LLC was ignored, and the loss benefits predicated on the partnership form, disappeared.

The court did not impose any penalties on the taxpayer based on tax opinions obtained from a law firm and an accounting firm that the taxpayer relied on.

SOUTHGATE MASTER FUND, L.L.C. v. U.S., 108 AFTR 2d 2011-XXXX, (CA5), 09/30/2011