Disguised Sale Rules Negate Taxpayer's Loss

(Parker Tax Publishing September 2025)

The Second Circuit affirmed the Tax Court and held that a taxpayer's transfers of distressed foreign trade receivables through several purported domestic partnerships was a disguised sale under Code Sec. 707 and Reg. Sec. 1.707-3. As a result, the taxpayer (1) was not entitled to deduct the losses incurred in those transactions, and (2) was liable for related penalties. PIMLICO, LLC v. Comm'r, 2025 PTC 277 (2d Cir. 2025).

Background

In 2002, three parties engaged in a structured distressed debt investment transaction ("the transaction"), which involved transfers of distressed foreign trade receivables through several purported domestic partnerships. The parties to this transaction were: (1) BDO Seidman, LLP (BDO), a professional services firm providing accounting, tax, financial, and consulting services, that marketed the transaction; (2) John Howard, who invested in the transaction; and (3) Gramercy Advisors, LLC (Gramercy Advisors), an investment advisory firm that implemented the transaction on Howard's behalf.

The receivables involved in the transaction originated with Santa BInde Comde Ferro Ltda. (Santa Barbara), a metal products supplier organized under the laws of Brazil and consisted of duplicatas (i.e., orders for payments under Brazilian law) issued by Santa Barbara in 1996 to Encol S/A Engenharia Come Ind (Encol), a real estate development and construction company organized under the laws of Brazil. In 1997 Encol filed for bankruptcy protection. A Brazilian bankruptcy court declared Encol bankrupt and directed the liquidation of its assets.

On August 1, 2002, Santa Barbara contributed the Encol receivables using a tiered partnership structure. First, Gramercy Advisors and Santa Barbara formed XBOXT, LLC (XBOXT). Santa Barbara contributed the Encol receivables in exchange for a 99 percent interest in XBOXT. Gramercy Advisors owned the remaining 1 percent membership interest. Second, XBOXT and Tall Ships, a limited liability company affiliated with Gramercy Advisors, formed a partnership called PIMLICO, LLC. XBOXT contributed the majority of its Encol receivables to PIMLICO in exchange for a membership interest.

BDO subsequently approached Howard to pitch a distressed debt structure arrangement. BDO discussed with him tax benefits - including specific tax losses - that could be obtained through the transaction. On December 10, 2002, Howard entered into an agreement with BDO in which he agreed to pay BDO a consulting fee of $865,000, while BDO agreed to provide him with an opinion letter concerning the federal income tax consequences of the transaction. Howard also entered into an investment management agreement with an affiliate of Gramercy Advisors, with respect to an investment of $360,000. On December 11, 2002, Howard transferred $360,000 to an account at Boston Safe Deposit & Trust Co. (Boston Trust) managed by Gramercy Advisors for the benefit of Howard. On that same day, Howard acquired an 89.1 percent membership interest in PIMLICO from XBOXT in exchange for $300,164. An interest-bearing account for XBOXT at Boston Trust was opened on December 20, 2002, and on December 23, 2002, an internal transfer of $300,164 was made into the XBOXT account. After Howard's acquisition of his interest, PIMLICO's three members were (1) Howard with an 89.1 percent interest, (2) XBOXT with a 9.9 percent membership interest, and (3) Tall Ships with a 1 percent interest.

PIMLICO and Tall Ships then formed another partnership - PICCIRC, LLC. On December 11, 2002, PIMLICO contributed Encol receivables valued at Brazilian real 23,585,000 to PICCIRC for a 99 percent ownership interest. On December 26, 2002, PICCIRC sold all its Encol receivables to an affiliate of Gramercy Advisors for $357,144. On January 16, 2003, Gramercy Advisors received a letter, dated December 16, 2002, from Santa Barbara requesting a withdrawal of $300,164 of its membership interest in XBOXT. XBOXT's account at Boston Trust, which had received a transfer of $300,164 on December 23, 2002, had a closing balance of $79 on January 30, 2003.

On its 2002 Form 1065, PICCIRC reported an ordinary loss of $22,718,351 from the transaction. This purported loss was allocated to PIMLICO. Howard's share of the purported loss from the transaction was $20,446,516. He claimed flow-through ordinary loss deductions of $14,506,070 and $6,118,531 from PIMLICO for tax years 2002 and 2004, respectively. In a notice of final partnership administrative adjustment, the IRS disallowed PICCIRC's $22,718,351 ordinary loss.

The IRS characterized the transaction as a disguised sale under Code Sec. 707(a)(2)(B) and Reg. Sec. 1.707-3. Under Code Sec. 707, a disguised sale occurs where a partner contributes property to a partnership and receives a related distribution that is, in effect, consideration for the contributed property. Under Reg. Sec. 1.707-3(b)(1), a transaction may be deemed a disguised sale if, on the basis of all the facts and circumstances (1) the partnership's transfer of money or other consideration to the partner would not have been made but for the partner's transfer of property and (2) if the transfers were not made simultaneously, the subsequent transfer was not dependent on the entrepreneurial risks of partnership operations. Under Reg. Sec. 1.707-3(c)(1), transfers between a partnership and a partner within a two-year period are presumed to be a sale of property to the partnership unless the facts and circumstances "clearly establish" otherwise. The IRS also adjusted the partnership's basis in the receivables to zero and assessed accuracy-related penalties under Code Sec. 6662.

PICCIRC filed a petition with the Tax Court. In PICCIRC, LLC v. Comm'r, T.C. Memo. 2024-50, the Tax Court sustained the IRS's denial of loss deductions and the imposition of penalties under Code Sec. 6662 after concluding that the transaction involving transfers of distressed foreign trade receivables through several purported domestic partnerships was a disguised sale under Code Sec. 707 and Reg. Sec. 1.707-3. The court also found that the partnerships involved in the transactions were not bona fide partnerships and thus should be disregarded as such under the anti-abuse rules in Reg. Sec. 1.701-2. PIMLICO, as a member of PICCIRC, appealed to the Second Circuit.

Analysis

The Second Circuit affirmed the Tax Court. Santa Barbara, the court noted, contributed the duplicatas to XBOXT in August 2002 and XBOXT then contributed these duplicatas to PIMLICO, which contributed them to PICCIRC. Further, the court observed that (1) on the day PICCIRC was created, Howard joined PIMLICO by purchasing part of XBOXT's interest in the partnership for $300,164; (2) on December 16, 2002, Santa Barbara requested to partially withdraw its interest in XBOXT for $300,164, and (3) by January 31, 2003, XBOXT's bank account no longer reflected the $300,164 it had received from Howard. The natural inference from this evidence, the court said, was that XBOXT transferred the $300,164 it received from Howard to Santa Barbara.

The Second Circuit also looked at whether the relevant facts and circumstances rebutted the presumption of a disguised sale and found they did not. As the relevant bank account records demonstrated, Howard's contribution of $300,164 to XBOXT permitted the partnership to make a transfer of money to Santa Barbara and because Santa Barbara partially withdrew from XBOXT by selling its interest for $300,164, the transfer was disproportionate to its continuing interests in the partnership. The close timing between the creation of the partnership, Howard's purchase of an interest in XBOXT, and Santa Barbara's partial sale of its interest in XBOXT - for the same exact sum - indicated to the court that this was not mere coincidence and these actions had the effect of engineering a tax windfall for Howard.

Observation: Prior to 2004, the regulations under Code Sec. 704(c) allowed a new partner to buy an existing partner's interest - and, in so doing, claim the built-in loss from the asset the existing partner had contributed. By purchasing XBOXT's interest, then, Howard became entitled to the tax loss XBOXT would have claimed from PICCIRC's sale of the duplicatas it contributed. This loophole was eliminated by the American Jobs Creation Act of 2004 in Code Sec. 704(c)(1)(C).

For a discussion of the disguised sale rules, see Parker Tax ¶25,520.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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