Partnership Fails in Attempt to Deduct Loss With Related Party

(Parker Tax Publishing August 2021)

The Court of Federal Claims held that, as a result of the step-transaction doctrine, a partnership's loss on the sale of business assets was treated as a single event and, because the transaction was with a related party, Code Sec. 707(b)(1) applied to disallow the loss. The court rejected the partnership's argument that the loss was deductible under Code Sec. 165 as an ordinary loss after concluding that the loss stemmed from the sale of a capital asset. GSS Holdings, Inc. v. U.S., 2021 PTC 240 (Fed. Cl. 2021).

Background

GSS Holdings, Inc. (GSS) is a partner in Liberty Street Funding LLC (Liberty), a type of company called a commercial paper conduit. Liberty issues commercial paper and invests the proceeds in receivables purchase agreements and similar debt assets. It benefits from the spread of interest rates between the two.

For tax purposes, Liberty is a flow through partnership. In 2011, Liberty filed a Form 1065, U.S. Return of Partnership Income, that included the sale of financial assets on Form 4797, Sales of Business Property, reflecting a loss of approximately $22.55 million. That loss stemmed from a payment made to the Bank of Nova Scotia (BNS) out of a Liberty-held account in conjunction with a sale of a package of assets to BNS by Liberty. BNS was also the parent of GSS's 1065 Liberty tax partner, Scotiabank (Ireland) Limited (Scotiabank). The relevant transactions occurred on December 29 and 30, 2011. The first was the exercise by Liberty of a Liquidity Asset Purchase Agreement (LAPA) which required BNS to purchase distressed financial assets (known as "Aaardvark IV") from Liberty at a preset (par) value equal to Liberty's basis in the assets. In conjunction with the sale of these assets to BNS, Liberty was also required, under the terms of a separately executed document, to transfer $24 million to BNS from its First Loss Note Reserve Account. Liberty simultaneously received approximately $1.45 million in insurance proceeds from this event. The $24 million cash transfer netted with the $1.45 million insurance proceeds resulted in the disputed $22.55 million loss.

The IRS determined that, because the transaction was with a related party, Code Sec. 707(b)(1) applied to disallow the deduction. Under Code Sec. 707(b)(1), no deduction is allowed in respect of losses from sales or exchanges of property (other than an interest in the partnership), directly or indirectly, between (1) a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership, or (2) two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests.

GSS argued that the loss was an ordinary business loss deductible under Code Sec. 165 and that the related entity rule should not apply. Code Sec. 165 provides that there is allowed as a deduction any loss sustained during the tax year and not compensated for by insurance or otherwise. GSS filed a refund claim with the IRS and, when the IRS rejected the claim, took its case to the Court of Federal Claims.

Before the court, the government made two arguments as to why the $24 million payment should have a capital character. The first was that, in substance, the First Loss Note payment was inextricably linked to the LAPA sale of Aaardvark IV, and, as such, the two events must be viewed collectively, with the end result that the payment is collapsed into a capital sale under the step-transaction doctrine. Second, the government said, Liberty originally reported the transaction on IRS Form 4797 and netted the results of the LAPA sale with the payment from the First Loss Note (thus giving it capital character) and as such the Danielson rule precluded the taxpayer from later recharacterizing the transactions.

The Danielson rule is based on the Third Circuit's decision in Comm'r v. Danielson, 378 F.2d 771 (3d Cir. 1967), in which the court held that if, in an asset sale, a seller and buyer agree in writing as to the allocation of any amount of consideration to (or as to the fair market value of) any of the assets in an applicable asset acquisition, the agreement is generally binding on them. However, the IRS can challenge the allocations (or values) arrived at in such an allocation agreement. If the parties then wish to challenge the IRS construction, they must offer proof that, in an action between the parties, would be admissible to alter that construction or show its unenforceability because of mistake, undue influence, fraud, duress, etc. Not all circuits have adopted the Danielson rule.

GSS argued that it was improper to artificially consolidate the First Loss Note payment with the LAPA sale of Aaardvark IV because, at the time of the creation of the LAPA, the parties could not have intended that the transaction would occur for the simple reason that the First Loss Note Agreement was not yet in place. Relying on the decision in Falconwood Corp. v. U.S., 422 F.3d 1339 (Fed. Cir. 2005), GSS contended that independent business purposes precluded applying the step transaction doctrine. It argued that regulatory and accounting changes drove the creation of the First Loss Note and its later acquisition by Scotiabank, not tax avoidance.

GSS also argued that the Danielson Rule was inapplicable because it only applies to bind parties to reflect the same characterization for tax purposes as the parties agreed upon in the associated contractual obligations. GSS contended that Danielson was inapplicable because Liberty never explicitly contracted or agreed to any allocation or characterization of the First Loss Note payment in the disputed transactions. Rather, GSS argued that Liberty merely incorrectly netted the two separate events on Form 4797 as a single sale of business assets. According to GSS, it would be an impermissible extension of the rule to bind a taxpayer to an allegedly erroneous characterization reported on a tax form.

Analysis

The Court of Federal Claims held that the First Loss Note payment was part of a capital sale and, because Code Sec. 707(b)(1) precludes a partnership from deducting losses on the sale of assets to a related party, the $22.55 million loss deducted on Liberty's Form 4797 was properly disallowed.

The central question before the Court of Federal Claims was the relation of the $24 million First Loss Note to the sale of Aaardvark IV. If the payment was part of a capital sale, in essence an offset to the price paid by BNS, then Code Sec. 707 would disallow the loss because it was part of a related-party transaction. If the payment was an ordinary business loss, it was irrelevant that the parties are related, and the loss would be an allowable deduction under Code Sec. 165.

The court began by disagreeing with the government that the Danielson rule was applicable in the instant case. The Danielson rule, the court noted, binds a taxpayer to the original form chosen for a transaction if the taxpayer later tries to recharacterize part of that transaction for tax purposes. The court agreed with GSS that Form 4797 is not an agreement to characterize a transaction in a particular way and that the Danielson rule has only been used to bind taxpayers to certain characterizations agreed upon by contract. Those contractual allocations, the court said, bind taxpayers to report transactions consistent with their business arrangements. The court declined to expand Danielson's reach. According to the court, Liberty's tax return (i.e., its partnership return) was only informational, not an allocation of consideration in a contractual agreement. Thus, the court concluded, it was not binding as an allocation for tax purposes.

The court then turned to the government's step-transaction argument, but thought it more useful to view the question under the larger tax law concept of substance over form. In the larger family of substance-over-form cases, the court observed, several factors are considered. With respect to the government's argument that the end-result test applied in the instant case, the court noted that this test is used to determine if a series of transactions are independent, or if they are actually components of a single transaction that was intended from the outset to reach an ultimate result. Intent of the taxpayer is especially relevant for an end-results analysis, the court said.

With respect to GSS's argument about the timing of the creation of the First Loss Note Agreement, the court said the relevant event was not the creation of the First Loss Note Account but rather the payment out of it to BNS at the end of 2011. That payment had no purpose other than to offset, or rebate, some of the loss built into the Aaardvark purchase price. When that narrower focus is applied, the court said, the answer became clear. The $24 million payment was part of the Aardvark transaction and there was no question that the "taxpayer intended to reach a particular result" - namely, to use the First Loss Note payment to offset some of the LAPA counterparty's losses.

With respect to GSS's reliance on Falconwood, the court observed that the Falconwood court itself rejected the notion that a valid business purpose necessarily bars application of the step-transaction doctrine and found no application of the principle in Falconwood to the facts at bar that would save GSS's loss deduction.

For a discussion of the loss disallowance rule in Code Sec. 707(b), see Parker Tax ¶25,540. For a discussion of the Danielson rule, see Parker Tax ¶118,110.

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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