Corporation s Transfer of Value to Shareholders Using Partnership

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1 Corporation s Transfer of Value to Shareholders Using Partnership by Steven B. Gorin Thompson Coburn LLP Cox Enterprises, Inc. Subsidiaries v. Commissioner, T.C. Memo , held that a corporation s contribution of a television station to a partnership did not constitute a dividend even though the partnership interest it received was originally worth $60.5 million less than the assets it contributed. The partners in the partnership were the remaindermen of certain trusts. These trusts, indirectly and collectively, owned 98% of the corporation s stock. The IRS argued that the transfer to the partnership should be deemed an indirect distribution to the remaindermen of the trusts and therefore a distribution to the trusts. Judge Halpern rejected the IRS contention. First, he held that the corporation s transfer to the partnership was not intended to provide a gratuitous economic benefit to the other partners. Second, he held that, even if the corporation had made such a gratuitous transfer, the transfer did not benefit the shareholder trusts. Several factors demonstrated that the corporation s directors did not intend a gratuitous transfer: 1. The partnership s formation had nontax business reasons. As recommended by independent consultants, the corporation tried to sell these operating assets but was unable to do so. The partnership s formation allowed the corporation to retain, for use in other areas, the working capital it had previously needed for the television station. 2. The corporation s board s executive committee adopted a resolution that the other partners be required to make cash contributions to the partnership in an amount corresponding to the fair market value of the partnership interests acquired by those other partners. Furthermore, the other partners acquisition of partnership interest was to be on terms and conditions no less favorable to the corporation than the terms and conditions that would apply in a similar transaction with persons who are not affiliated with the corporation. 3. The corporation retained an outside accounting firm to render an opinion of appropriate marketability and minority interest discounts applicable to a minority interest in the partnership as of the date of formation. The partners made contributions based on the appraised amount. Three years later, the corporation s management discovered errors in computing the other partners interests in the partnership and obtained a new appraisal. The other partners made additional contributions to bring their contributions up to the appraised value. 4. The court relied on United States v. Byrum, 408 U.S. 135, (1972), to find that the controlling shareholders were subject to fiduciary duties to the minority shareholders. In the Cox case, two percent of the stock was owned by people who

2 were not members of the controlling family; these minority shareholders were principally employees of the corporation. Judge Halpern pointed out that the minority shareholders did not own interests in the other partners and would not be made financially whole for the likely shortfall in income and liquidation (or sale) proceeds if the corporation s contribution to the partnership constituted a transfer to the other partners. The court also found that any gratuitous transfer to the other partners would not have benefitted the shareholder trusts. The remaindermen of the trusts held significant interests in the partners, so a transfer to the other partners would have accelerated the remaindermen s interests in violation of the trust agreements. Because the trusts were the controlling shareholders (and the court assumed for the sake of argument that the trustees also controlled the actions of the other board members), the trustees would have violated their fiduciary duties by accelerating the interests of the remaindermen. Thus, a gratuitous transfer to the other partners would have been detrimental to the shareholder trusts as entities and would have violated the trustees fiduciary duties. The court concluded that any gratuitous transfer of an interest from the corporation to the other partners did not constitute a distribution to the shareholder trusts subject to Internal Revenue Code section 311. Other issues relating to these parties were still before the court when Judge Halpern wrote this opinion, some of which involved the trusts themselves. Subject to any light shed by those cases, one may draw some planning tips from this case: 1. As usual, documenting a transaction very well is always advisable, particularly documentation demonstrating an intent to deal at arms-length. 2. Although the Tax Court seems to place little weight on the Byrum case in family limited partnership cases under Internal Revenue Code section 2036, having nonfamily member employees hold 2% of the stock might to the trick. 3. Practitioners often wonder whether parties must contribute assets with fair market value to obtain capital accounts proportionate to their interests in profits when all partners are making their initial contributions on formation of the partnership. In this case, the majority partner (the corporation) contributed assets with value significantly in excess of the value of its partnership interest. However, the minority partners contributed assets equal to the value of their interests in the partnership. Thus, the majority partners received capital accounts that were higher relative to their interests in profits compared with the minority partners capital accounts relative to their respective interests in profits. Judge Halpern did not seem to recognize this issue; if he did, he did not mention it in analyzing the dividend issue. It will be interesting to see whether the companion cases consider this issue to be of consequence. Private Letter Ruling illustrates how to shift marketable securities using a partnership drop-down. A family-owned S corporation ( Corp ) owned 100% of the

3 membership interests in LLC, which was disregarded as an entity separate from Corp for federal tax purposes. LLC s operations consist solely of investing in a diversified portfolio of passive investment assets, including hedge funds, mutual funds, and private equity funds. LLC has no outstanding liabilities. Shareholder A and Corp reached an agreement pursuant to which Shareholder A was admitted as a new member of LLC. Specifically, Shareholder A contributed cash to LLC in exchange for a newly issued, non-voting, preferred interest in LLC. The terms and pricing of the preferred interest were based on an independent appraiser s determination of market rate terms for similar equity investments. For what have been represented to be valid business purposes, the following steps were proposed: (i) Corp will distribute some of its membership interests in LLC pro-rata to its stockholders (the Distributed LLC Interests ) and (ii) LLC s operating agreement will be amended to provide Corp with a share of LLC s profits disproportionate to capital in exchange for Corp providing future management services to LLC with respect to LLC s ongoing activities. Corp made the following representations with respect to this ruling request: (a) (b) (c) (d) The principal purpose of the Shareholder A contribution to LLC in exchange for a preferred membership interest was to allow Shareholder A to invest his excess cash directly in a diversified portfolio of investment assets managed by a team of experienced professionals, in a manner that allows Shareholder A to enjoy a high rate of preferred return and a priority on distributions. The principal purposes of the Proposed Transaction are to: (1) increase flexibility with respect to the allocation of profits, losses, and cash distributions associated with the LLC asset pool through issuance of various classes of interests in LLC, (2) provide increased liability protection to the LLC asset pool from the ongoing business operations of Corp, (3) facilitate estate planning and charitable objectives of Corp shareholders with respect to their investment in LLC, and (4) facilitate continued co-investment amongst family members outside of Corp. Shareholder A cannot independently cause Corp to distribute its interest in LLC. Additionally, Shareholder A s contribution to LLC was not dependent upon the consummation of the Proposed Transaction and the Corp stockholders had not ratified the Proposed Transaction as of the date of the ruling request. Following the Proposed Transaction, it is intended that LLC will continue to carry on the operations that were carried on by LLC before the Proposed Transaction. At the time of the Proposed Transaction, there will be no amounts payable or receivable between LLC and Corp or LLC and Shareholder A.

4 (e) (f) (g) (h) (i) (j) (k) For purposes of measuring the Code 311(b) gain to Corp on the Proposed Transaction, if any, the Distributed LLC interests will be valued as a percentage of the value of the assets held by LLC. 1 To the best of Corp s knowledge and belief, there is no plan or intention for any transferor to transfer assets to LLC other than cash and/or a diversified portfolio of stocks and securities. 2 The assets of LLC immediately prior to the admission of Shareholder A consisted of a diversified portfolio of stocks and securities. 3 There is no intention following the Proposed Transaction to dispose of any material assets of LLC (other than dispositions in the ordinary course of business). To the best of Corp s knowledge and belief, the Corp stockholders have no plan or intention to dispose of any portion of the distributed LLC interests except for the potential transfer to irrevocable trusts which will be taxed as grantor trusts to the respective grantor. LLC has not, and will not, elect to be classified as a corporation. No property, other than cash, has ever been contributed by Corp to LLC, and LLC has never made a distribution of property to Corp. The IRS ruled: 4 The admission of Shareholder A to LLC caused LLC to convert to a partnership for U.S. federal income tax purposes. Corp, as the sole owner of LLC prior to the admission of Shareholder A, is deemed to contribute the existing assets of LLC to the newly-formed LLC partnership in exchange for a membership interest in LLC. 5 This deemed transaction is treated as a nontaxable contribution of property to LLC by Corp. 6 Additionally, because the assets of LLC are represented to be a diversified portfolio of assets, Code 721(b) does not cause taxation with respect 1 Citing Pope & Talbot, Inc. v. Commissioner, 104 T.C. 574 (1995), aff d 162 F.3d 1236 (9 Cir. 1999). 2 For this representation, a portfolio of stocks and securities is diversified under Reg (c)(6)(i) if it satisfies the 25 and 50 percent tests of Code 368(a)(2)(F)(ii), applying the relevant provisions of Code 368(a)(2)(F)(ii), except that in applying Code 368(a)(2)(F)(iv), government securities are included in determining total assets unless government securities are acquired to satisfy the requirements of Code 368(a)(2)(F)(ii). 3 As defined under Reg (c)(6)(i). 4 The IRS also ruled regarding Code 2701 that a preferred payment right, the rate at which changes over time, was not a qualified payment right except to the extent that a qualified payment right election is made. Reg (b)(6). 5 Rev. Rul Code 721(a).

5 to Shareholder A s contribution of cash and to Corp s deemed contribution of property to LLC. Corp s adjusted basis in the Distributed LLC Interests is equal to the product of (A) the amount of Corp s adjusted tax basis in its entire membership interest in LLC and (B) a fraction, the numerator of which is the fair market value of the Distributed LLC Interests on the date of the distribution, and the denominator of which is the fair market value of Corp s entire membership interest in LLC as of that date. Corp will recognize gain, if any, on the pro-rata distribution of the Distributed LLC Interests to its stockholders to the extent the fair market value of the Distributed LLC Interests exceeds their adjusted tax basis in the hands of Corp on the date of the distribution. 7 7 Code 311(b).