For any of you out there owning a partnership interest that restructures from an S Corp to an LLC or perhaps borrows funds and takes partnership or shareholder distributions, watch out for the IRS Disguised Sale Trap (DST). Or perhaps you own some land or stock with a very low or even negative basis and are told by tax advisors that you can borrow money on those assets without every having to pay back the loan tax free. Watch out for the IRS DST. What exactly is a DST? A DST is simply cash you received that the Government says is a taxable sale resulted from you selling your equipment, partnership interest, real estate or land that you claimed on your tax return was nontaxable proceeds from a loan. If you are snared by this trap you will be viewed by the IRS as if you sold your interest. When that happens be prepared to pay a large tax to the Government or be forced to appeal to the US Tax Court for relief. The US Tax Court will be looking for evidence unique to your case which when applied to the case law will support your position that your distribution was not a disguised sale. Just how to do this is where we are headed on TaxView with Chris Moss CPA. So stay with us here on TaxView to protect your partnership interest from IRS DST traps and save you taxes.
We are going to start with a very simple concept: If it’s too good to be true it isn't, as was the case of United Circuits vs IRS US Tax Court (1995). Frank Schubert and Gary Jump owned United Circuits (United) a company that ensured that waste products from manufacturing were in compliance with EPA standards. United would purchase various equipment each year which would be depreciated in accordance with IRS regulations. Equitable Lomas Leasing contacted United offering an alternative one year leasing program from 1989 and 1990 with a $1 dollar buy out after one year allowing United to deduct all; their depreciable equipment in one year. United deducted the entire one year lease expense on both years tax returns. The IRS audited and disallowed all deductions. United appealed to US Tax Court in United Circuits vs IRS US Tax Court (1995). If you saw this case as a DST in reverse you are right. The Court easily found for the IRS. IRS Wins United Loses.
Moving to a much more complex set of facts we move to Virginia Historic Tax Credit vs IRS US Tax Court (2009) in which an investment fund (the Fund) was issuing tax credits to investors. The IRS disallowed the allocations of tax credits and increased income of the partnership claiming that in fact these tax credit allocations were disguised sales to the investors. By the way, do you see the DST in this case? Was the sole reason for joining the partnership to obtain a tax credit? The Government is going to see this this as a disguised sale of tax credits with the investors being nothing more than buyers.
The Fund appealed to US Tax Court in Virginia Historic Tax Credit v IRS US Tax Court (2009). The Court concludes based on all the evidence presented, including a detailed review of the operating agreements, the investors were not purchasers but investor partners who genuinely wanted to support historic rehabilitation. The Court looked closely at the executed multiple documents creating the partnerships signed by each investor. The partnerships operating agreements indicated the purpose of the partnership was to help rehabilitate historic property and to receive State tax credits in return. Investors who testified at trial all testified credibly and accurately. Finally Judge Kroupa points to Congressional intent to encourage State historic rehabilitation programs and supports individuals involved in these programs citing the National Historic Preservation Act (1966). Fund wins, IRS loses.
Be careful though. If it’s too good to be true it isn't. In Superior Trading LLC v IRS, 728 F.3d 676 (7th Cir. 2013) dozens of complex partnerships were formed around noncollectable receivables and bogus promissory notes in attempt to create a tax shelter scheme that was too good to be true. 7th Circuit Chief Judge Easterbrook, Posner and Williams chides Superior Trading, noting a genuine partnership is a business jointly owned by two or more persons (or firms) and created for the purpose of earning money through business activities. If the only aim and effect are to beat taxes, the partnership is disregarded for tax purposes. Which is exactly what the Court did in ensnaring Superior in the DST. IRS wins, Superior Trading Loses.
Our final case, Gateway Hotel v IRS US Tax Court (2014), involves the former Statler and Lennox Hotels of St Louis Missouri which were being renovated by Gateway Hotel Partners (Gateway).
The facts are complex so hold on to your tax-belts and enjoy the ride: The Court notes that Gateway had two members, Washington Avenue Historic Developer, managing partner, (WHAD), and Housing Horizons (HH), with profits split 1% to WAHD and 99% to HH. WAHD was substantially owned and controlled by an S Corporation Historic Restoration (HR). HH on the other hand was owned and controlled by Kimberly Clark Corporation (KC) and was just a passive investor with a 70% membership in Gateway,. Gateway ultimately would get funding from investors interested in the partnerships Missouri Historic Preservation Tax Credits (MHTCs) that investors would be entitled to. However, Gateway needed interim financing until they could offer the MHTCs to investors. The Missouri Development Finance Board (MDFB) in December 2000 agreed to make an $18 Million bridge loan to fill the Gap. The loan was made to HRI, who signed the bridge loan agreement on behalf of WAHD and GHP. The MDFB intended HRI to be the sole borrower and be solely liable for repayment of the bridge loan in the event of default. HRI agreed to make a capital contribution of the bridge loan proceeds to WAHD (HRI contribution) concurrently with the funding of the bridge loan, and WAHD was in turn required to contribute those proceeds to Gateway.
The bridge loan was repaid in 2002 with proceeds from the transfer of MHTCs to various investors. Gateway filed Form 1065 for 2002 and did not reflect the distribution of MHTCs in any amount to WAHD nor did it report it had income from transfers of MHTCs to various investors. The IRS audited Gateway for 2002 and 2003 and determined that Gateway failed to report $18 million of income from its transfers or what the Government claimed were disguised sales of the MHTCs. Gateway filed an appeal with US Tax Court in Gateway Hotel v IRS US Tax Court (2014).
Judge Goeke notes under Section 1.707-3 rules are providing for identifying disguised sales based on the facts and circumstances of each case. Section 1.707-3(b)(2) specifically provides a non-exhaustive list of 10 factors to prove the existence of a disguised sale. The Court looked very closely at all parties operating agreements and reviewed all 10 factors, comparing each factor to the facts of the case. The Court found only 2 of the 10 factors supporting a disguised sale. Gateway wins, IRS loses.
What can all of us do with much less complex business facts and circumstances to avoid DSTs? First and most important have your tax attorney annually review with you all K-1 distributions from partnerships and proceeds from loans as they pertain to Section 1.707-3(b)(2). Make sure cash or property you receive are put through the 10 factor scrutiny for analysis by your tax attorney. Second review all your operating agreements and financing arrangements with your attorney. Amend agreements as necessary to make certain you are ready for any DSTs coming your way. As you can see in Gateway, Courts look very closely at operating agreements and apply them to Section 1.707-3(b)(2) to your unique tax facts. Finally, if you receive any distribution in cash from loans or partnerships be sure you receive a written tax opinion from your tax attorney that this money is a “nontaxable distribution” and not a disguised sale. Insert that written tax opinion in your tax return before your file. When you get DST audited years later you will be glad you did. Thanks for joining Chris Moss CPA on TaxView.
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Chris Moss CPA