The Tax Court, in a consolidated case involving a distressed asset/debt tax shelter, held that several partnerships’ basis in purchased consumer debt acquired from a Brazilian company was zero and that the transfer to the partnerships and subsequent redemption of the Brazilian company's partnership interests were a sale of receivables. The Service’s imposition of accuracy related penalties was upheld.
The transaction in issue has been referred to as a “DAD” or distressed asset debt transaction. In contrast to a Son-of Boss transaction, which exploited the narrow definition of partnership liability under §752 to deny liability assumption for a contingent debt obligation which is still reflected in outside basis, the DAD deal is far more pedestrian in the sense that it does not rely on hyper-technical interpretations of the Code and regulations. As to the Son-of-Boss basis plays see, e.g., Cemco Investors LLC v. United States, 515 F.3d 749, 752 (7th Cir. 2008); New Phoenix Sunrise Corp. & Subs. v. Commissioner, 132 T.C. 161, 185 (2009), affd. 408 Fed. Appx. 908 (6th Cir. 2010); Jade Trading, LLC v. United States, 80 Fed. Cl. 11 (2007), revd. on other grounds 598 F.3d 1372, 1376 (Fed. Cir. 2010).
In a DAD transaction, the loss is claimed by application of §§723 and 704(c) from the alleged contribution of a built-in loss asset by a tax indifferent party to a partnership However, this loss is preordained to be nullified by a matching gain upon the dissolution of the venture. Consequently, the tax benefits sought by the tax sensitive party are, absent other factors, confined to timing gains. Moreover, claiming these benefits requires sufficient "outside basis", which, in turn, entails an investment of real assets.
In a consolidated Tax Court proceeding, the facts of the case focused to a large extent on the business dealings between Warwick Trading LLC and Lojas Arapua, S.A., (“Arapua”) a Brazilian retail company in a bankruptcy proceeding/reorganization. In particular, Arapua transferred its troubled consumer receivables to Warwick in exchange for a membership or ownership interest in Warwick and an expectation to receive a cash distribution within a relatively short period of time.
Warwick next transferred the low value or trouble consumer debt several trading companies, and investors acquired interests in those companies through several holding companies that were all organized as LLCs. The various LLCs elected partnership treatment and claimed bad debt deductions related to the Brazilian consumer receivables. The investors claimed the deductions on their tax returns. Warwick also claimed losses related to the receivables.
The IRS issued notices of final partnership administrative adjustments (“FPAA”) denying the members of the LLCs, including Warwick losses on the worthless debt and applied accuracy related penalties for lack of economic substance, violation of the partnership anti-abuse regulation, and disguised sales provisions.
The various LLCs subject to the FPAA filed petitions with the Tax Court and the cases were consolidated. In a full opinion of the Court, per Judge. Wherry Jr., the Tax Court upheld the proposed deficiiencies in income tax set forth in the FPAAs, finding that two necessary conditions for allocation of the built-in losses of the distressed debt contributed among the various LLCs were not met. The Court first denied that the alleged partnership that Arapua formed with the managing member or Warwick was not a partnership for federal income tax purposes. Instead, Arapua wanted cash from the receivables and Warwick wanted the receivables to generate deductible tax losses. The Tax court also found that the second condition for allocation of the built-in losses, that there had been a bona fide contribution of the distressed receivables, had not been met.
The Tax Court recharacterized the contributions as disguised sales under §707(a)(2)(B) since Arapua received money within two years of the transfer of the receivables. As a purchase, Warwick’s cost basis in the receivables was the amount of cash paid and there was no transferred or exchanged basis for which built in losses could be claimed. Applying the step transaction as a judicial aide or rule of construction, the several steps were joined into a single transaction, i.e., Arapua’s sale of receivables to Warwick for the amount of cash paid. Therefore, the losses are measured against a zero basis as a factual matter and not deductible. The gross valuation misstatement penalty under §6662(h) was imposed since the taxpayers failed to show that they acted with reasonable cause and in good faith in their reporting of the losses.