An S corporation’s disposition of a major league baseball team was a disguised sale to a newly formed partnership. The taxpayer had formed the partnership, with a renowned family, where the taxpayer contributed the major league baseball team and related assets and the family contributed cash. Subsequently, the partnership then distributed cash to the taxpayer (the transaction) which represented a “disguised sale” which was taxable under Code Sec. 707. Further, the IRS had issued a notice of deficiency to the taxpayer and a notice of final partnership administrative adjustment (FPAA) as to the partnership for the tax year at issue. The IRS claimed that since the debt funded by the family was not bona fide debt, it was supposed to be disregarded for purposes of the debt-financed distribution rule. The taxpayer argued that the transaction was a disguised sale but that the distribution to the taxpayer was not taxable because it was a debt-financed distribution. Moreover, the taxpayer contended that it should be allocated to the debt because it bore the economic risk of loss on account of its guaranties. However, the IRS contended that the possibility of the taxpayer being called on to fulfill the guaranties was so remote it they should be disregarded.
Whether the Sub Debt was Bona Fide Debt or Equity
The parties disputed whether the amount of sub debt which the partnership borrowed from a finance company was bona fide debt and therefore a partnership liability. The factors which determined the same (the Dixie Dairies factors), such as: 1) presence or absence of a fixed maturity date; (2) names given to the certificates evidencing the indebtedness; (3) source of payments; (4) right to enforce payments; (5) participation rights; (6) status of the advances in relation to regular corporate creditors; (7) intent of the parties weighs strongly toward equity; (8) identity of interest between creditor and stockholder; (9) ‘thinness’ of capital structure in relation to debt; (10) ability of the corporation to obtain credit from outside sources; (11) use to which the advances were put; (12) failure of the debtor to repay; and (13) risk, all strongly favored that the sub-debt was equity. Because the sub debt was equity, it was not allowed to be allocated to the taxpayer as recourse debt.
Allocation of Partnership Liabilities
The economic substance of the transaction was a disguised sale with a debt-financed distribution, a structure contemplated by both the statute and the regulations. Moreover, under the constructive liquidation test, the taxpayer bore the risk of economic loss for the senior debt. According to the terms of the taxpayer’s guaranty of the senior debt, the taxpayer was obligated to pay when the partnership failed to make a payment and the debt was accelerated, the creditors had exhausted their remedies, and the creditors had failed to collect the full amount of the debt. Therefore, the senior debt guaranty was a nontaxable debt-financed distribution. Finally, the amount of expenses, in the form of legal expenses, paid by the taxpayer to a group of potential buyers, was required to be capitalized.