Canal Corp. v. Comm'r
135 T.C. No. 9, 2010 U.S. Tax Ct. LEXIS 25, 135 T.C. 199 (2010)
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Rule of Law:
A transaction involving a partnership contribution and a simultaneous large distribution may be recharacterized as a disguised sale if a partner's purported assumption of economic risk of loss for a partnership liability, designed to avoid taxation, lacks economic substance and is disregarded under the anti-abuse rule. Furthermore, reliance on a tax advisor's opinion for reasonable cause against an accuracy-related penalty is invalid if the advisor has an inherent conflict of interest and the opinion is based on unreasonable assumptions.
Facts:
- Chesapeake Corporation ("Chesapeake"), a paper company, owned Wisconsin Tissue Mills, Inc. ("WISCO"), its largest subsidiary, which manufactured commercial tissue products and accounted for a significant portion of Chesapeake's sales and earnings.
- WISCO faced substantial environmental liabilities related to Fox River contamination and other liabilities, and its tissue business was struggling due to industry consolidation, leading Chesapeake to seek restructuring options.
- Chesapeake, advised by Salomon Smith Barney and PricewaterhouseCoopers ("PWC"), developed a "leveraged partnership structure" with Georgia Pacific ("GP") to exit the tissue business while deferring tax on a sale.
- Under this structure, GP and WISCO formed Georgia-Pacific Tissue LLC ("LLC"); WISCO contributed its tissue business assets (valued at $775 million) for a 5-percent interest, and GP contributed its tissue assets for a 95-percent interest.
- The LLC immediately borrowed $755.2 million from Bank of America, which it distributed to Chesapeake's bank account, and GP guaranteed this loan while WISCO agreed to indemnify GP for any principal payments, but the indemnity was structured to be unlikely to be triggered and did not require WISCO to maintain a certain net worth.
- PWC, Chesapeake's long-term tax preparer, issued a "should" tax opinion, conditioned on the transaction's closing and for an $800,000 fixed fee, advising that the distribution was a non-taxable debt-financed transfer.
- After the transaction, WISCO's remaining assets, aside from its LLC interest, primarily consisted of a $151 million intercompany note from Chesapeake and a $6 million corporate jet, representing 21 percent of its maximum exposure on the indemnity, and it remained subject to the Fox River liability.
- Chesapeake treated the transaction as a sale for financial accounting purposes and informed rating agencies that the primary risk associated with the transaction was tax risk.
Procedural Posture:
- The Respondent (Commissioner of Internal Revenue) issued a deficiency notice to Chesapeake for its 1999 Federal income tax, asserting a $183,458,981 deficiency, determining that a joint venture transaction constituted a disguised sale.
- Chesapeake timely filed a petition in the United States Tax Court, challenging the deficiency.
- The Respondent filed an amended answer, asserting a $36,691,796 substantial understatement of income tax penalty under section 6662(a) for 1999.
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Issue:
1. Does a subsidiary's contribution of assets and most liabilities to a newly formed LLC, combined with a simultaneous receipt of a large cash distribution, constitute a disguised sale, requiring the parent corporation to recognize gain, when the subsidiary's indemnity of the LLC's debt is disregarded under the anti-abuse rule for lacking economic substance? 2. Is a taxpayer liable for a substantial understatement of income tax penalty when it relies on a tax opinion from an advisor who was actively involved in structuring the transaction, issued the opinion for a fixed fee contingent on closing, and based the opinion on dubious legal reasoning and unreasonable assumptions?
Opinions:
Majority - Kroupa, Judge
Yes, the transaction constituted a disguised sale requiring Chesapeake to recognize a $524 million gain in 1999, and yes, Chesapeake is liable for the substantial understatement penalty. The court found that the transfer of WISCO's assets and the simultaneous distribution of $755.2 million within a two-year period created a presumption of a disguised sale under IRC Section 707(a)(2)(B) and Income Tax Reg. 1.707-3(c)(1). Chesapeake attempted to fit the transaction within the debt-financed transfer exception, which requires the distributee partner to bear the economic risk of loss for the partnership liability. However, the court disregarded WISCO's indemnity of GP's guaranty under the anti-abuse rule of Income Tax Reg. 1.752-2(j). The court reasoned that the indemnity agreement's primary purpose was to create a facade of economic risk of loss for WISCO to defer tax, not to provide real protection to GP. This was evidenced by GP not requiring the indemnity, the indemnity covering only principal (not interest), GP having to exhaust LLC assets first, and WISCO receiving an increased LLC interest if it paid. Furthermore, WISCO's post-transaction assets, especially the intercompany note from Chesapeake, were under Chesapeake's absolute control and could be reduced, as demonstrated by the note's cancellation in 2001. WISCO's other existing liabilities also reduced its net worth, and GP never asked for assurances regarding WISCO's assets. The court rejected arguments to apply a 10-percent net worth test from an obsolete revenue procedure (Rev. Proc. 89-12) or to consider speculative fraudulent conveyance claims, concluding that the indemnity lacked economic substance. Regarding the accuracy-related penalty, the court found Chesapeake liable for a substantial understatement of income tax under Section 6662(a). Chesapeake failed to demonstrate reasonable cause and good faith by relying on PWC's tax opinion. The court determined that PWC's advice was based on unreasonable assumptions (e.g., the 20 percent asset maintenance and the "all or nothing" debt allocation test without legal authority) and was littered with errors. Crucially, PWC had an inherent conflict of interest because Mr. Miller, who drafted the opinion, was deeply involved in structuring the transaction, and the $800,000 fixed fee was contingent on the transaction's closing and the issuance of a "should" opinion (the highest level of comfort). This created a "quid pro quo" arrangement, undermining the independence necessary for good faith reliance.
Analysis:
This case significantly reinforces the IRS's ability to recharacterize complex partnership transactions as disguised sales, particularly when arrangements for debt allocation lack true economic substance and appear designed solely for tax deferral. It highlights the stringent application of the anti-abuse rule under Treasury Regulation 1.752-2(j), emphasizing that formal legal obligations will be disregarded if facts and circumstances indicate a plan to create a facade of economic risk. Moreover, the decision provides a strong precedent regarding the limits of relying on professional tax advice to avoid accuracy-related penalties. It establishes that taxpayers cannot claim reasonable cause or good faith when their advisor has an inherent conflict of interest due to active involvement in structuring the transaction, a contingent fee arrangement, and providing an opinion based on dubious legal reasoning.
