On October 26, 2021, the Tax Court issued a Memorandum Opinion in the case of Tribune Media Company v. Commissioner (T.C. Memo. 2021-122). The primary issue presented in Tribune Media Company v. Commissioner was whether the Ricketts family (a partner of the petitioner in “Chicago Baseball Holdings, LLC”) entered into a “bona fide debt” for tax purposes. (You may remember these parties from the January 2020 decision of Chicago Baseball Holdings v. Commissioner, T.C. Memo. 2020-2).
Held: The Tax Court found the petitioner’s argument as futile as the Chicago Cubs were between 1907 and 2016.
Background to the Debt Structure in Tribune Media Company v. Commissioner
Despite its ups and downs, your fearless editor still views baseball as America’s pastime. I should add that I have been a Red Sox fan since birth, and so I understand the futility, the heartbreaks, and the triumphs of the Cubs more than most casual fans. In 2009, the Cubs were sold to the Ricketts family—with the petitioner contributing the Cubs to a newly formed partnership and the Ricketts contributing cash and debt…to the tune of $900 million, approximately…for a 95% interest in the Cubs.
The transaction was not a simple one. It involved a leveraged partnership with 95% owned by the Ricketts family and 5% owned by Tribune along with a debt-financed distribution to Tribune (Cubs transaction). The Cubs transaction structure was dictated by Tribune and nonnegotiable. The Ricketts family contributed the equity through the trust, which wholly owned RAC. The trust transferred $191,985,182 to RAC, which then transferred $150 million to CBH as an equity investment.
The leveraged financing came from two tranches of debt: senior debt and sub debt. Chicago Baseball Holdings (CBH) was funded with $425 million of senior debt from unrelated third parties and $248,750,000 of sub debt from the Ricketts family. CBH is a limited liability company (LLC), and neither Tribune nor RAC had an obligation to contribute capital to CBH. Importantly, the members of CBH were not liable for the debts and obligations of CBH.
Several banks lent CBH a total of $425 million. Under the terms of the senior credit agreement governing these loans, CBH could use the senior debt only to (1) pay transaction costs, (2) fund a debt service reserve account, and (3) make the special distribution to Tribune. The IRS and the petitioner stipulated that the senior debt is bona fide debt for Federal income tax purposes; however, they disagree as to whether the senior debt should be characterized as recourse or nonrecourse to Tribune.
Sub debt was also used to fund CBH. RAC and Tribune chose to use sub debt after a failing financial market left the parties with few options. RAC pulled as much debt funding as possible from third-party lenders as senior debt. The matriarch of the Ricketts clan and the Ricketts entity, Ricketts Acquisition LLC (RAC), a separate entity from which to fund the sub debt and to hold the corresponding promissory note: RAC Education Trust Finance, LLC (RAC Finance). The matriarch’s LLC contributed $250,750,000 to RAC Finance, and RAC contributed $18 million. The sub debt was subordinated to the senior debt under the subordination agreement.
The subordination agreement makes payment of the sub debt conditional on full payment of the senior debt. The agreement also prioritizes the senior debt in the event of a dissolution or reorganization. Further, CBH was not obligated to repay the sub debt principal (only interest) until the sub debt note reached maturity. At CBH’s discretion, CBH may pay the total principal amount after five years from the closing date of the Cubs transaction.
RAC Finance could not demand payment on the sub debt except in the case of default or other limited circumstances; however, in practice, RAC Finance had no power to compel RAC to make its sub debt interest payments. The sub debt ranked higher than equity but lower than the senior debt at CBH. The parties do not appear to dispute this fact, but they disagree on whether the sub debt was debt or equity for Federal income tax purposes.
The Ricketts family ultimately did not sell interests in the sub debt. Although there was some effort to market the debt, the record does not establish that anyone was genuinely interested in acquiring any of the sub debt. Ultimately, the matriarch of the Ricketts kith funded the entire sub debt. On the closing date, Tribune executed two guaranties, the senior debt guaranty and the sub debt guaranty (collectively, guaranties). The guaranties were guaranties of collection of principal and interest; they were not guaranties of payment.
Tribune placed “no value” on the guaranties’ contingent and noncontingent liabilities due to RAC’s limited enforcement rights. Tribune thus did not report the value of the guaranties on its financial statements. It did, however, disclose the guaranties in footnotes within those statements.
Tribune timely filed its 2009 Form 1120S, on which Tribune reported the Cubs transaction as a disguised sale. It reported a loss of $190,685,361 and a net long-term capital gain of $33,542,275. It reported a net built-in gain of $33,830,135 attributable to the Cubs transaction. And Tribune deducted the $2.5 million it paid for legal fees. CBH timely filed its Form 1065. CBH reported that its partners contributed $150 million of cash and $730,879,891 of property during the 2009 taxable year. It also reported that it made a $704,872,594 cash distribution.
Examination, Petition, and Trial
The IRS examined Tribune’s and CBH’s 2009 tax returns. On June 28, 2016, the IRS sent Tribune a notice of deficiency for 2009. In the notice, the IRS determined an increased tax liability of $181,661,831 attributable to built-in gains under IRC § 1374 and denied Tribune’s $2.5 million deduction of legal fees on the basis that these costs should instead be capitalized.
On June 28, 2016, the IRS sent Northside Entertainment Holdings, LLC (formerly RAC), an FPAA for 2009. Through the FPAA, the IRS determined partnership items of CBH, namely, adjustments to income, capital contributions, and disguised sale proceeds. The FPAA also set forth the IRS’s determinations regarding the nature of CBH’s liabilities, reclassifying CBH’s sub debt as equity and its senior debt as nonrecourse. The IRS then adjusted CBH’s recourse liabilities down from $673,750,000 to zero and adjusted its nonrecourse liabilities from $122,878,291 to $547,878,291. The IRS also adjusted capital contributions to CBH.
Getting Down to Brass Tacks
Before entering into the Cubs transaction, Tribune elected subchapter S treatment for Federal income tax purposes. Ordinarily, S corporations are passthrough entities, which generally are not subject to Federal income tax. Instead, tax is imposed at the shareholder level. However, there are exceptions to this rule, including when a C corporation converts to an S corporation, a corporate-level tax applies to any net recognized built-in gain during the recognition period. The recognition period generally extends for 10 years from the date of conversion.
The Cubs transaction occurred within 10 years of when Tribune converted from a C corporation to an S corporation in 2007. Thus, when Tribune completed the Cubs transaction in 2009, it could be taxed on built-in gain at the corporate level. The question for the Tax Court was the extent of this built-in gain. The petitioners argue that the Cubs transaction is a disguised sale but that the distribution to Tribune is not taxable because it was a debt-financed distribution. The IRS argues that the distribution to Tribune is taxable. The IRS claims the guaranties promise repayment in name only, the senior debt is nonrecourse, and the sub debt is not bona fide debt.
Overview of Disguised Sales
Imagine a scenario where a person contributes property to a partnership in exchange for a partnership interest. The contribution is not a taxable event, and the contributing partner’s basis in the partnership interest is generally equal to the basis in the property at the time of contribution. Under normative rules, if that partner receives a distribution of cash from the partnership in excess of the basis of the property at the time of contribution, that excess distribution would be income.
Economically, however, the transaction looks a lot like a sale: Property is transferred and cash is received. This is a disguised sale, and the Code and the regulations set forth rules on how to calculate the gain, if any. These same basic principles to a situation in which a person borrows against property before contributing it.
What if the contributing partner is personally liable on that loan? Assuming responsibility for that liability would result in an increase to the contributing partner’s basis. As a result, that partner could receive a greater tax-free distribution because the partner’s basis includes the combination of the basis in the property at the time of contribution plus the amount of the liability assumed by the contributing partner.
This relatively straightforward example is the debt-financed distribution exception to the disguised sale rule. However, for the debt-financed distribution exception to apply, the debt must be bona fide debt, and the contributing partner must, in fact, have assumed or guaranteed the liability, which is the rub in Tribune Media Company v. Commissioner.
Generally, a partner who contributes property to a partnership will receive nonrecognition treatment, while a partner who sells property to a partnership must recognize any gain on that sale. Congress provides nonrecognition of gains on contributions to and distributions from a partnership to promote the free flow of capital between a partner and the partnership; these transfers reflect a mere change in the form of the investment, rather than a cashing-out and realization of the income from that investment.48 However, when a transaction is in reality the cashing out of an investment, the policy rationale behind tax-free treatment no longer applies.
The Debt-Financed Distribution Exception
There are exceptions to the disguised sale rules, including the debt-financed distribution rule. The debt-financed distribution rule permits a partner to receive a debt-financed distribution of property from a partnership as part of a disguised sale tax free up to the amount of debt allocated to that partner. To invoke the debt-financed distribution rule, the partner must “retain substantive liability for repayment” of the debt, meaning it must be allocated the partnership liability.
Under the debt-financed distribution rule, a partner’s allocable share of a partnership liability is its share of the liability under normal rules for allocation of partnership liabilities, multiplied by the percentage of the liability used to fund the distribution. The allocation of partnership liabilities among partners depends on whether the liability is a recourse liability or a nonrecourse liability. A recourse liability is a liability for which “any partner or related person bears the economic risk of loss.” A nonrecourse liability is one for which “no partner or related person bears the economic risk of loss.” Whether a transaction is abusive can depend on whether a partner bears the economic risk of loss.
A nonabusive debt occurs when a partner contributes property to a partnership and that property is borrowed against, pledged as collateral for a loan, or otherwise refinanced, and the proceeds of the loan are distributed to the contributing partner, there is not a disguised sale to the extent the distributed proceeds are attributable to indebtedness properly allocable to the contributing partner under the rules of IRC § 752 (i.e., to the extent the contributing partner is considered to retain substantive liability for repayment of the borrowed amounts), since, in effect, the partner in this case has simply borrowed through the partnership.
In contrast, an abusive situation occurs when the transferor partner receives the proceeds of a loan related to the property and responsibility for the repayment of the loan rests, directly or indirectly, with the partnership (or its assets) or the other partners. Essentially, the distinction is whether the contributing partner is still economically liable for the debt.
The Tax Court’s Analysis (VERY Briefly)
The opinion is 127 pages long; suffice it to say, a lot is packed in. We give a thumbnail sketch here. For more on these synopses, the full opinion is below.
Factors to Determine Debt or Equity
In determining whether an advance is debt or equity the Tax Court considers the 13 factors outlined in Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493 (1980):
- the names given to the certificates evidencing the indebtedness;
- presence or absence of a fixed maturity date;
- source of payments;
- right to enforce payments;
- participation in management as a result of the advances;
- status of the advances in relation to regular corporate creditors;
- intent of the parties;
- identity of interest between creditor and stockholder;
- “thinness” of capital structure in relation to debt;
- ability of corporation to obtain credit from outside sources;
- use to which advances were put;
- failure of debtor to repay;
- and risk involved in making advances.
The sub debt was equity, not bona fide debt, for tax purposes. Although the sub debt had the superficial appearance of bona fide debt, it more closely resembles equity. Most of the factors the Tax Court addressed signaled equity. Many of these factors–intent of the parties, right to enforce payment, risk, identity of the interest, and use of the advance–weigh significantly toward equity. Because the sub debt is equity, it cannot be allocated to Tribune as recourse debt. The portion of the special distribution funded by the sub debt thus does not qualify under the debt-financed distribution exception of the disguised sale rules.
- See, e.g., Bill Freaking Buckner. ↑
- IRC §§ 721(a), 722. ↑
- IRC § 731(a)(1). ↑
- IRC § 707(a)(2)(B); Treas. Reg. § 1.707-3. ↑
- IRC § 752(a). ↑
- Treas. Reg. § 1.707-5(b)(1). ↑
- See, e.g., Eisner v. Macomber, 252 U.S. 189, 212-13 (1920). ↑
- Treas. Reg. § 1.707-3(b)(2). ↑
- Treas. Reg. § 1.707-3(b)(1). ↑
- Treas. Reg. § 1.707-5(b)(2). ↑
- Treas. Reg. § 1.707-5(a)(2). ↑
- Treas. Reg. § 1.707-1(a)(1). ↑
- Treas. Reg. § 1.707-1(a)(2). ↑
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