Southgate Master Fund: The Sham Partnership Doctrine Gets Messy… Or Does It?

By Jonathan Prokup

Two weeks ago, the Fifth Circuit summarily rejected a taxpayer request for an en banc rehearing in Southgate Master Fund LLC v. United States.  The appellate court had previously concluded that the taxpayer was not entitled to a claimed capital loss from a transaction involving the acquisition of distressed debt via a partnership because the partnership was a “sham” that should be disregarded for federal tax purposes.  The taxpayer’s petition for rehearing, along with two amicus briefs, raised the specter that the Fifth Circuit’s opinion would require taxpayers to have a non-tax business purpose for choosing to conduct business activities in a partnership rather than a corporation.

Described briefly, the transaction at issue involved the acquisition of distressed debt by the taxpayer in a manner that would create a large tax loss.  First, an unrelated party holding the distressed debt formed a partnership with an accommodation party and transferred the debt to partnership.  This transfer created a large built-in loss in the transferor’s partnership interest.  The taxpayer then acquired the transferor’s partnership interest and contributed additional assets to the partnership, thereby entitling the taxpayer, at least under the technical rules of Subchapter K, to claim a deduction for the built-in loss when the partnership ultimately disposed of the distressed debt.

Although both the District Court and the Fifth Circuit concluded that the taxpayer’s acquisition of the underlying debt had economic substance, the courts also concluded that the additional steps beyond the basic acquisition – the formation of a partnership and the transfer of assets to it – lacked a non-tax business purpose and should be disregarded for tax purposes.  Without these transactional appendages, the transaction was recharacterized as a direct sale of the debt to the taxpayer, thereby eliminating the tax benefits that had putatively arisen from the partnership structure.

The taxpayer’s request for a rehearing rested on a variety of grounds, including the appellate panel’s apparent imposition of “a requirement that a taxpayer demonstrate that the choice of the partnership form had a business purpose that could not have been ‘equally well assured by alternative, less tax-beneficial means.’”  See App.’s Petition for Rehearing, No. 09-11166 at 12 (Nov. 14, 2011).  The Fifth Circuit’s original opinion reasoned that the “selection of the partnership form must [be] driven by a genuine business purpose.”  Southgate Master Fund, LLC v United States, No, 09-11166 at 27 (Sep. 30, 2011).

The taxpayer and its amici curiae read this statement as imposing a requirement that the taxpayer have a business purpose to use a partnership, rather than another form (e.g., a corporation), to conduct business activity.  According to the rehearing petition and amicus briefs, this “destabilizing” requirement is inconsistent with the decisions of other circuit courts as well as the elective entity-classification (i.e., “check-the-box”) regime.  In the taxpayer’s view, “much of federal partnership tax law set forth in Subchapter K is rendered meaningless if a separate business purpose for selecting the partnership form is required.”  Id. at 15.

The taxpayer and amici curiae are correct that no statute, regulation, or judicial opinion mandates that a taxpayer must have a business purpose for choosing to use a partnership, rather than another form, to conduct business activities.  Furthermore, the “check-the-box” entity classification rules have rendered the choice between a partnership and a corporation as a business vehicle largely elective.

These propositions, however, do not squarely address the appellate panel’s criticism of the transaction.  The Fifth Circuit was not criticizing the taxpayer’s choice of using a partnership rather than, say, a corporation as a vehicle to acquire the distressed debt.  Rather, the court was criticizing the taxpayer’s use of an entity to acquire the debt in the first place.  In the court’s view, had the taxpayer simply acquired the distressed debt directly, without resorting to the machinations of any intervening entity, he would have achieved the same economic result, but without the considerable tax benefits that the partnership structure provided.

To be sure, this reading of the opinion hearkens back to a constant tension running through tax law: while taxpayers are free to arrange their affairs in a way that minimizes their taxes, they may not do so in a manner that accomplishes nothing other than the creation of tax benefits.  Thus, for example, taxpayers are generally free to conduct activities through their vehicle of choice, which includes the choice of conducting activities directly, rather than through a partnership.  See Ginsburg & Levin, 2 Mergers, Acquisitions, and Buyouts 9-11 (2011).  On the other hand, as the Fifth Circuit’s analysis suggests, well-established precedent requires that a partnership be formed for the joint conduct of business activity and the sharing of profits and losses, not simply for facilitating tax benefits.  Without the intent to pursue a common business objective, a partnership generally will not be respected, as it was not in Southgate.

Given the court’s imprecise language, the taxpayer may be forgiven for adopting such a pessimistic interpretation of the opinion.  Nevertheless, the Southgate opinion does not represent the negative sea change that the taxpayer and the amici curiae made it out to be.

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