It has been reported that Tribune Company has reached an agreement in principle to “sell” its Long Island newspaper, Newsday to News Corp. The “selling price” would be in neighborhood of $580 million and the structure of the deal would not be an outright sale but, instead, a joint venture arrangement.
Under the terms of the deal, Newsday would be part of a joint venture with News Corp.’s New York Post and other News Corp. assets. News Corp. would own most of the joint venture — on the order of 95 percent — and Tribune would own the remaining stake. Reuters is reporting that “…The structure of the deal is in part designed to meet Tribune’s demand that it be as tax-efficient as possible, with Tribune getting cash from the deal by guaranteeing debt raised by the joint venture…”
The need for tax-efficiency can be traced to the presence of the “built-in gain” tax rules. If, as here, an ‘S’ corporation (Tribune is believed to have elected this status) was formerly a ‘C’ corporation, the erstwhile ‘C’ corporation will be taxed on its “net recognized built-in gains.” Such gains are generated during the 10-year recognition period, which is the 10-year period beginning on the first day of the first taxable year for which the election is effective.
For this purpose, the ‘S’ corporation’s net recognized built-in gains — on which a tax is imposed —l consists of any gain it recognizes during the recognition period tied to the disposition of any asset. That is, except to the extent that the ‘S’ corporation affirmatively establishes that all or a portion of such gain was not “built-in.” To demonstrate that a portion of the gain was not built-in, the ‘S’ corporation must establish the extent to which the gain exceeded the amount by which the asset’s fair value exceeded its basis at the time of the ‘S’ election.
If the transaction is considered an outright sale of assets at the time of the ‘S’ election, Tribune will be hit with the tax consequences. Indeed, a tax, assessed at a 35 percent rate will be imposed on the portion (likely to be close to 100 percent) of the gain from the sale which was “economically accrued” at the time the ‘S’ election became effective.
Accordingly, Tribune appears to be employing an approach that will enable it to raise substantially all of the cash it would have raised had an outright sale been attempted, but in a manner which will delay the occurrence of the “sale,” for tax purposes, until after the 10 year recognition period has expired. Gains recognized by Tribune more than 10 years after the date on which the ‘S’ election became effective will be exempted from the built-in gains tax.
Similar to the “forward sale” structure we are speculating might be employed by Tribune for the purpose of disposing of properties tax-efficiently, the company seems to be resorting to another well-established technique, the so-called “leveraged partnership.” This technique, which should accomplish Tribune’s tax avoidance objectives, does however carry some unusual baggage.
The tax-related idea behind a leveraged partnership is to avoid having the transaction branded as a “disguised sale.” In general, a transfer of property by a partner (Tribune) to a partnership (the joint venture), and a transfer of money by the partnership to the partner, constitute a sale of the property if the surrounding facts and circumstances indicate that, in substance, the transaction closely resembles a conventional sale. Moreover, if within a two-year period, a partner transfers property to a partnership, and the partnership transfers money to the partner, the transfers are presumed to be a sale unless the facts and circumstances “clearly establish” that the transfers do not constitute a sale.
However, under Reg. Section 1.707-5(b)(1), the Tribune deal may not qualify as a disguised sales. Here’s why. Say that a partner transfers property to a partnership, and the partnership incurs a liability. Then, the proceeds of that liability are allocable to a transfer of money to the partner within 90 days of incurring the liability. In that case, the transfer of money to the partner is taken into account (for purposes of determining whether a disguised sale has transpired) only to the extent the amount of money transferred exceeds the partner’s allocable share of the partnership liability.
To be sure, if the funds conveyed to Tribune do not exceed its allocable share of the partnership liability, the second “leg” of a disguised sale will not be present. As a result, there is no transfer of money by the partnership to the partner and, therefore, the arrangement cannot be considered a disguised sale.
A partner’s share of a “recourse” liability equals the portion of the liability for which the partner “bears the economic risk of loss.” For this purpose, a partner bears such risk if the partnership constructively liquidated. In that case, the partner would be obligated to make a payment to any person because, (1) the liability becomes due and payable, and (2) the partner would not be entitled to reimbursement for its outlay.
According to tax regulations, determination of the extent to which a partner has an obligation to make a payment (to any person) is based on those ubiquitous “facts and circumstances.” For this purpose, and this seems to be key to the technique’s efficacy, the regulations provide that all contractual obligations are taken into account, including contractual obligations outside of the partnership agreement such as, among other things, guarantees.
Thus, it appears that Tribune’s guarantee of the partnership’s recourse debt will enable Tribune to conclude that its allocable share of that debt is at least equal to the amount of money that will be conveyed to it by the joint venture. Accordingly, the formation of the joint venture will not constitute a disguised sale.
Presumably, the “sale” (of Newsday) will occur when the joint venture pays off the loan incurred to fund the distribution to Tribune. So long as that event is delayed to a point in time after the expiration of the 10-year recognition period, the gain derived from such sale should not be subjected to the ravages of the built-in gains tax.
There may be one complication with the deal from a tax perspective, however — the so-called “anti-abuse” regulations. Reg. Section 1.701-2(b) states that if a partnership is formed in connection with a transaction, which principal purpose is to reduce substantially the present value of the partners’ aggregate tax liability, “in a manner that is inconsistent with the intent of Subchapter K,” the tax commissioner can recast the transaction for federal income tax purposes as appropriate to achieve tax results that are consistent with such intent.
The Internal Revenue Service — in LTR 200513022, November 15, 2004 — concluded that these anti-abuse rules properly applied to a leveraged partnership transaction engaged in by a taxpayer who sought to defer the gain realized on the conveyance of a building. It is unclear, of course, whether the IRS will attempt to advance this line of reasoning in the Tribune case. And it is, in our judgment, even more problematic that such an attempt would be successful.
Therefore, if all goes according to plan, Tribune will have “monetized” Tribune without incurring a tax liability, and will have done so at a seemingly modest, tax efficient cost. That cost: the incurrence by Tribune of a guarantee of the liability incurred by the joint venture to fund the distribution to Tribune. It seems highly unlikely that Tribune’s creditors would seek to prevent the company from incurring this secondary liability.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.