The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 1, August 2002, Panel Publishers, New York, NY.


By Robert W. Wood

We often think of the step transaction doctrine as applying primarily in the context of reorganizations (whether acquisitive or divisive), or at least as somehow related to the merger and acquisition field. (See Venigalla and Geracimos "Section 355(e): Now You See It, Now You Don't," this issue, p. 1). Indeed, most of the concern about the step transaction doctrine from practitioners arises in this context. (See Wood, "Step Transaction Doctrine and Mergers," Vol. 10, No. 6, The M&A Tax Report (Jan. 2002), p. 6.) Recently, though, there is good evidence that the Service does not view the step transaction doctrine as so limited. Step transactions in partnership deals? Yes, read on.

An IRS legal memorandum, ILM 200224007, Tax Analysts Doc. No. 2002-14217, 2002 TNT 116-26, concludes that the step transaction doctrine can be used (and is used there) to recharacterize a transaction as a sale of partnership interests, rather than a sale of partnership assets followed by a liquidating distribution. The fact pattern involves controlled foreign corporations and joint ventures, and suggests that maybe we all should be scratching our heads about potential applications of the step transaction doctrine in fields considerably more far flung than the typical acquisition.

In the ILM, an affiliated group and an unrelated company entered into a foreign joint venture. The joint venture was formed between a controlled foreign corporation of the affiliated group (CFC1) and a controlled foreign corporation of the other corporate partner (CFC2). The two CFCs formed a partnership in a foreign country. Thereafter, the two CFCs and the partnership they had formed created a lower tier partnership (in the same country) to actually own the facility that would produce the product. Later, the affiliated group and the other partner entered into an agreement which terminated the international joint venture.

The agreement called for CFC1 to sell its interest in both partnerships to CFC2. As it was structured, this sale was a sale of partnership interests (CFC1 sells its partnership interest to CFC2), rather than a sale of assets (the partnership selling assets and then making distributions). Thereafter, this structure was revisited. Indeed, the arrangement was restructured to occur as a three-step transaction, the goal being to avoid the creation of subpart F income.

If the restructuring was given effect in accordance with its form, the first CFC would not be treated as selling its partnership interests. That means that Section 954(c)(1)(B)(ii) would not apply. However, the IRS applied the step transaction doctrine, noting that the same end result would be achieved by the three supposedly separate transactions as would have occurred had the originally planned single transaction been actually carried out. The result was that the transaction was recharacterized under the step transaction doctrine as a sale of the partnership interests by CFC1.

The Service mentions substance-over-form, too, concluding that the transaction was more appropriately treated as a sale of a partnership interest (like the first documented plan), rather than a sale of partnership assets (the structure of the second plan). Almost as an afterthought, the memorandum notes that the "sale of a going concern doctrine" could also apply — as an alternative argument in the event that the Service needed one.

More Step Transaction Lore

There are a couple of points about this legal memorandum that are worth noting. Watching how the IRS and the courts apply the step transaction doctrine has become a recent fascination here at The M&A Tax Report, so merely the "watch-how-laws-and-sausages-are-made" inquiry itself is interesting. See Wood, "Step Transaction Doctrine in Mergers," Vol. 10, No. 6, The M&A Tax Report (January 2002), p. 6; and Wood, "Revisiting the Step Transaction Doctrine," Vol. 10, No. 5, M&A Tax Report (December 2001), p. 1. The Service says that there are "three distinct formulations" of the step transaction doctrine. According to the Service, those three formulations are:

The Service gives a predictable and formulaic description of each of these legal indices. Everyone has (or is entitled to have) their own mantra about the step transaction swamp. I think of factors, and four main ones: interdependence, binding commitment, elapsed time and end result/intention of the parties. I suppose elapsed time is merely one facet of interdependence, but it seems sufficiently distinct to merit its own moniker. Anyway, at least some courts have agreed.

Turning to the facts in the ILM, the Service then states (again, not surprisingly) that the original contract in this case indicates the intent of the parties was to engage in a sale of the first controlled foreign corporation's partnership interests. The Service finds that the original contemplation of the parties was clearly a single transaction that would have resulted in one of the controlled foreign corporations holding assets directly. Of course, it turned out the parties didn't like the tax result of this original deal. Instead of undertaking this simple transaction that would result in CFC2 holding the assets, the parties entered into a binding commitment to undertake three purportedly (the IRS is big on this word!) independent steps.

First, the two controlled foreign corporations contributed their interests in one partnership to another partnership. This caused the first partnership to have only one member, thus being treated as a disregarded entity for tax purposes. Thus, at this juncture we now have the two controlled foreign corporations as partners in a partnership, which in turn had a lower tier partnership (a disregarded entity). Next, the upper tier partnership sold all of its interest in the lower tier partnership to the second controlled foreign corporation. Because this lower tier partnership was a disregarded entity, this portion of the transaction would be treated as a sale of the operating assets held through the lower tier partnership.

Finally, the upper tier partnership made a liquidating distribution of the sale proceeds to both the first and second controlled foreign corporations. When the smoke clears, what is the tax result of this deal? The result is that the second controlled foreign corporation would be treated as holding the lower tier partnership's assets directly for U.S. federal tax purposes. Obviously, these three transactions (if one views them independently), wind up with the same end result for U.S. federal income tax purposes as the single transaction that was originally contemplated.

Given that this original transaction was contemplated (and in fact was the subject of a binding agreement — ouch!), it is not very surprising that the Service found it appropriate (and maybe even necessary) to invoke the step transaction doctrine. Under it, the Service characterizes the sale by CFC1 of its partnership interests in the upper tier and lower tier partnerships to CFC2. The Service, referring again to the three indicia of step transaction analysis (end result, mutual interdependence and binding commitment), says that any one of these theories (pick one, loser!) would be enough to make the recharacterization stick.

Actually, given the clarity of the binding commitment test, you'd think the Service would just say "binding commitment here, so you lose." Six words. Simple.

Of Substance, Form and Style

We can't leave this area, it seems, without spilling over into the substance-over-form analysis. After its step transaction diatribe, the IRS turns to the indisputably related doctrine of substance-over-form. Again alluding to the tax saving animus of the taxpayers, the IRS refers to the two controlled foreign corporations and their recasting of a transaction that was originally negotiated as a sale of the first controlled corporation's partnership interests (in both upper and lower tier partnerships) into an agreement between the two controlled foreign corporations to take three ostensibly unrelated steps. Reviewing those steps again, the Service says that even if the step transaction doctrine did not apply (and even if what the Service calls the "putative separate steps" were given independent significance), the Service believes that the substance of the second and third steps was simply a sale of the first controlled foreign corporation's partnership interests.

The Service actually mentions some partnership tax law. Indeed, the question whether a partner has sold its interest in a partnership on the one hand, or the partnership has redeemed that partner's interest on the other, comes up frequently. It's a kind of tax law who's-on-first routine. A departing partner, says the Service, often can either sell its partnership interest or have its partnership interest redeemed. The departing partner should generally receive the same proceeds in both cases, yet the tax treatment of the two alternatives can be quite different.

For example, a retiring partner may be entitled to capital gains treatment on a sale of his interest to another partner. Of course, the buying partner gets no deduction for these payments. A retiring partner may have to report the payments as ordinary income (from guaranteed payments for liquidation of his interest by the partnership). In that event, the partnership is able to deduct the payments made to the retiring partner. See discussion in Coven v. Commissioner, 66 T.C. 295 (1976), acq'd, 1976-2 C.B. 1. See also Miller v. U.S., 181 Ct. Cl. 331 (1967).

Partnership Steps and Coven

The Coven case is actually quite appropriate for discussion. One of five partners in an accounting firm decided to withdraw. He initially agreed to sell his partnership interest to another partner in the firm. Then, the deal was revisited and restructured. The withdrawing partner and the purchasing partners subsequently entered into a consulting agreement to supersede the original sales agreement. That consulting agreement provided that the withdrawing taxpayer would receive certain cash payments from the purchasing partner as a "consultant" to the firm.

The Tax Court actually allowed the taxpayer to disregard the form of the consulting agreement, and ruled that the taxpayer had essentially sold his partnership interest rather than receiving a liquidating distribution. The court based its decision on the following six factors: (1) the partnership was not a party to the agreement, and had no liability to make payments; (2) the taxpayer and the purchasing partner testified that they had intended a sale between them; (3) the payments came from the purchasing partner, and not the partnership; (4) when the obligation to pay was assumed by another partnership, the other partnership did not indicate any understanding that it was assuming an obligation of the first partnership; (5) no payments were made by the partnership to the taxpayer; and (6) the evidence indicated that the transaction had originally been negotiated as the sale of a partnership interest.

Using these Coven factors, the IRS then went back to the situation it was considering in the memorandum. Despite the taxpayer's characterization of the transaction as an asset sale by the upper tier partnership, the IRS found that in substance, this was simply a sale by the first controlled foreign corporation of its partnership interest in the upper tier partnership. Indeed, neither of the two partnerships were parties to the subsequent agreement that purported to bind the upper tier partnership to sell its interest in the lower tier partnership. This agreement was signed by the corporate owner of CFC1 and the corporate owner of CFC2. The IRS drew support for this mismatching of parties from the Coven opinion.

In Coven, the Tax Court did note (and presumably placed some weight) on the fact that the partnership was not a party to the agreement — an agreement that the government argued should be treated as providing full redemption payments. Similarly, here the upper tier partnership was not a party to the agreement that purported to bind it to sell its assets to the second controlled foreign corporation.

Real Money, or Smoke and Mirrors?

There were also parallels between the Coven facts and the instant CFC-partnership mess as to the source of funds. The Coven court noted that the payments to the departing party came from another partner. The partnership itself did not provide the money. The court therefore refused to find a liquidating distribution where the partnership neither made (nor was obligated to make) payments. Here, the upper tier partnership supposedly sold its assets and distributed a portion of the proceeds to the first controlled foreign corporation as a liquidating distribution.

Yet, the agreement that purported (that word again!) to effectuate a sale of all of the upper tier partnership's assets involved only a commitment from one company (the owner of the second controlled foreign corporation) to tender an amount that previously had been agreed was sufficient to purchase the partnership interest owned by the first controlled foreign corporation. Here the Service notes that offsetting legal obligations and "circular cash flows" may effectively eliminate any real economic significance to a transaction.

For this proposition, the Service cites Knetsch v. U.S., 364 U.S. 361 (1960). In Knetsch, it was a bond and taxpayer's borrowings which constituted offsetting obligations. The Supreme Court found the transaction was a sham. The taxpayer repeatedly borrowed against increases in the cash value of a bond, producing no significant economic effect. The court found that it was structured only to provide the taxpayer with interest deductions. Again, bad taxpayer animus. The Service found an analogy with the note issued by the second controlled foreign corporation, because it found it represented a "circular" cash flow lacking economic significance. After all, since the note was immediately distributed back to the second controlled foreign corporation.

Ah, There is the Rub

I suppose it's pretty obvious that the real death knell for the taxpayer considered in this ILM was the fact that it had already negotiated everything (and signed), and later thought better of it. That is certainly clear in the step transaction analysis. And, it is even more true with the substance-over-form analysis. The taxpayer made a perfect roadmap for the IRS, and put the map in a kind of metaphorical concrete.

The Service notes outright that "the substance-over-form analysis relies heavily on the fact that the alleged purchaser of the [upper tier partnership's] assets had previously negotiated to purchase [the first controlled foreign corporation's] partnership interests and committed to tender the amount previously agreed upon as the purchase price for those interests. One wonders how heavy the burden is to show that somehow enough has changed to apply a different result.

Perhaps it may be necessary to wipe the slate totally clean (such as by eradicating or nullifying all contracts, agreements, etc., and even allowing for some cooling off period before entering into a transaction that, at least on the surface, is substantially more tax favored. If this kind of old deal radical surgery isn't absolutely necessary, then it's at least potentially helpful. It darned sure can't hurt.

Last Gasp

I'm not sure why the Service raises it, but at the bitter end of the ILM, the Service notes that the sale of a going concern doctrine is a specialized substance-over-form argument. It is applicable, says the Service, when a partnership sells its operating assets to a third-party buyer and makes liquidating distributions to the existing partners. Maybe it was a bootstrap, but the Service notes again that the facts here don't support treating this as an asset sale.

Thus, so the Service does not think it needs to argue the sale of a going concern doctrine. However, the Service notes that it has another metaphorical arrow in its quiver, saying that it could use the sale of a going concern doctrine as an alternative theory. Any way you look at this one, you lose.

The minimum moral of this story? Get tax advice before you ink the deal.

Better moral: Get tax advice before you negotiate the deal.

Best moral: Get tax advice before you even structure the deal.

More Step Transaction Authority, Vol. 11, No. 2, The M&A Tax Report (August 2002), p. 1.