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In structuring business reorganization, form matters

Wilshire Courtyard in the “Miracle Mile” is one of the premiere office buildings in that highly desirable section of Los Angeles. Sold at the high point of the market in a complex transaction using substantial debt, the partnership that had legal title to the building ultimately was unable to pay its debts. After a bankruptcy filing that averted foreclosure, ownership of the property was restructured by admitting the debt holders into the partnership in exchange for a modest cash payment and cancellation of the partnership’s debt, reducing the interest of the prior owners of the partnership’s equity to 1 percent.

Thus, the debt holders obtained, through their interests in the partnership, indirect ownership of 99 percent of the property. Because this restructuring occurred under the jurisdiction of a bankruptcy court, the discharge of indebtedness, normally a taxable event under the Kirby Lumber case, 284 U.S. 1 (1931), and section 61(a)(12) of the Internal Revenue Code, can be exempt from federal income taxes by reason of section 108(a)(1)(A) of the Internal Revenue Code. But this was a state tax case, and Congress had then provided in section 346(j) of the Bankruptcy Tax Act a blanket exemption from state income taxes for cancellation of indebtedness income.

The California Franchise Tax Board nevertheless argued that the transaction was taxable under California law, and its principle argument was that the transaction should be treated as if the property had been sold by the partnership, creating not cancellation of indebtedness income but rather capital gain.

After two rounds before the Bankruptcy Appellate Panel and one review by the Ninth Circuit Court of Appeals, the taxpayer won. In re Wilshire Courtyard, CC-10-1275 (9th Cir. BAP April 28, 2015).The bankruptcy workout could have been structured as a sale of the property, and if it had been, it would have generated taxable capital gain rather than income from the discharge of indebtedness. But it was in fact structured not as a sale of the property but rather as the admission of new partners in exchange for cancellation of the partnership’s debt, and while the two forms have considerable overlap in their economic results, they have wildly different tax outcomes.

In terms of substance, sale of the property and cancellation of the debt/admission of the creditors as new partners are very similar, but this is an area in which Congress has determined that form matters. Because the partnership and its tax advisors were careful to structure the transaction as a cancellation of indebtedness, it gets the tax results (in this case, highly favorable tax results) that follow from that form. Sometimes substance trumps form, but sometimes form controls. And when form does control, it is important to have tax counsel involved in the transaction at an early enough stage.

Howard E. Abrams, Warren Distinguished Professor and director of tax programs at USD School of Law, wrote an amicus brief for the Real Estate Roundtable in support of the taxpayers in the Ninth Circuit litigation of the Wilshire Courtyard bankruptcy transaction.

-Submitted by USD School of Law

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