Category: Sales & Exchanges Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Partnership A is in the cable television business. In order to obtain financing necessary to complete construction of its cable system, Partnership A borrowed money secured by all of A's assets. Under the debt arrangement, a number of ostensibly unrelated cable television operators, including Partnership A, raised a pool of debt financing. The proceeds of the debt pool were allocated among the various borrowers. Each participant pledged all its assets as security for repayment of the entire debt pool. In essence, each participant cross-collateralized the debt incurred every other participant. Partnership A sold its assets. Under the terms of the cross-collateralization agreement, the lender impounded all the proceeds from A's sale. I have not seen the agreement, but I presume that A will recover the portion of its sale proceeds in excess of its share of debt when and if the portion of the debt owed by the other participants is paid off. This is a crucial point. Please confirm it. It has been suggested that the sale proceeds in excess of A's share of debt should be added to the basis of A's property thereby reducing A's gain. Although it seems that this novel situation has never been addressed, it has been suggested the James Caldwell and Company v. Comr., 234 F. 2d 660 (6 Cir. 1956), and B. Zermeno, 62 TCM 1155, support the addition-to-basis approach. I agree that this situation is novel and has not been addressed, but I strongly disagree with the addition-to-basis approach. In Caldwell, the taxpayer transferred real estate to his closely-held corporation in exchange for stock. Later, Mr. Caldwell's creditors tried to lay claim to the real estate in satisfaction of a personal obligation of Mr. Caldwell. The creditors claimed that the transfer of the property was a fraud on creditors and should be rescinded, thereby exposing the real estate to the claims of Caldwell's creditors. The transferee corporation paid around $50,000 to settle the suit and quiet title. The court held that the amount paid should be added to basis on the well-settled theory that amounts paid to quiet a title dispute with respect to a piece of property are properly considered part of the cost basis of that property. In Zermeno, the taxpayer's brother-in-law (Miranda) owned a shopping center. The taxpayer orally agreed to acquire the center from Miranda. Shortly thereafter, the taxpayer made certain payments to Miranda's two lenders in order to prevent foreclosure on the property. The court held that the payments were made to protect the taxpayer's putative property interest and were therefore properly includable in basis. I think these cases fall far short of providing any sort of authority for excluding or deferring a portion of the gain from the sale of A's assets. There is a critical difference between the present set of circumstances and those of Zermeno and Caldwell: whereas Zermeno and Caldwell permanently parted with cash in order to protect a present or future property interest, Partnership A has not yet permanently parted with anything of value other than the use of the funds from the sale. It has been suggested that the collateral arrangement is effectively a second tranche of debt used to acquire A's cable system. I disagree with that analysis. At one point, A's property, the cable system, stood as collateral for various debts. Now, the collateral has been converted to cash and the cash itself stands as collateral for those same debts. In my view, nothing has changed except the form of the collateral. Unfortunately, the change of form was a taxable event, and no provisions were made for releasing a portion of the collateral to pay the resulting tax liability. At one point, Partnership A had assets (the cable system) subject to a contingent obligation (in effect a secured guaranty arrangement). After the sale, Partnership A has an asset (cash) subject to the same contingent obligation. It is well settled that contingent obligations do not add to basis or produce a deductible loss until the taxpayer is required to perform based on the contingency. I have been unable to come up with any theory upon which A's gain can be reduced or offset at this point. Until A's rights in the collateral are diminished by a default on the loan covenant, it is my opinion that there is no taxable event that would give rise to an offsetting loss or a diminution of the gain.  |