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19th AnnualReal Estate Tax Forum

Volume Two

Co-ChairsLeslie H. Loffman

Sanford C. PresantBlake D. Rubin

© Practising Law Institute

34

Tax Court Goes Overboard in Canal

Blake D. Rubin Andrea Macintosh Whiteway

EY

Jon G. Finkelstein

KPMG LLP

January 10, 2011

Copyright 2011 Blake D. Rubin, Andrea Macintosh Whiteway and Jon G. Finkelstein. All rights reserved.

© Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. Reprinted with permission of Tax Notes.

Reprinted from the PLI Course Handbook, 18th Annual Real Estate Tax Forum (Order #144587)

If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.


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Tax Court Goes Overboard inCanalBy Blake D. Rubin,

Andrea Macintosh Whiteway, andJon G. Finkelstein

Table of Contents

I. Introduction . . . . . . . . . . . . . . . . . . . . . . 185II. Summary of the Facts in Canal . . . . . . . . . 185

A. Application of the Disguised SaleRules . . . . . . . . . . . . . . . . . . . . . . . . . 187

B. Partnership Disguised Sales — InGeneral . . . . . . . . . . . . . . . . . . . . . . . 188

C. Allocation of Recourse Liabilities . . . . . 188D. Court’s Disguised Sale Analysis . . . . . . 190

III. Application of Accuracy-Related Penalty . 193IV. Conclusion . . . . . . . . . . . . . . . . . . . . . . . 195

I. Introduction

In Canal Corp. v. Commissioner,1 the Tax Courtanalyzed the application of the partnership dis-guised sale rules under section 707(a)(2)(B) and the

regulations thereunder to a leveraged partnershiptransaction. Judge Kroupa held that the transactionfailed to qualify for the exception to partnershipdisguised sale treatment for some debt-financeddistributions, finding that the antiabuse rule in thepartnership liability allocation regulations undersection 752 applied. Also, Judge Kroupa found thatthe taxpayer was subject to an accuracy-relatedpenalty under section 6662(a) even though it hadobtained a ‘‘should’’-level tax opinion from a BigFour accounting firm that the transaction was nottaxable. Judge Kroupa held that the taxpayer couldnot rely on the tax opinion to avoid the applicationof the accuracy-related penalty because, in thecourt’s view, the opinion was tainted by an ‘‘inher-ent conflict of interest’’ for several reasons, includ-ing the fact that the accounting firm had advised thetaxpayer regarding the structure of the transaction.The court imposed the accuracy-related penaltywithout discussing whether the taxpayer had sub-stantial authority for its position.

This report summarizes the transaction at issuein Canal and analyzes the Tax Court’s holdings. Asdiscussed below, we disagree with the court’s con-clusion on the partnership disguised sale issue. Wealso believe that the court’s analysis regarding theapplication of the accuracy-related penalty is seri-ously flawed and that the court’s conclusion isincorrect.

Unfortunately, on October 28, 2010, the taxpayerissued a press release stating that the company isbankrupt and intends to settle the United States’approximately $106.7 million claim for 50 percent ofthe company’s $4 million of assets. Although thetaxpayer filed an appeal to the Fourth Circuit onOctober 29, 2010, if the settlement is approved bythe bankruptcy court, we understand that the ap-peal will not be pursued.

II. Summary of the Facts in Canal

Canal Corp., formerly known as ChesapeakeCorp., owned 100 percent of the stock of WisconsinTissue Mills Inc. (WISCO), which (along with othersubsidiaries) filed a consolidated federal income taxreturn with Chesapeake as the common parent.WISCO was in the business of manufacturing com-mercial tissue paper products. Because of consoli-dation in the tissue industry in the late 1990s,

1135 T.C. No. 9 (Aug. 5, 2010), Doc 2010-17535, 2010 TNT151-9.

Blake D. Rubin, Andrea Macintosh Whiteway, andJon G. Finkelstein are partners at McDermott Will &Emery.

In Canal Corp. v. Commissioner, the Tax Court heldthat a leveraged partnership transaction was taxablebecause it did not qualify for the debt-financed distri-bution exception to partnership disguised sale treat-ment. The Tax Court further held that an accuracy-related penalty applied because the taxpayer could notrely on a ‘‘should’’-level tax opinion from a Big Fouraccounting firm that was involved in structuring thetransaction. In this special report, the authors disagreewith the Tax Court’s analysis of the application of anaccuracy-related penalty, finding it seriously flawedand unworkable.

Copyright 2011 Blake D. Rubin,Andrea Macintosh Whiteway, and Jon G. Finkelstein.

All rights reserved.

tax notes®

SPECIAL REPORT

TAX NOTES, January 10, 2011 185

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WISCO’s tissue business was smaller than its com-petitors’.2 As a result, Chesapeake decided to dis-pose of its tissue business and concentrate on itsspecialty packaging business.3 Chesapeake had alow tax basis in WISCO. Accordingly, an outrightsale of Chesapeake’s tissue business would havegenerated a large tax liability.4

Chesapeake decided to dispose of the businessoperated by WISCO through a leveraged partner-ship structure (the transaction) with Georgia Pacific(GP), which was also in the tissue paper manufac-turing business. Chesapeake engaged SalomonSmith Barney and PricewaterhouseCoopers (PwC)to assist it in negotiating and documenting thetransaction. PwC had served as Chesapeake’s audi-tor and tax return preparer for many years.5 PwCand Chesapeake entered into an engagement letteron September 21, 1999, under which PwC agreed toprovide specified services to Chesapeake in ex-change for an $800,000 fee.6 Those services included(1) issuing a tax opinion in connection with thetransaction; (2) overall business and tax consulta-tion regarding issues related to the joint venturewith GP, including formation, operations, and dis-solution; and (3) consultation on an unrelated trans-action.7 The PwC engagement letter stated thatPwC would bill Chesapeake for those services onthe closing of the financing to be entered into inconnection with the transaction. The court con-strued the terms of the PwC engagement letter asproviding that the $800,000 fee was contingent onPwC delivering a ‘‘should’’-level tax opinion re-garding the tax consequences of the transaction.8However, the PwC engagement letter does not onits face provide for such a contingency.

The basic terms of the leveraged partnershipstructure were set forth in a letter of intent datedJune 25, 1999.9 The parties then negotiated thespecific terms of the transaction over an approxi-mately three-month period, and the transactionclosed on October 4, 1999 (the closing date).

In the transaction, WISCO and GP formedGeorgia-Pacific Tissue LLC (the LLC) and contrib-uted assets associated with their respective tissuemanufacturing businesses to the LLC. GP contrib-uted assets with an agreed value of $376.4 million in

exchange for a 95 percent interest in the LLC.10

WISCO contributed assets with an agreed value of$775 million in exchange for a 5 percent interest inthe LLC and a special cash distribution of approxi-mately $755 million.11 The special cash distributionwas funded with the proceeds from a loan fromBank of America (BOA).12 The BOA loan had amaturity date of the earlier of 180 days from theclosing date or March 21, 2000. In the LLC operatingagreement, WISCO and GP contemplated the refi-nancing of the BOA loan with long-term (30-year)debt after closing the transaction.13 The LLC did infact refinance the BOA loan with two 30-year loansfrom an affiliate of GP on November 12, 1999, andMay 1, 2000 (collectively, the refinance loans).14 Theobligations of the LLC under the BOA loan and therefinance loans were unconditionally guaranteed byGP.15

WISCO agreed to indemnify GP for any pay-ments of the original principal amount of the BOAloan or the refinance loans that GP was required tomake under its guarantee.16 Interest on the princi-pal amount was not covered by the indemnity.Further, WISCO’s indemnity provided that WISCOwould have no obligation to make a payment underits guarantee until GP had exhausted its rights toreimbursement or recovery from the LLC or theLLC’s assets.17 Thus, WISCO’s indemnity was anindemnity of collection rather than an indemnity ofpayment. The indemnity further provided thatWISCO would be subrogated to GP’s rights againstthe LLC to the extent of any payment it made to GPunder the indemnity.18 WISCO also had the optionto obtain an increased interest in the LLC in satis-faction of its subrogation rights against the LLC.19

However, the indemnity provided that WISCOwould have no right to pursue GP or any othermember of the LLC for reimbursement for anypayments WISCO made under the indemnity.20 Theindemnity provided that it could be terminated onthe third anniversary of the closing date or anysubsequent anniversary with at least 15 days’ no-tice, but only if there was no default on the BOA

2Opening Brief for Petitioner (Feb. 9, 2010) (Chesapeakebrief), Tax Ct. Dkt. No. 14090-06, at 3-4.

3Id. at 4.4Id.5Canal, 135 T.C. No. 9, at 9.6See letter from PwC to Chesapeake, Sept. 21, 1999 (PwC

engagement letter), Tax Ct. Dkt. No. 14090-06, Exhibit 53-J.7Id.8Canal, 135 T.C. No. 9, at 37.9Chesapeake brief at 6.

10Canal, 135 T.C. No. 9, at 14.11Id.12Id.13Brief for Respondent, Feb. 9, 2010 (IRS brief), Tax Ct. Dkt.

No. 14090-06, at 40.14Id.15Tax opinion from PwC to Chesapeake, Oct. 4, 1999, Tax Ct.

Dkt. No. 14090-06, Exhibit 157-P, at 7.16Id.17Id.18Id. at 7-8.19Id. at 8.20Id.

COMMENTARY / SPECIAL REPORT

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loan or the refinance loans and if neither WISCOnor an affiliate of WISCO owned an interest in theLLC.21

GP agreed to indemnify WISCO for any tax costWISCO might incur if GP were to buy out itsinterest in the LLC.22

WISCO used a portion of the proceeds from thespecial distribution to repay an intercompany loanto another subsidiary of Chesapeake.23 WISCO usedthe remaining proceeds of the special distribution topay a dividend to Chesapeake, repay amountsowed to an affiliate of Chesapeake, and to make a$151.05 million intercompany loan to Chesapeake.24

Following the closing of the transaction, WISCO’sassets included the $151.05 million intercompanynote from Chesapeake and a corporate jet with avalue of approximately $6 million. Accordingly,WISCO’s net worth represented approximately 21percent of its maximum exposure on the indem-nity.25

PwC issued the tax opinion to WISCO on theclosing date, which concluded at a ‘‘should’’ level ofcomfort26 that the LLC qualified as a partnership fortax purposes, that WISCO was a partner, and that thedistribution to WISCO qualified for the debt-financed distribution exception to the partnershipdisguised sale regulations under section 707(a)(2)(B).27 Further, in connection with the refinanceloans, PwC issued two additional opinions on No-vember 23, 1999, and on August 3, 2000, regardingwhether the refinance loans would have an impacton the conclusions reached in the tax opinion. Theauthor of PwC’s two additional opinions was not thesame as the author of the initial tax opinion.28 Thetwo additional opinions recited that the tax opinionhad been issued and that the author of the additionaltax opinions had examined the transaction docu-ments and concluded that the refinance loans should

not cause the transaction to be treated as a disguisedsale for federal income tax purposes.29

The LLC operated for only approximately oneyear. In 2001, because of antitrust considerations,GP was required to sell its interest in the LLC toconsummate another acquisition transaction.30 As aresult, GP negotiated a deal for the sale of 100percent of the interests in the LLC. WISCO agreedto sell its interest in the LLC for $41 million, whichrepresented a gain of $21.2 million.31 In connectionwith the sale of the LLC interests, GP paid WISCO$196 million to compensate it for the loss of taxdeferral associated with the transaction.32 Chesa-peake reported $524 million of capital gain on itsconsolidated income tax return for 2001. Chesa-peake also reported $196 million of ordinary in-come in 2001 for the indemnity payment it receivedfrom GP.33 Following the sale in 2001, WISCOdeclared a dividend of $166 million to Chesapeakein cancellation of Chesapeake’s intercompany noteto WISCO.34

The IRS issued Chesapeake a deficiency noticefor 1999 in which it determined that the transactionconstituted a disguised sale of assets under section707(a)(2)(B) that resulted in $524 million of capitalgain in 1999. The IRS also argued that the transac-tion should be recast as a sale under the substance-over-form and economic substance doctrines.35

Further, the IRS asserted a $36.7 million accuracy-related penalty under section 6662 for a substantialunderstatement of income tax in connection withChesapeake’s reporting of the transaction on its1999 consolidated federal income tax return.36

Chesapeake argued that the transaction was not adisguised sale because it qualified for the debt-financed distribution exception to disguised saletreatment under reg. section 1.707-5(b)(2).

A. Application of the Disguised Sale RulesAs noted above, the IRS argued that the transac-

tion should be recast as a sale both under thetechnical requirements of section 707(a)(2)(B) andon general substance-over-form or economic sub-stance grounds. The Tax Court, however, limited its21Id.

22Id. at 11.23Id. at 15.24Id.25Id.26A PwC representative testified that a ‘‘should’’-level tax

opinion is the highest level of comfort that PwC offers to a clientregarding whether the position taken by the client will succeedon the merits. Id. at 34.

27We note that the Tax Court stated that only a draft of the taxopinion was submitted into evidence. However, our review ofthe record indicates that the final tax opinion that was issued onthe closing date was in fact submitted into evidence. Thedocument that the Tax Court refers to as a draft tax opinion isactually a draft of a supporting memorandum for the taxopinion.

28Chesapeake brief at 28.

29Id. at 27-28.30Canal, 135 T.C. No. 9, at 17.31Id. at 18.32Id.33Id.34Id.35IRS brief at 99-104.36Id. The amount of the accuracy-related penalty plus ap-

proximately $28 million of interest on the penalty exceeded theasserted deficiency of $42 million. As noted above, becauseChesapeake reported its deferred gain associated with thetransaction in 2001, the deficiency related only to the interestaccrued on this amount from 1999 through 2001.



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analysis to the application of the technical require-ments of section 707(a)(2)(B) and the regulationsthereunder, as discussed below. Given the explicitprovisions of the regulations that address the factpattern raised by the transaction, we believe the TaxCourt’s rejection of the IRS’s economic substanceand substance-over-form arguments was appropri-ate.

B. Partnership Disguised Sales — In GeneralSection 707(a)(2)(B) provides that if:

i. there is a direct or indirect transfer ofmoney or other property by a partner to apartnership;ii. there is a related direct or indirecttransfer of money or other property bythe partnership to such partner (or an-other partner); andiii. the transfers described in clauses (i)and (ii), when viewed together, are prop-erly characterized as a sale or exchange ofproperty,

those transfers shall be treated either as a transac-tion occurring between the partnership and onewho is not a partner or as a transaction between twoor more partners acting other than in their capacityas members of the partnership.

Similarly, the regulations under section 707(a)(2)(B) provide:

A transfer of property (excluding money or anobligation to contribute money) by a partner toa partnership and a transfer of money or otherconsideration (including the assumption of orthe taking subject to a liability) by the partner-ship to the partner constitute a sale of prop-erty, in whole or in part, by the partner to thepartnership only if based on all the facts andcircumstances —i. the transfer of money or other considerationwould not have been made but for the transferof property; andii. in cases in which the transfers are not madesimultaneously, the subsequent transfer is notdependent on the entrepreneurial risks of part-nership operations.37

Regarding the requirement in section707(a)(2)(B)(iii) that ‘‘the transfers described inclauses (i) and (ii), when viewed together, areproperly characterized as a sale or exchange ofproperty,’’ the conference report on the disguisedsale legislation in 1984 states:

The conferees wish to note that when a partnerof a partnership contributes property to thepartnership and that property is borrowedagainst, pledged as collateral for a loan, orotherwise refinanced, and the proceeds of theloan are distributed to the contributing part-ner, there will be no disguised sale under theprovision to the extent the contributing part-ner, in substance, retains liability for repay-ment of the borrowed amounts (i.e., to theextent the other partners have no direct orindirect risk of loss with respect to suchamounts) since, in effect, the partner has sim-ply borrowed through the partnership. How-ever, to the extent the other partners directly orindirectly bear the risk of loss with respect tothe borrowed amounts, this may constitute apayment to the contributing partner.38

The regulations under section 707(a)(2)(B) imple-ment this ‘‘borrowing through the partnership’’exception to disguised sale treatment. Reg. section1.707-5(b)(2) provides:

For purposes of section 1.707-3, if a partnertransfers property to a partnership, and thepartnership incurs a liability and all or aportion of the proceeds of that liability areallocable under section 1.163-8T to a transfer ofmoney or other consideration to the partnermade within 90 days of incurring the liability,the transfer of money or other consideration tothe partner is taken into account only to theextent that the amount of money or the fairmarket value of the other consideration trans-ferred exceeds that partner’s allocable share ofthe partnership liability.For a recourse partnership liability, a partner’s

allocable share of the partnership liability is equalto the partner’s share of the liability determinedunder the section 752 regulations, multiplied by afraction, the numerator of which is the portion ofthe proceeds that are distributed to the partner andthe denominator of which is the total amount of theliability.39

C. Allocation of Recourse LiabilitiesUnder the section 752 regulations, a recourse

partnership liability is allocated to a partner to theextent that the partner bears the ‘‘economic risk ofloss’’ for the liability. A partner is treated as bearingthe economic risk of loss for a partnership liabilityto the extent that, if the partnership’s assets wereworthless and the partnership liquidated, the part-ner or a related person would be obligated to make

37Reg. section 1.707-3(b).

38H.R. Rep. No. 98-861, at 862 (1984).39Reg. section 1.707-5(b)(2).



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a payment because the liability becomes due andpayable. Obligations of the partner or a relatedperson regarding the liability — including obliga-tions to the lender, the partnership, or other part-ners — are taken into account for that purpose.40

To determine who bears the economic risk of lossfor a recourse liability, the regulations use a me-chanical ‘‘constructive liquidation’’ test. Reg. sec-tion 1.752-2(b)(1) provides that on a constructiveliquidation, all of the following events are deemedto occur simultaneously:

• all the partnership’s liabilities become payablein full;

• with the exception of property contributed tosecure a partnership liability, all the partner-ship’s assets, including cash, have a value ofzero;

• the partnership disposes of all its property in afully taxable transaction for no consideration(except relief from liabilities for which thecreditor’s right to repayment is limited solelyto one or more assets of the partnership);

• all items of income, gain, loss, or deduction areallocated among the partners; and

• the partnership liquidates.A partner bears the economic risk of loss for a

liability to the extent that if the partnership con-structively liquidated, the partner (or a relatedperson) would be obligated to pay a creditor ormake a contribution to the partnership because theliability would be due and the partner (or relatedperson) would not be entitled to reimbursement.41

Reg. section 1.752-2(b)(3) provides that all statutoryand contractual obligations relating to the partner-ship liability are taken into account for purposes ofdetermining which partner bears the economic riskof loss, including (i) contractual obligations outsidethe partnership agreement such as guarantees, in-demnifications, reimbursement agreements, andother obligations running directly to creditors or toother partners, or to the partnership; (ii) obligationsto the partnership that are imposed by the partner-ship agreement, including the obligation to make acapital contribution and restore a deficit capitalaccount on liquidation of the partnership; and (iii)payment obligations (whether in the form of directremittances to another partner or a contribution tothe partnership) imposed by state law, including thegoverning state partnership statute.42 Special rulesapply when the obligation is imposed on an entity

that is disregarded as separate from its owner, suchas a single-member limited liability company.43

Also, a partner is considered to bear the economicrisk of loss for a partnership liability to the extentthat the partner or a related person makes (oracquires an interest in) a nonrecourse loan to thepartnership and the economic risk of loss for theliability is not borne by another partner.44

The section 752 regulations contain a presump-tion that a partner or related person will in factsatisfy an obligation to make a payment to a credi-tor or the partnership in connection with the con-structive liquidation of the partnership. Reg. section1.752-2(b)(6) provides:

For purposes of determining the extent towhich a partner or related person has a pay-ment obligation and the economic risk of loss,it is assumed that all partners and relatedpersons who have obligations to make pay-ments actually perform those obligations, irre-spective of their actual net worth, unless the factsand circumstances indicate a plan to circum-vent or avoid the obligation. [Emphasisadded.]

However, the section 752 regulations also containan antiabuse rule under which a partner’s or arelated person’s obligation to make a payment maybe disregarded if facts and circumstances indicatethat a principal purpose of the arrangement is toeliminate the partner’s or related person’s economicrisk of loss on that obligation or create the appear-ance of the partner or related person bearing theeconomic risk of loss when in fact the substance ofthe arrangement is otherwise.45 Reg. section 1.752-2(j)(4) contains the following example of an ar-rangement that would be subject to the section 752antiabuse rule:

A and B form a general partnership. A, acorporation, contributes $20,000 and B contrib-utes $80,000 to the partnership. A is obligatedto restore any deficit in its partnership capitalaccount. The partnership agreement allocateslosses 20 percent to A and 80 percent to B untilB’s capital account is reduced to zero, afterwhich all losses are allocated to A. The part-nership purchases depreciable property for$250,000 using its $100,000 cash and a $150,000

40Reg. section 1.752-2(b).41Id.42For a general discussion of these rules, see Blake D. Rubin,

Andrea Macintosh Whiteway, and Jon G. Finkelstein, ‘‘WorkingWith the Partnership Liability Allocation Rules: Guarantees,DROs and More,’’ 68 N.Y.U. Fed. Tax Inst., ch. 10 (2010).

43Reg. section 1.752-2(k). For a discussion of these rules, seeRubin, Whiteway, and Finkelstein, ‘‘Final Regulations on theTreatment of Disregarded Entities Under Code Sec. 752: Ques-tions and Complexities Continue,’’ 10 J. Passthrough Entities No.2 (2007). These rules were not applicable to the tax year at issuein Canal.

44Reg. section 1.752-2(c).45Reg. section 1.752-2(j).



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recourse loan from a bank. B guarantees pay-ment of the $150,000 loan to the extent the loanremains unpaid after the bank has exhaustedits remedies against the partnership. A is asubsidiary, formed by a parent of a consolidatedgroup, with capital limited to $20,000 to allow theconsolidated group to enjoy the tax losses generatedby the property while at the same time limiting itsmonetary exposure for such losses. These facts,when considered together with B’s guarantee,indicate a plan to circumvent or avoid A’sobligation to contribute to the partnership. Therules of section 752 must be applied as if A’sobligation to contribute did not exist. Accord-ingly, the $150,000 liability is a recourse liabil-ity that is allocated entirely to B. [Emphasisadded.]The IRS previously asserted the application of

the section 752 antiabuse rule in ILM 200246014,Doc 2002-25564, 2002 TNT 222-46. In that memoran-dum, a subsidiary of the taxpayer that was apartner in a partnership guaranteed a partnershipliability, the proceeds of which were distributed tothe partner. In concluding that the subsidiary’sguarantee should be disregarded under the section752 antiabuse rule, the IRS noted that the subsidiarypartner was ‘‘severely undercapitalized with re-spect to the loan guarantee.’’46

D. Court’s Disguised Sale AnalysisIn its analysis of the application of the debt-

financed distribution exception to disguised saletreatment to the transaction, Judge Kroupa focusedon the fact that WISCO, rather than Chesapeake,served as the indemnitor on the BOA loan and therefinance loans. The court noted that ‘‘WISCO waschosen as the indemnitor, rather than Chesapeake,after PWC advised Chesapeake’s executives thatWISCO’s indemnity would not only allow Chesa-peake to defer tax on the transaction, but wouldalso cause the economic risk of loss to be borne onlyby WISCO’s assets, not Chesapeake’s.’’47 The courtalso observed that the indemnity agreement did notobligate WISCO to maintain a specified net worth.48

Accordingly, the court analyzed the transactionunder the section 752 antiabuse rule. It determinedthat the antiabuse rule in reg. section 1.752-2(j)applied to the transaction because WISCO’s indem-nity created the appearance that it bore the eco-nomic risk of loss when in substance it did not.Judge Kroupa said:

WISCO’s principal asset after the transfer wasthe intercompany note. The indemnity agree-ment did not require WISCO to retain this noteor any other asset. Further, Chesapeake and itsmanagement had full and absolute control ofWISCO. Nothing restricted Chesapeake fromcancelling the note at its discretion at any timeto reduce the asset level of WISCO to zero.49

The court found that the structure at issue wasnot distinguishable from the example in the section752 antiabuse regulation:

This appears to be a concerted plan to drainWISCO of assets and leave WISCO incapable,as a practical matter, of covering more than asmall fraction of its obligation to indemnifyGP. We find this analogous to the illustration[in the section 752 antiabuse regulation] be-cause in both cases the true economic burdenof the partnership debt is borne by the otherpartner as guarantor. Accordingly, we do notfind that the anti-abuse rule illustration extri-cates Chesapeake, but rather it demonstrateswhat Chesapeake strove to accomplish.50

The court said that a ‘‘thinly capitalized sub-sidiary with no business operations and no realassets cannot be used to shield a parent corporationwith significant assets from being taxed on adeemed sale.’’51 As a result, the court held that thedistribution of cash to WISCO did not qualify forthe debt-financed distribution exception to the dis-guised sale rules and that the transaction should berecast as a sale of WISCO’s business assets to GP in1999.52

While we acknowledge that the structure of thetransaction, with an indemnity from a subsidiary oflimited net worth rather than the parent of aconsolidated group, raises an issue under the sec-tion 752 antiabuse rule, we disagree that WISCO’sindemnity should be disregarded. WISCO’s networth supporting its indemnity obligation bears noresemblance to the net worth of partner A in theexample set forth in reg. section 1.752-2(j)(4). In theexample, A’s net worth is limited to the value of itsinterest in the partnership. As noted above, forpurposes of the constructive liquidation test in reg.section 1.752-2(b)(1), it is assumed that all assets ofthe partnership are worthless, including cash. As aresult, an analysis of the allocation of the partner-ship’s recourse debt in the example requires one to

46See Rubin and Whiteway, ‘‘Here Comes the Kitchen Sink:IRS Throws ‘Everything But’ at Two Partnership Tax DeferralStructures,’’ 6 J. Passthrough Entities No. 2 (2003).

47Canal, 135 T.C. No. 9, at 24.48Id.

49Id. at 26.50Id. at 27-28.51Id. at 27.52Id. at 30.



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assume that the value of A’s interest in the partner-ship is zero and therefore that A’s net worth is zero.In contrast, WISCO’s net worth on the closing date,not taking into account its interest in the LLC, wasapproximately $156 million.

We also note that although WISCO did not enterinto an agreement with GP to maintain its net worthin connection with its indemnity, WISCO did rep-resent to PwC in connection with the issuance of thetax opinion that it would hold assets with a netFMV greater than or equal to $151 million at alltimes WISCO’s indemnity remained in effect.53 Thetax opinion could be relied on by Chesapeake onlyto the extent that WISCO’s representations weretrue. As noted repeatedly by the Tax Court, WISCOlikely would not have participated in the transac-tion if it had been structured as a taxable transac-tion.54 WISCO therefore had a significant incentiveto maintain its net worth in accordance with itsrepresentation to PwC at a level far in excess of thenet value of the partner in the section 752 antiabuseregulation example. In fact, WISCO did maintain itsnet worth until its interest was sold to GP in 2001.Further, unlike the example in the section 752antiabuse regulation, WISCO was not a newlyformed entity created to shelter Chesapeake fromliability. WISCO was the historic owner of the assetscontributed to the LLC.

Given the purely mechanical nature of the part-nership recourse liability allocation rules in thesection 752 regulations, which do not take intoaccount the actual net worth of partners for pur-poses of allocating partnership recourse liabilities,and the fact that WISCO’s indemnity is distinguish-able from the extreme example set forth in thesection 752 antiabuse rule involving a newly cre-ated entity partner with zero net worth, we do notagree that WISCO’s indemnity should be disre-garded.

The court also found that the terms of the indem-nity reduced the likelihood of GP invoking theindemnity against WISCO, thereby further creatingthe appearance that WISCO bore the economic riskof loss when it in fact did not. The terms of theindemnity that troubled Judge Kroupa include thefact that the indemnity only covered principal andnot interest, that GP had to first proceed against thejoint venture’s assets before demanding indemnifi-cation from WISCO, and that, to the extent WISCOpaid on the indemnity, it would receive an in-creased interest in the LLC.55 The court’s analysis

regarding whether it was likely that WISCO wouldhave to satisfy its indemnity is wholly inconsistentwith the constructive liquidation test mandated bythe section 752 regulations. The constructive liqui-dation test is by its nature hypothetical and requiresassumptions that are unlikely if not impossible tooccur (for example, that cash become worthless).The point of the test is to assess who bears theultimate risk of loss, regardless of how remote thatrisk may be.

Regarding WISCO’s guarantee of principal, thesection 752 regulations clearly provide that such aguarantee is effective to treat the guarantor asbearing the economic risk of loss for the guaranteedprincipal. Reg. section 1.752-2(f), Example 5, statesas follows:

A partnership borrows $10,000, secured by amortgage on real property. The mortgage notecontains an exoneration clause which providesthat in the event of default, the holder’s onlyremedy is to foreclose on the property. Theholder may not look to any other partnershipasset or to any partner to pay the liability.However, to induce the lender to make theloan, a partner guarantees payment of $200 ofthe loan principal. The exoneration does notapply to the partner’s guarantee. If the partnerpaid pursuant to the guarantee, the partnerwould be subrogated to the rights of thelender with respect to $200 of the mortgagedebt, but the partner is not otherwise entitledto reimbursement from the partnership or anypartner. For purposes of section 752, $200 ofthe $10,000 mortgage liability is treated as arecourse liability of the partnership and $9,800is treated as a nonrecourse liability of thepartnership. The partner’s share of the re-course liability of the partnership is $200.Thus, the example confirms that a guarantee of

principal (without a guarantee of interest) shifts theeconomic risk of loss to the guarantor. The courtdoes not analyze or even cite this example in itsanalysis.

Further, the fact that WISCO’s indemnity was anindemnity of collection should have no bearing onwhether WISCO bore the economic risk of loss forthe BOA loan or the refinance loans. The section 752regulations simply do not take into account thelikelihood that an obligation will need to be satis-fied in determining whether a partner bears theeconomic risk of loss for a liability. As discussedabove, the deemed liquidation analysis in reg. sec-tion 1.752-2(b)(1) mandates that all assets of thepartnership are deemed to be worthless in deter-mining whether a partner bears the economic riskof loss for a partnership liability. Treasury deter-mined not to require an analysis of the credit risk

53See Certificate of WISCO, Oct. 4, 1999, attached to the TaxOpinion (WISCO certificate).

54See Canal, 135 T.C. No. 9, at 7, 8-9, 37.55Id. at 24.



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associated with a loan in connection with the evalu-ation of whether a partner has an obligation tomake a payment on a partnership liability. It optedinstead to use the deemed liquidation analysis.Accordingly, under those rules, tax practitioners arecomfortable that a partner’s ‘‘bottom’’ guaranty of awell-secured partnership liability should be takeninto account as an obligation even though there is avery low likelihood that the partner would actuallyever have to make a payment on that guaranty.56 Wealso note that the section 704(b) regulations specifi-cally address the consequences of a bottom guaran-tee on the computation of minimum gain under thesection 704(b) regulations but in no way suggestthat the bottom guarantee is illusory or should bedisregarded.57 Similarly, reg. section 1.737-4(b), Ex-ample 2, involves a fact pattern in which a partnerguarantees a partnership nonrecourse debt with aprincipal purpose of increasing the partner’s basisunder section 752(a) and avoiding gain under sec-tion 737.58 Despite that malicious principal purpose,the example concludes that the basis increase undersection 752(a) must be given effect and that thesection 737 gain is therefore avoided. Accordingly,the fact that a guaranty may be tax motivatedshould not affect the section 752 analysis regardingthe allocation of debt.

Likewise, because the section 752 regulationsmandate the assumption that all the LLC’s assetsare worthless, the fact that GP must pursue all ofthe assets of the LLC before making a claim on theindemnity should have no effect on the analysis ofwhether WISCO has an obligation to make a pay-ment for purposes of reg. section 1.752-2(b). Thepursuit of the LLC’s assets under the assumptionsrequired by the regulations would not preventWISCO from having to satisfy its indemnity.

Similarly, the fact that WISCO had the option toreceive an additional interest in the LLC in satisfac-tion of its subrogation rights for payments madeunder the indemnity should not affect the analysisof whether WISCO’s indemnity should be taken

into account for purposes of section 752. The section752 regulations clearly allow a capital contributionobligation to be taken into account as an obligationfor purposes of allocating partnership recourse li-abilities even though that contribution will gener-ally result in the contributing partner receiving bothan additional capital and profits interest in thepartnership.59 Under the deemed liquidation analy-sis, such an additional interest in the partnership isworthless and is therefore not taken into account asa reimbursement right. Similarly, under the section752 regulations’ deemed liquidation test, WISCO’soption to receive an additional interest in the LLCwas worthless and should have no effect on theanalysis of whether WISCO had a payment obliga-tion.

Finally, we note that the Tax Court’s partnershipdisguised sale analysis did not consider the capitalexpenditures WISCO had incurred for the assetscontributed to the LLC. The WISCO certificate saysthat WISCO made in excess of $47 million of capitalexpenditures for the assets contributed to the LLCduring the two years immediately preceding theclosing date. The certificate also says that the FMVof the property resulting from the capital expendi-tures made by WISCO for the contributed assetsduring the two years immediately preceding theclosing date was at least $40 million as of the closingdate. Reg. section 1.707-4(d) provides:

Exception for reimbursements of preformation ex-penditures. — A transfer of money or otherconsideration by the partnership to a partneris not treated as a part of a sale of property bythe partner to the partnership under section1.707-3(a) (relating to treatment of transfers asa sale) to the extent that the transfer to thepartner by the partnership is made to reim-burse the partner for, and does not exceed theamount of, capital expenditures that —

1. Are incurred during the two-year pe-riod preceding the transfer by the partnerto the partnership; and

2. Are incurred by the partner with re-spect to —

i. Partnership organization and syndi-cation costs described in section 709; or

ii. Property contributed to the partner-ship by the partner, but only to theextent the reimbursed capital expendi-tures do not exceed 20 percent of thefair market value of such property atthe time of the contribution. However,

56A bottom guarantee is a guarantee of the last dollars of theliability, which is the least risky portion of the liability. SeeTerrence Floyd Cuff, ‘‘Investing in an UPREIT — How theOrdinary Partnership Provisions Get Even More Complicated,’’102 J. Tax’n 43 (2005); John P. Napoli and John F. Smith,‘‘Emerging Issues in UPREIT Transactions,’’ 26 J. Real EstateTax’n 187 (1999); Rubin, Whiteway, and Finkelstein, ‘‘HandlingUPREIT and DownREIT Transactions: Latest Techniques andIssues,’’ 65 N.Y.U. Fed. Tax Inst., ch. 7 (2007). To be clear,WISCO’s indemnity was not a bottom indemnity.

57Reg. section 1.704-2(m), Example 1(vii).58Section 737 generally requires gain recognition in the case

of specified distributions of property to a partner to the extentthe FMV of the property exceeds the partner’s basis in thepartnership interest. 59See reg. section 1.752-2(b)(3).



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the 20 percent of fair market valuelimitation of this paragraph (d)(2)(ii)does not apply if the fair market valueof the contributed property does notexceed 120 percent of the partner’sadjusted basis in the contributed prop-erty at the time of contribution.

Under this exception to disguised sale treatment,even if WISCO’s indemnity obligation is disre-garded, at least $46 million of the distributionshould have been analyzed as a nontaxable reim-bursement of WISCO’s preformation expenditures.The court did not analyze or even cite the prefor-mation expenditures exception to partnership dis-guised sale treatment.

Fundamentally, the court seemed to be uncom-fortable treating the transaction as a nontaxablepartnership distribution, because it believed thetransaction resembled a sale. While a leveragedpartnership, like a sale, results in the taxpayerreceiving cash proceeds, so does a borrowing. Asnoted above, Congress directed that such a transac-tion should not result in taxable gain because itviewed the transaction as essentially equivalent to aborrowing through the partnership. Treasury issuedreg. section 1.707-5(b)(2) at Congress’s direction.The disguised sale regulations, including the sec-tion 752 liability allocation rules incorporatedtherein, are extremely detailed and mechanical, andtaxpayers should be entitled to rely on them inplanning their transactions. Although a debt-financed distribution, a direct borrowing, and a saleall may result in the receipt of cash proceeds, the taxconsequences are different, and taxpayers are notobligated to structure transactions in a manner thatmaximizes their taxable income.60

III. Application of Accuracy-Related PenaltyHaving concluded that the transaction consti-

tuted a disguised sale, the court then analyzedwhether the accuracy-related penalty for a substan-tial understatement of income tax under section6662(a) should apply to Chesapeake.61 A substantialunderstatement of income tax exists for a corpora-tion if the amount of the understatement exceedsthe greater of 10 percent of the tax required to beshown on the return, or $10,000.62 The accuracy-related penalty does not apply, however, to anyportion of an understatement to the extent that ataxpayer shows there was reasonable cause for, andthat the taxpayer acted in good faith regarding the

understatement.63 Further, section 6662(d)(2)(B)provides that the amount of any understatement isreduced by any portion of the understatementattributable to (i) the tax treatment of any item bythe taxpayer if there is or was substantial authorityfor the treatment, or (ii) any item if — (I) therelevant facts affecting the item’s tax treatment areadequately disclosed in the return or in a statementattached to the return, and (II) there is a reasonablebasis for the tax treatment of that item by thetaxpayer.64

Chesapeake argued that its reliance on a‘‘should’’ level tax opinion from PwC constitutesreasonable cause and good faith.65 Judge Kroupafound that it was not reasonable for Chesapeake torely on PwC’s tax opinion.66 Among the factorscited by the court were that Chesapeake paid PwCan $800,000 flat fee for the tax opinion and thecourt’s determination that the tax opinion was‘‘riddled with questionable conclusions and unrea-sonable assumptions.’’67 The court further statedthat PwC:

assumed that the indemnity would be effec-tive and that WISCO would hold assets suffi-cient to avoid the anti-abuse rule. PWC

60See, e.g., Salyersville National Bank v. United States, 613 F.2d650, 653 (6th Cir. 1980).

61Canal, 135 T.C. No. 9, at 30.62Section 6662(d).

63Section 6664(c)(1).64In 1999 section 6662(d)(2)(B) did not apply to any item of a

corporation attributable to a tax shelter. For any item of a tax-payer other than a corporation that was attributable to a taxshelter, section 6662(d)(2)(B)(ii) did not apply, and section6662(d)(2)(B)(i) did not apply unless the taxpayer reasonablybelieved that its tax treatment of that item was more likely thannot the proper treatment. Section 6662(d)(2)(C) now providesthat, for any taxpayer, section 6662(d)(2)(B) does not apply to anyitem attributable to a tax shelter. A tax shelter is defined as apartnership or other entity, any investment plan or arrangement,or any other plan or arrangement, if a significant purpose of thatpartnership entity, plan, or arrangement is the avoidance orevasion of federal income tax. Section 6662(d)(2)(C)(ii). Before thepassage of the Taxpayer Relief Act of 1997, such a partnership,entity, plan, or arrangement was characterized as a tax shelteronly if its principal purpose was the avoidance or evasion offederal income tax. The regulations on the pre-1997 definition oftax shelter, which have not been modified or withdrawn, explainthat ‘‘the principal purpose of an entity, plan or arrangement isnot to avoid or evade Federal income tax if the entity, plan orarrangement has as its purpose the claiming of exclusions fromincome, accelerated deductions or other tax benefits in a mannerconsistent with the statute and Congressional purpose.’’ Reg.section 1.6662-4(g)(2)(ii). We do not believe that a leveragedpartnership transaction should be characterized as a tax shelterfor purposes of section 6662(d)(2)(B), because such a transactionis entirely consistent with the legislative history of, and theregulations under, section 707(a)(2)(B), which clearly contem-plate that such a transaction should not give rise to taxableincome.

65Canal, 135 T.C. No. 9, at 32.66Id. at 35-36.67Id. at 33-34.



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assumed away the very crux of whether the trans-action would qualify as a nontaxable contributionof assets to a partnership.68 [Emphasis added.]

The court also said that PwC’s advice was taintedby an inherent conflict of interest because PwC:

not only researched and drafted the tax opin-ion, but [PwC] also ‘‘audited’’ WISCO’s andthe LLC’s assets to make the assumptions inthe tax opinion. [PwC] made legal assump-tions separate from the tax assumptions in theopinion. [PwC] reviewed State law to makesure the assumptions were valid regardingwhether a partnership was formed. In addi-tion, [PwC] was intricately involved in draft-ing the joint venture agreement, the operatingagreement and the indemnity agreement. Inessence, [PwC] issued an opinion on a trans-action [PwC] helped plan without the normalgive-and-take in negotiating terms with anoutside party.69

The court found that Chesapeake’s reliance onPwC’s opinion did not constitute good-faith reli-ance and held Chesapeake liable for the accuracy-related penalty.70 Judge Kroupa did not evenmention the existence of the two additional taxopinions issued by PwC, which address the federalincome tax consequences of the refinance loans onthe transaction, arguably confirm the conclusions inthe tax opinion, and were issued to Chesapeakebefore the filing of Chesapeake’s 1999 federal taxreturn.

We believe the court’s analysis regarding theapplication of the accuracy-related penalty is seri-ously flawed. First, while WISCO represented thatthe indemnity was a valid and legally enforceableobligation of WISCO under applicable state law andthat WISCO would hold assets with a FMV greaterthan or equal to $151 million during all times thatthe indemnity remained in effect, we see no basis inthe record for Judge Kroupa’s assertion that PwC‘‘assumed that the indemnity would be effectiveand that WISCO would hold assets sufficient toavoid the anti-abuse rule.’’ Rather, PwC analyzed atlength the application of the section 752 antiabuserule based on the facts at issue in the supportingmemorandum and concluded that it should notapply. Thus, based on our review of the record, wefind no justification for Judge Kroupa’s statementthat ‘‘PWC assumed away the very crux of whetherthe transaction would qualify as a nontaxable con-tribution of assets to a partnership.’’

Second, the court’s assertion that a taxpayercannot in good faith rely on a tax opinion if theauthor was involved in structuring the subjecttransaction is extremely troubling and potentiallydisastrous for taxpayers. The court faults PwC for‘‘auditing’’ WISCO’s assets and researching statelaw issues associated with the formation of the LLC.The court concludes that those activities created animpermissible conflict of interest for PwC. Thecourt equates the tax opinion to tax advice given bypromoters of noneconomic-loss-producing mar-keted tax shelters.71 The transaction is clearly dis-tinguishable from those marketed tax shelters.Unlike the transactions at issue in the tax sheltercases cited by the Tax Court, the Canal transactionhad significant nontax economic consequences. Un-der the transaction, Chesapeake disposed of a sig-nificant interest in its tissue manufacturing businessand received a significant distribution of borrowedfunds and an interest in a partnership. Also, thetransaction was not a marketed tax shelter, but wasspecifically structured in light of the business goalsand the economic and tax characteristics of Chesa-peake and GP. Moreover, the transaction was struc-tured in accordance with clear, detailed, andmechanical rules set forth in regulations as directedby Congress. The court’s holding on whether thetransaction was taxable rested on the application ofa vague antiabuse rule with a single example of aclearly abusive transaction. As noted above, thetransaction can be readily distinguished from theexample in the section 752 antiabuse regulations.Accordingly, it is inappropriate to equate the trans-action with the tax shelters in the cases cited by thecourt.

Further, tax practitioners are often actively in-volved in negotiating transaction terms and draft-ing transaction documents when the parties’ taxliabilities are of concern. Nothing prohibits thatinvolvement. Also, not only is it prudent for a taxpractitioner to engage in due diligence and researchin connection with issuing a tax opinion, but it is

68Id. at 35.69Id. at 36-37.70Id. at 38.

71Id. at 32 (citing Mortensen v. Commissioner, 440 F.3d 375 (6thCir. 2006), Doc 2006-3918, 2006 TNT 40-10 (holding that taxpayercould not in good faith rely on tax advice from promoter ofloss-producing cattle breeding tax shelter)); Pasternak v. Commis-sioner, 990 F.2d 893 (6th Cir. 1993), Doc 93-4831, 93 TNT 88-10(holding that investors in marketed loss-producing masterrecording lease program tax shelter could not in good faith relyon tax advice from promoters); Neonatology Associates P.A. v.Commissioner, 115 T.C. 43 (2000), Doc 2000-20409, 2000 TNT148-3, aff’d, 299 F.2d 221 (3d Cir. 2002), Doc 2002-17616, 2002 TNT147-9 (holding that investors in a marketed loss-producing taxshelter involving contributions to life insurance plans could notin good faith rely on advice from promoters who were not taxprofessionals).



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required by Circular 230.72 The court’s conclusion inthis respect is wrong and unworkable.

Third, as noted above, the $800,000 fee paid toPwC was not only for services related to issuing thetax opinion, but was also for consultation on taxissues associated with the formation, operation, anddissolution of the joint venture with GP, as well asfor tax advice regarding an unrelated transaction.We understand that the two additional tax opinionsissued by PWC in connection with the refinanceloans were also covered by the $800,000 fee. Thecourt did not analyze the hours worked by PwCpersonnel on the transaction and the other servicesnoted in the engagement letter or whether the feewas objectively unreasonable.73 The court simplyconcluded that the existence of a large flat fee wasevidence of bad faith. We note that flat fee engage-ments are increasingly replacing the bill-by-the-hour approach in the legal industry. Clients aredemanding a more creative approach to billing thatincentivizes all parties to be efficient and produc-tive. Chesapeake was clearly a sophisticated con-sumer of professional services and presumablynegotiated a flat fee that it thought was reasonablefor the services that were being provided. Withoutfurther analysis or explanation, the court’s sugges-tion that a flat fee is per se evidence of bad faith forpurposes of applying the accuracy-related penaltyis unrealistic and unjustified.

Fourth, even if the tax opinion could not be reliedon because of a conflict of interest or otherwise, thecourt never determined whether there was ‘‘sub-stantial authority’’ within the meaning of section6662(d)(2)(B) for the taxpayer’s position. As notedabove, the general section 752 recourse partnershipliability allocation regulations are mechanical, andunder those general rules, WISCO clearly should beallocated 100 percent of the BOA debt and therefinance loans. Also, WISCO’s indemnity is distin-guishable from the single example in the section 752antiabuse regulations of an obligation that shouldbe disregarded. Further, the legislative history ofsection 707(a)(2)(B) clearly demonstrates Congress’sintention that a borrowing through a partnership inthe form of a debt-financed distribution does notconstitute a taxable event. Accordingly, we believeChesapeake clearly had at least substantial author-ity for its position and, as a result, the accuracy-related penalty should not apply to the transaction.

IV. ConclusionAs discussed above, we believe the transaction

complied with the clear requirements set forth inthe partnership disguised sale regulations. Further,we believe the court’s application of the section 752antiabuse rule to the transaction was incorrect.Also, we believe the court’s analysis regarding theapplication of the accuracy-related penalty is seri-ously flawed. The court’s conclusion that a taxpayermay not in good faith rely on a tax opinion issuedby its tax advisers if those advisers participate in thestructuring and negotiation of the subject transac-tion is extremely troubling. Taxpayers routinely relyon their tax advisers to structure transactions incompliance with complex tax rules so that theadviser can issue a tax opinion. The court’s sugges-tion that these tax advisers are unable to render atax opinion on which the client may rely is simplyunworkable.

As noted above, Chesapeake issued a press re-lease stating that the company is bankrupt andintends to settle the United States’ claim for 50percent of the company’s $4 million of assets avail-able for priority claims or unsecured claims afterapproval of a Chapter 11 bankruptcy plan. Accord-ingly, although Chesapeake filed an appeal to theFourth Circuit on October 29, 2010, we understandthat if the settlement is approved by the BankruptcyCourt, the appeal will not be pursued.

72See sections 10.33 and 10.35 of Circular 230, 31 C.F.R.sections 10.33 and 10.35.

73A PwC representative testified that PwC spent ‘‘hundredsof hours’’ analyzing the structure of the transaction, helping todocument the transaction and working on the tax opinion.Chesapeake brief at 23.



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