But loans between related buyer and seller were respected as debt
The Tax Court in Dynamo Holdings 1 upheld withholding tax and penalty assessments with respect bargain sales between related taxpayers. The bargain sales resulted in constructive distributions of over $210 million. However, the Tax Court did not uphold additional tax assessments made by the IRS with respect to related party loans, holding that the taxpayers’ treatment of the loans as debt for Federal tax purposes was proper.
The taxpayers in Dynamo Holdings were a U.S. corporation, Beekman Vista, and a U.S. limited partnership, Dynamo Holdings. Both operated real estate development businesses and were owned by members of the same family. Beekman Vista was owned by a Canadian company, and had been in business since about 1984. In 2005, after one of the family members moved to the U.S., Dynamo Holdings was formed and began its U.S. real estate business.
Bargain purchases resulted in constructive distributions
Beekman Vista sold multiple properties to Dynamo Holdings, including real estate and securities. The IRS claimed that the sale prices were less than the properties’ fair market values (FMVs). The Tax Court agreed, holding that the properties’ FMVs exceeded the sale prices by a total of over $210 million.
The bargain purchase element, the Tax Court explained, demonstrated transfers of value but was not by itself sufficient to demonstrate a constructive distribution occurred. Having determined that transfers of value occurred, the next step was to determine whether the transfers occurred primarily for the common shareholders’ personal benefit rather than for a valid business purpose. The court determined that primary purpose of the transfers was to benefit the transferee Dynamo Holdings, and thereby benefit Dynamo Holdings’ owners, rather than serving a purpose related to the furtherance of Beekman Vista’s business.
Because Beekman Vista’s owner was a Canadian company, the constructive distributions gave rise to tax withholding obligations, including both (i) withholding on dividends and (ii) withholding on nondividend distributions under the FIRPTA (Foreign Investment in Real Property Tax Act) provisions. In addition, the Tax Court upheld IRS-assessed penalties on the amounts required to be withheld. Additional discussion of the withholding tax and penalty aspects of this case and the related Tax Court decision 2
Released on the same day are beyond the scope of this alert but are discussed in our other alerts here and here.
Loans treated as debt for federal tax purposes
Beekman Vista had advanced funds to Dynamo Holdings to fund operating expenses and for use in acquiring assets. The intercompany advances were booked to an asset account and to an account labeled “due from/to” and accrued interest on that balance. Beekman Vista and Dynamo Holdings treated the recorded transfers as debt for Federal tax purposes.
The IRS argued that the advances should instead be treated as gifts from the ultimate beneficial owners of Beekman Vista to those of Dynamo Holdings. The IRS noted that at the time the advances were made, the companies failed to adhere to state laws or other customary industry practices that serve to formalize commercial lending agreements, such as providing invoices, demanding payments, requiring collateral or security, providing a fixed due date or identifying the terms of the agreement in a contemporaneous promissory note.
The taxpayers noted that the parties later executed a promissory note as part of a restructuring transaction that included customary loan terms, including the amount of the loan, interest rate accrual, and demand terms. Although the promissory notes were not executed contemporaneously with all of the advances, some courts have found that after-the-fact consolidation of advances and execution of promissory notes can indicate that the advances were debt.
Management of the borrower and lender did not believe formal procedures were necessary because they managed both parties. As a result, the lender, Beekman Vista had access to and knowledge of all of the details related to each project and the risks associated. Management expected that the recorded transfers would be repaid and the companies had a history of advances followed by repayments made without demand. Expert testimony indicated that Dynamo was adequately capitalized and that it could have obtained the amounts advanced as loans from a third-party lender.
When determining whether an advance should be treated as debt or equity for Federal tax purposes, courts generally apply a facts and circumstances-based test requiring consideration of multiple factors. The Tax Court summarized its inquiry as determining whether there was a bona fide creditor-debtor relationship, which required a determination that, at the time the advances were made, there was an unconditional obligation on the part of the transferee to repay the money and an unconditional intention on the part of the transferor to secure repayment. The court noted that when analyzing transfers between related parties, although it is useful to compare the transactions at issue to arm’s-length transactions and normal business practices, courts must also be mindful of the business realities of related parties.
The Tax Court held that the advances from Beekman Vista to Dynamo Holdings should be treated as debt. Even though not all of the formal indicia of debt were met, many meaningful indicia were present. The parties maintained records that reflected the advances as debt in their general ledgers, and they later executed promissory notes. Dynamo had an unconditional obligation to repay Beekman who likewise had an unconditional intent to be repaid, the loans were appropriately accounted for and eventually satisfied. Because the court found that the advances were bona fide debt, the advances did not represent constructive distributions from Beekman Vista. Also, Dynamo Holdings’ deduction of the resulting interest expense was upheld.
The Dynamo Holdings case illustrates some of the tax issues and risks presented by transfers of assets between related parties. The taxpayers’ characterization of related party loans as debt was upheld here, but the dispute demonstrates that related party advances remain an area where tax risk assessment is helpful. The taxpayer’s property valuations, on the other hand, did not pass muster in the Tax Court and significant tax and penalty liabilities resulted. As this case illustrates, consulting with a tax advisor is important when planning asset transfers between related parties.
1. Dynamo Holdings Limited Partnership v. Commissioner, T.C. Memo 2018-61.↩
2. Dynamo Holdings Limited Partnership v. Commissioner, 150 T.C. No. 10 (2018).↩