A recently decided Tax Court case, Tribune Media Co. v. Commissioner,1 addressed the 2009 sale of the Chicago Cubs baseball franchise. The Tax Court characterized a $248 million subordinated loan partially funding the acquisition as equity. Additional tax liability for the seller in the tens of millions of dollars would apparently result, unless an appeal or settlement reaches a different conclusion. The Tribune Media case illustrates the significant amounts of tax that may hinge upon a debt-equity determination and highlights the relevance of debt-equity determinations for partnership borrowers.
Partnership formed, with distribution to selling partner
The 2009 sale of the Cubs involved the combination of (1) the formation of a new partnership and (2) the new partnership distributing about $750 million of cash to the seller. All parties agreed that the transaction resulted in some portion of the $750 million representing taxable gain to the seller under the Tax Code’s disguised sale rule.2 They disagreed as to what part of that $750 million should be treated as taxable sale proceeds.
The partnership was funded with debt financing in two classes, a senior debt of $425 million funded by banks, and subordinated debt of $248.75 million funded by an entity owned by the family acquiring control of the partnership (and the Cubs) in the transaction. The seller’s position was that the $750 million cash distribution was not taxable to the seller in the year of the transaction.
Tax on sale would be reduced by characterization as debt, rather than equity
Under the disguised sale rules, the $750 million distribution would not be taxable at the time of the sale to the extent funded by a class of debt that both (1) was treated as debt for tax purposes, and (2) was considered a debt for which the seller retained potential ultimate responsibility for repayment (via a seller’s guarantee of the debt). The Tax Court held that the $248.75 million subordinated loan was not debt for tax purposes, leaving $248.75 million of the $750 million cash distribution unprotected from taxation in the year of sale.
Tribune Media Co. v. Commissioner
The Tax Court determined that the $248.75 million subordinated debt should be treated as equity for tax purposes by applying the 13 factors outlined in Dixie Dairies Corp., v. Commissioner 3 to the case’s facts and circumstances. These factors are:
- Names given to certificates evidencing indebtedness;
- Presence or absence of a fixed maturity date;
- Source of payments;
- Right to enforce payments;
- Participation in management as a result of the advances;
- Status of the advances in relation to regular corporate creditors;
- Intent of the parties;
- Identity of interest between creditor and equity holder;
- “Thinness” of capital structure in relation to debt;
- Ability of corporation to obtain credit from outside sources;
- Use to which advances were put;
- Failure of debtor to repay; and
- Risk involved in making advances.
The factors are not weighed equally but are intended to indicate whether the economic reality of an investment is equity or represented a debtor-creditor relationship. In examining the above-listed factors, the Tax Court found that seven more clearly indicated equity treatment, two were neutral, and four more favored debt treatment for the advance. In the course of its analysis the court indicated that three factors (presence/absence of a stated maturity, intent of the parties and failure of the debtor to repay) were of considerable importance. Two of these factors (lack of a fixed maturity date and intent of the parties) heavily favored equity characterization while one (no failure to repay) indicated debt treatment.
A debt-equity determination for tax purposes requires an inquiry into all the relevant facts and circumstances. This Alert focuses on the big picture and does not discuss the many details spelled out in the Tax Court’s opinion.
Conclusion
Although the Tribune Media case is interesting because it involved the sale of a famous baseball team and a multi-million-dollar tax dispute, that is not the only reason. The case also serves as a reminder that determining whether an advance of funds or borrowing is properly treated as debt or equity can have substantial impact on a transaction’s tax results.
Many debt versus equity cases arise in situations where the borrower’s tax deductions for interest expense are at stake, and the borrower is a corporation. If a loan is treated as equity for tax purposes, no interest deduction is permitted. The taxpayer in Tribune Media, however, was not a corporation but a partnership. In addition, the amount of tax liability hinging on the court’s characterization of the loan as debt or equity was well in excess of the potential interest deduction benefits.
Whether an advance or an instrument is treated as debt or equity for tax purposes can affect tax results such as gain or loss on sale, tax basis in assets, whether a transfer of cash (or other property) is taxable and, yes, interest deductions too. Taxpayers who are counting on the characterization of a loan as debt for tax purposes should consult with their tax advisors.
1Tribune Media Co. v. Comm’r, T.C. Memo. 2021-122.
2The disguised sale rules under section 707(b) under certain circumstances characterize a partner’s transfer of property to a partnership as a sale where it is combined with the partnership’s distribution of cash to that partner.
3Dixie Dairies Corp. v. Comm’r, 74 T.C. 476 (1980).
