Opinion ID: 61651
Heading Depth: 2
Heading Rank: 5

Heading: The Revenue Rulings

Text: On September 19, 1988, over a decade before the Trust engaged in these transactions, the IRS issued Revenue Ruling 88-77, 1988-2 C.B. 128, 1988 WL 546796, which defined liability under section 752 to include an obligation only if and to the extent that incurring the liability creates or increases the basis to the partnership of any of the partnership's assets (including cash attributable to borrowings). In this case, the $102.5 Million in cash proceeds from the short sale increased the Trust's outside basis under section 722. The cash received in the short sale was an asset of the partnership, and the basis of the partnership's assets was increased. Thus, under the definition of liability contained in Revenue Ruling 88-77, Valiant's assumed obligation to close the short sale would constitute a liability under section 752. Citing to Revenue Ruling 88-77, the IRS explicitly stated in 1995 that [t]he short sale of securities described in this ruling creates a partnership liability under § 752. Rev. Rul. 95-26, 1995-14 I.R.B. 6, 1995 WL 95470 (1995); see also Rev. Rul. 95-45, 1995-1 C.B. 53, 1995 WL 335770 (1995) (applying the same principle to short-sale obligations assumed by corporations). According to Revenue Ruling 95-26, GMK was required to adjust its outside basis to reflect [its] share of the [partnership] liability under § 752. Although Revenue Ruling 95-26 did not address the value of the liability, Revenue Ruling 95-45 explicitly held that the amount of the short-sale liability is the amount of basis to which the short sale gave rise. Stated differently, [t]he amount of the liability assumed equals the proceeds of the original short sale. [15] Rev. Rul. 95-45 (regarding short-sale obligations assumed by corporations); IRS Field Service Advisory, 1997 WL 33313960 (Nov. 21, 1997) (stating that the basis liability principles contained in Rev. Ruling 95-45 are applicable to partnerships [b]ecause Congress has directed the [IRS] to interpret section 752 consistently with section 357.). Importantly, Revenue Rulings 88-77, 95-26, and 95-45 were issued before the transactions that gave rise to this litigation occurred. The Appellants argue that the obligation to replace the borrowed securities is not a liability because section 752, which addresses the calculation of a partner's outside basis in a partnership, must be read in conjunction with section 1233, which addresses the calculation of capital gains and losses in short sales. Section 1233(a) states that gain or loss from the short sale of property shall be considered as gain or loss from the sale or exchange of a capital asset to the extent that the property. . . used to close the short sale constitutes a capital asset in the hands of the taxpayer. The Appellants cite to the IRS's implementing regulations, which state that [f]or income tax purposes, a short sale is not deemed to be consummated until delivery of property to close the short sale. Treas. Reg. § 1.1233-1(a)(1). Because a short sale is an open transaction, for which a gain or loss cannot be determined until replacement securities are purchased and delivered to the lender, the Appellants argue that the value of a taxpayer's obligation to deliver borrowed securities is too contingent and indefinite to be determined prior to the date on which the short position is closed. Based on the short sale taxation principles contained in section 1233, the Appellants argue that the obligation to cover a short position is not a liability for purposes of section 752 because it is a contingent obligation. Because a partner's outside basis in his partnership interest is determined at the time of the contribution, see I.R.C. § 722, the Trust argues that its outside basis in Valiant cannot be adjusted by Valiant's assumed liability ( i.e. its obligation to replace the borrowed securities) because the value of this contingent obligation was not ascertainable at the time the brokerage account was transferred from the Trust to Valiant. Citing to several tax court cases and revenue rulings, the Appellants argue that obligations that are contingent, unmatured, indefinite or executory such that they cannot be taken into account for tax purposes until certain events occur at some point in the future do not constitute liabilities for purposes of I.R.C. § 752. The Appellants argue that the obligation to replace the T-Notes was not a liability under section 752 at the time GMK sold its partnership interest in Valiant, so Czerwinski's assumption of this contingent obligation did increase the amount realized on the sale. At oral argument, the Appellants asserted that section 1233 defines whether an obligation is a contingent liability for purposes of section 752. The Appellants insist that section 752 must follow section 1233 as night follows day, but we believe that [our] conclusion that a partnership's short sale of securities creates a partnership liability within the meaning of section 752 . . . does not create tension or conflict with the deferred recognition of gain or loss prescribed for short sale transactions under section 1233. Salina P'ship, 2000 WL 1700928, at . [16] Simply put, there is no fundamental link between section 1233, which deals with the calculation of capital gains and losses in short sales, and section 752, which deals with the effect of liabilities on a partner's outside basis. By its own terms, section 1233 does not purport to define the scope of the term liability under section 752. We will accord significant weight to the IRS's considered judgment (made prior to the transactions as issue in this case) that, in the case of an open short sale, the amount of liability assumed for basis purposes equals the proceeds of the original short sale. [17] Because the sale of a partnership interest is treated as the sale of a unitary capital asset, section 1001 is used to calculate the gain or loss on the sale. Section 1233 plays no role in this case because the gain or loss from the short position in the brokerage account is irrelevant to determining GMK's adjusted outside basis in Valiant. GMK sold its partnership interest in Valiant; it did not close a short sale. While the gain or loss on the short position was certainly relevant to the amount that Czerwinski was willing to pay for Valiant ( i.e. the $1.8 Million promissory note), it was not relevant to the calculation of GMK's outside basis in that asset. The Appellants treat[ ] [their] contingent assets and . . . contingent liabilities asymmetrically. See Robert Bird & Alan Tucker, Tax Sham or Prudent Investment: Deconstructing the Government's Pyrrhic Victory in Salina Partnership v. Commissioner, 22 Va. Tax Rev. 231, 254 (2002). If the obligation to replace the borrowed securities was a contingent liability that did not increase the amount realized on the sale, then the proceeds from the short sale should also be treated as a contingent asset that has no effect on the outside basis calculation under section 722. The initial short sale that generates the cash proceeds and the subsequent covering transaction are inextricably intertwined. See Zlotnick, 836 F.2d at 820. To treat the $102.5 Million short sale proceeds as an unencumbered cash contribution that increases GMK's outside basis in Valiant without also treating the obligation to close the short sale as a liability flies in the face of reality. The Appellant's failure to treat its relief from partnership liability as an additional amount realized under section 752(d) produced unwarranted aberrations in the amount of . . . loss realized by the transferor. MCKEE ET AL., supra, at 7.02[6]. The Appellants argue that Revenue Ruling 95-26 is flawed because it ignores years of established law providing that a contingent, indeterminate and/or executory obligation is not considered in determining the basis of an asset such as a partnership interest. The Government successfully distinguishes the authorities relied upon by the Appellants in making this argument. Significantly, none of the cases or revenue rulings cited by the Appellants involve a short sale, which we consider a unique transaction. In Henricks v. Comm'r, 51 T.C. 235, 1968 WL 1424 (1968), aff'd 423 F.2d 485 (4th Cir.1970), the tax court held that the capital losses sustained by the taxpayers in a short sale were deductible in the tax year that the taxpayer actually delivered the securities to the lender to close the short position, not the tax year that the replacement securities were actually purchased by the taxpayer. 51 T.C. at 235. Henricks simply affirms the principle contained in Treasury Regulation § 1.1233-1(a)(1) that a short sale is not consummated until delivery of property to close the short sale; it has nothing to do with the calculation of a partner's outside basis in his partnership interest. In Helmer v. Comm'r, 34 T.C.M. (CCH) 727 (1975), a partnership received option payments pursuant to an agreement giving a corporation the option to purchase certain real estate. The tax court stated that the option agreement created no liability on the part of the partnership to repay the funds paid nor to perform any services in the future. Therefore we hold that no liability arose under section 752 and the partners' bases cannot be increased by such amounts. Id. In Revenue Ruling 73-301, 1973-2 C.B. 215, 1973 WL 33002, the IRS found that unrestricted progress payments on a two-year construction contract are not a liability under section 752 that increases the partner's adjusted outside basis. Importantly, the partnership had performed all the services required in order to be entitled to receive the progress payment and there was no obligation to return the payment or perform any additional services in order to retain it. Id. Helmer and Revenue Ruling 73-301 are distinguishable from this case because those partnerships did not receive assets giving rise to a partnership obligation. In Revenue Ruling 57-29, 1975-1 C.B. 519, 1957 WL 11396, the IRS stated that [i]n computing the cost basis of assets for any purpose, the [IRS] does not recognize an obligation of a taxpayer reflected in an executory contract prior to the performance of the contract. However, in the next sentence, the IRS noted that the executory contract at issue cost the taxpayer nothing [and] has a zero basis to him in computing his ultimate gain or loss. Id. The Appellants seize on general language in Long v. Comm'r, 71 T.C. 1, 1978 WL 3318 (1978), aff'd in part and rev'd in part on other grounds, 660 F.2d 416 (10th Cir.1981), stating that the tax court has held on a number of occasions that contingent and indefinite liabilities assumed by the purchaser of an asset are not part of the cost basis of the asset. We think that partnership liabilities should be treated in the same manner. 71 T.C. at 7-8. However, the claims in Long arose from structural defects in a building that the partnership had erected, and the claims in LaRue v. Comm'r, 90 T.C. 465, 1988 WL 23562 (1988) arose from a partnership's contractual obligation to replace missing property. The Government correctly observes that Revenue Ruling 57-29, Long, and LaRue did not involve obligations that created or increased the basis of the partnership assets. For example, in Long, the tax court held that the taxpayer could not increase his initial outside basis in the partnership until the partnership's contingent liability (a lawsuit) had a liquidated value. 71 T.C. at 8. Before the claim was liquidated, this liability did not create or increase the partner's outside basis in his partnership interest. In contrast, the contingent liability in this case immediately increased the Trust's outside basis in Valiant from $2 Million to $104.5 Million. Under Skidmore, we believe that Revenue Rulings 95-26 and 95-45 are reasonable because they reflect the Commissioner's desire to prevent taxpayers from deducting non-economic losses. Cf. Gregory v. Helvering, 293 U.S. 465, 470, 55 S.Ct. 266, 79 L.Ed. 596 (1935). We do not believe that the Appellants were unfairly surprised or prejudiced by the IRS's challenge to this tax shelter because they were on notice as early as 1988, and certainly by 1995, that the IRS considered the obligation to close a short sale to be a liability under section 752. Revenue Ruling 95-26 is distinguishable from the earlier cases and revenue rulings cited by the Appellants, and it is fully consistent with regulations promulgated by the IRS after 1995. See Treas. Reg. § 1.752-1(a)(4)(i) (adopting the definition of liability contained in Revenue Ruling 88-77).