Opinion ID: 614511
Heading Depth: 2
Heading Rank: 4

Heading: The basis-build

Text: Consistent with the collection strategy developed by Cinda and Montgomery, in late 2002 Southgate sold off approximately 22 percent of the loans in its portfolio. The net recovery on the sales was approximately $2.2 million. Southgate suffered a loss on the sales of approximately $294.9 million, of which $292.8 million was pre-contribution, built-in loss. Since Beal had purchased 90 percent of Cinda's interest in Southgate, 90 percent of that built-in loss was allocable to Beal and available for him to take as a deduction on his 2002 individual tax return. One final step remained in the tax plan: Beal needed to build his outside basis in Southgate. A partner's outside basis is his adjusted basis in his ownership interest in the partnership. When a partner purchases a partnership interest, he generally takes a cost basis in his partnership interest. [21] In other words, his outside basis is equal to the amount he paid to acquire the partnership interest. And while partnership losses are deductible by the individual partners, the amount of allocated partnership loss that a partner can claim as a deduction on his individual tax return is capped at the amount of his outside basis. [22] If the amount of a partnership loss that is allocable to the partner exceeds his outside basis, the overage remains suspended inside the partnership and can only be claimed if the partner builds his outside basis during a future tax year. Thus, the fact that some $263.5 million of Southgate's built-in losses were allocable to Beal was not enough to make the full value of those losses deductible by Beal on his 2002 tax return. Up until the very end of 2002, Beal's outside basis in Southgate was only about $29.9 million (the roughly $19.4 million he paid for his partnership interest plus about $10.5 million in transaction and operating costs). To be able to deduct most of the built-in loss that was allocable to him, Beal needed to build his outside basis in Southgate. This was the purpose of what the parties have dubbed the GNMA basis-build. [23] In late 2002, Beal owned some GNMAs with a fair market value of approximately $180.6 million. GNMAs are fixed-rate, mortgage-backed securities. The GNMAs that Beal owned were platinum securities backed by the full faith and credit of the United States, which guaranteed timely payment of principal and interest. In late December 2002, Beal nominally contributed the GNMAs to Southgate in an effort to build his outside basis in the partnership. As relevant here, the GNMA basis-build took place in three steps. First, Beal contributed the GNMAs to Martel (the single-member LLC through which he had purchased his interest in Southgate). [24] Second, Martel distributed its interest in Southgate to Beal. Beal thereby became an 89.1 percent owner of Southgate. Instead of owning an interest in Southgate through Martel, Beal now owned his interest in Southgate directly. Third, Beal contributed Martel to Southgate. Both Southgate's and Martel's operating agreements were amended to irrevocably appoint Beal as the sole manager of Martel and to reflect Beal's admission as a partner in Southgate, Beal's contribution of Martel to Southgate, and Southgate's admission as a partner in Martel. At the time of its contribution to Southgate, Martel still owned the $180.6 million worth of GNMAs. A partner's contribution of property to a partnership generally increases the partner's outside basis in his partnership interest. [25] As a result, Beal took the position that his contribution of the GNMAs to Southgate had increased his outside basis in Southgate by $180.6 million. Beal's contribution of the GNMAs to Southgate came with numerous strings attached. Four terms of the amendments to the operating agreements are particularly important for our later analysis of this putative contribution. Three of these terms expressly ensured that the vast majority of the GNMAs' value would be reserved to Beal. First, all of the interest that accrued on the GNMAs after their contribution to Southgate was allocated to Beal. Second, in his capacity as Martel's sole manager, Beal had the absolute right in his sole discretion to cause Martel to distribute to him the GNMAs and/or all payments received with respect to the GNMAs. Beal's exercise of this right would not give rise to an obligation on Southgate's part to make proportionate distributions to the other two partners. Third, Beal had unconditional rights to direct the use and application of all proceeds from the GNMAs and to direct any and all other matters pertaining to the GNMAs. There was a single provision that, at least theoretically, created a possibility that the other partners might profit from the contribution of the GNMAs. If the GNMAs appreciated in value during the time they were held in Southgate, the gain was to be allocated among Southgate's partners in accordance with their percentage interest in the partnership. The contribution of the GNMAs, at least in form, brought Beal's outside basis in Southgate up to a total of about $210.5 million. When Southgate filed its 2002 partnership return, it allocated to Beal a loss of approximately $263.5 million. The GNMA basis-build enabled Beal to claim $210.5 million of that loss as a deduction on his 2002 individual tax return.