Dynamo Holdings Limited Partnership, TC Memo 2018-61
The Tax Court, siding with the taxpayers, has held that a series of advances among two commonly-controlled real estate development entities were bona fide loans, not gifts, despite the fact that the advances failed to observe many formalities associated with a debtor-creditor relationship. However, the Court sided with IRS in holding that a number of property sales between the entities were for significantly less than the property’s fair market value (FMV) and resulted in a constructive distribution to the individual with ownership interests in both entities.
Background—debt vs. gift. In determining the existence of a bona fide debtor-creditor relationship, a court must determine 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”. (Haag, (1987) 88 TC 604) Special scrutiny is applied to intrafamily transfers and transactions between entities in the same corporate family or with shared ownership. (Kean, (1988) 91 TC 575)
The Tax Court has used the following 9-factor, facts-and-circumstances test to determine whether two parties entered into a valid debtor-creditor relationship, which considers whether:
- There was a promissory note or other evidence of indebtedness,
- Interest was charged,
- There was security or collateral,
- There was a fixed maturity date,
- A demand for repayment was made,
- Any actual repayment was made,
- The transferee had the ability to repay,
- Any records maintained by the transferor and/or the transferee reflected the transaction as a loan, and
- The manner in which the transaction was reported for Federal tax is consistent with a loan. (Jones, TC Memo 1997-400)
Background—constructive distributions. A transfer of property from one entity to another for less than adequate consideration may constitute a constructive distribution to an individual who has ownership interests in both entities. (Cox Enters., Inc., & Subs., TC Memo 2009-134)
For a court to find a constructive distribution, two tests must be satisfied: an objective test, which asks whether the transfer caused “funds or other property to leave the control of the transferor corporation” and whether it “allow[ed] the stockholder to exercise control over such funds or property either directly or indirectly through some instrumentality other than the transferor corporation”; and a subjective test, which asks whether the transfer occurred primarily for the common shareholder’s personal benefit rather than for a valid business purpose. (Wilkof, TC Memo 1978-496)
Facts. The Moog family had a real estate development business that originated in Canada then eventually expanded into the U.S.
During the years at issue (2005 through 2007), Beekman Vista, Inc. (Beekman Vista) was a U.S. holding company formed in ’84, the principal business activity of which was real estate management and development. Beekman Vista also had a hedge fund portfolio that produced investment income.
Beekman Vista was wholly owned by a Canadian entity and was, through a complex tiered ownership structure, indirectly controlled by Delia Moog, who was also an officer and director. Ms. Moog’s nephew, Robert Julien, who was also an officer and director, handled most of the development projects.
By the early 2000s, the business of Beekman Vista and its subsidiaries had changed substantially, and its management team decided to focus its efforts on Florida real estate development and to relocate its office and management team there.
Mr. Julien was concerned about certain implications of Beekman Vista being Canadian-owned so he and Ms. Moog decided to form a U.S. partnership. Beekman Vista continued to operate profitably from 2005 to 2007.
Dynamo Holdings Limited Partnership (Dynamo) was formed in early 2005 as a Delaware limited partnership. It was owned by two dynasty trusts—the Christine Moog (Ms. Moog’s daughter) Family Delaware Dynasty Trust, with a 59.9995% limited partnership interest, and the Robert Julien Family Delaware Dynasty Trust, with a 39.9995% limited partnership interest—with the 0.001% general partnership interest held by an entity that was indirectly controlled by Ms. Moog.
Dynamo had the same management team as Beekman Vista, and it also provided management services to Beekman Vista.
The cash advances. For efficiency purposes, Dynamo centralized its operations, including cash management, so as to easily allow for intercompany advances among the related entities.
Upon formation and through the years in issue, Beekman Vista advanced funds to Dynamo to fund operating expenses and to acquire assets, and Dynamo recorded the funds on its ledgers as an account payable to Beekman Vista. The year-end balances of the advances were approximately $240 million, $501 million, and $176 million in 2005, 2006, and 2007, respectively.
Beekman Vista and Dynamo treated the recorded transfers as debt. Dynamo made repayments to reduce the outstanding balance each year via proceeds received from capital contributions, wire transfers, paying Beekman Vista’s outstanding obligations to third parties, and providing management services to Beekman Vista for which it would otherwise collect fees. In 2007 and 2008, Dynamo engaged in a series of transactions that restructured the advances, including executing promissory notes evidencing prior advances, but it didn’t abide by State laws that serve to formalize lending agreements.
Expert testimony was offered by both the taxpayers and by IRS at trial that
- Generally supported the year-end balances described above, the charging of interest, and that the outstanding balances were entirely repaid by 2011;
- Concluded that no reasonable commercial lender would have entered into loans like those in this case, i.e., without any collateral, stated interest payments, fixed maturity dates, etc.; and
- Determined that Dynamo was sufficiently able to repay the advances such that it would have been able to borrow from a third-party lender (albeit under more commercially acceptable terms).
The asset transfers. In addition to providing advances to Dynamo, Beekman Vista also transffered to it real property, its hedge fund portfolio, and its interest in an LLC.
At the time of the real property transfers Beekman Vista and Dynamo did not obtain independent appraisals of the property because the members of the management team believed that, as experts in property valuation and real estate development, they had accurately priced the properties.
Expert testimony at trial was offered by both sides as to the value of the properties. While the parties didn’t dispute a number of the values, in general, the taxpayers’ experts provided values that were lower than those provided by IRS experts. And, the property values were generally lower than the payment that Beekman Vista received from Dynamo—in the form of increasing the amount of the outstanding balance owed to Beekman—at the time that the property was transferred.
With respect to the LLC interest transferred to Dynamo, Dynamo increased the outstanding balance due to Beekman Vista by $14.5 million, which reflected Beekman Vista’s partnership contribution for that interest.
The hedge fund portfolio had an FMV of $228 million on Dec. 31, 2005, and the assets of the fund were transferred to Dynamo during the first half of 2006 in exchange for $198 million (again, payments recorded as increases in the outstanding balance due).
Issues before the Tax Court. The primary issues raised in the case were
- Whether the advances from Beekman Vista to Dynamo were gifts or loans (i.e., whether the advances were bona fide debt), and
- Whether there were transfers of property from Beekman Vista to Dynamo at less than FMV.
Court’s decision. The Tax Court first concluded that the advances at issue were loans. Although at the time the advances were made there was no contemporaneous promissory note identifying all the terms of the agreement, there was no collateral set aside to ensure repayment, there was no invoice or demand made by Beekman Vista, and there was no fixed maturity date or intent to force Dynamo into bankruptcy if required to ensure repayment, there nonetheless were many meaningful formal indicia of debt, including that the taxpayers maintained records that reflected advances as debt in their general ledgers, and they executed promissory notes.
The Court also found economic indicia of debt, including the charging and paying of interest, which was reported and deducted by the taxpayers appropriately; that the advances were continuously repaid and that they were repaid in their entirety in 2011; and that Dynamo had the ability to repay—all of which supported the conclusion that Dynamo and Beekman Vista entered into a bona fide creditor-debtor relationship.
With respect to the property transfers, the Court found that Beekman Vista transferred property to Dynamo at less than FMV. Specifically, the first property was worth $23.5 million but sold for $12.3 million, the second property was worth $116.6 million but sold for $40.7 million; the third (a group of properties considered as a unit) was worth $12.8 million but sold for $9.9 million; and the final property was worth $140 million but sold for $49.5 million.
The Court also sided with the taxpayers that the LLC interest was transferred at FMV, but sided with IRS that the hedge fund portfolio was transferred for approximately $30.2 million less than its FMV.
The cumulative effect of the value differences described above resulted in a transfer from Beekman Vista to Dynamo of almost $211 million.
The Court then determined that this transfer constituted a constructive distribution to Ms. Moog. It easily concluded that the objective prong was met, given the control that she exercised over both Beekman Vista and Dynamo. It also found that the subjective test was met, given that the benefit of the transfer was primarily to Dynamo and, by extension, to the dynasty trusts, furthering Ms. Moog’s estate planning.
References: For constructive dividends, see FTC 2d/FIN ¶ C-2512; United States Tax Reporter ¶ 3014.08.
Sourced from CHECKPOINT NEWSSTAND, Reuters