Edwin Watts Got a Golf Lesson from the IRS

In 1968, Edwin and Ronnie Watts founded Edwin Watts Golf Shops. Over time, the company grew into a large regional brand, operating primarily in the Southeast. The Watts brothers also owned the real estate housing the majority of their retail locations, allowing them to receive the associated rental income.

In 2003, Wellspring, a private equity firm, offered the brothers $93 million, a small equity stake and the ability to retain day-to-day control of the business. Under the agreed-upon offer, the brothers retained the rental income stream from the associated real estate — which was kept out of the deal. In the newly-formed partnership, Wellspring received a preferred position in the return of and on their capital, as well as control over any decision to dispose of the business. The Watts brothers received a residual position.

Sun Capital or Dick’s Sporting Goods?

Fast forward to 2007, and the parties were approached by two suitors: Dick’s Sporting Goods and Sun Capital. Dick’s offered to pay $35 million more than Sun for the Edwin Watts business operations, and both offers excluded the real estate owned by the Watts brothers. In the Dick’s offer, the Edwin Watts “store” would presumably be housed within the extensive chain of Dick’s Sporting Goods locations. On the other hand, Sun planned to continue to use the existing chain of Edwin Watts locations. If the Dick’s offer were to be selected, the value of the Watts brothers’ real estate would decline precipitously. Conversely, Sun’s offer would preserve the brothers’ real estate values and rental income stream.

The Watts brothers, not surprisingly, preferred the offer from Sun Capital. As an inducement to Wellspring to accept Sun’s offer, the brothers agreed to take no cash from the sale. In the end, Wellspring agreed to the brothers’ offer, and the transaction was consummated with Sun Capital.  Edwin and Ronnie received no cash for the deal.

According to the language in the court case, the Watts brothers did not include their accountant in the sales process. Their accountant apparently was first made aware of the transaction when preparing the tax returns for the year of the sale. He decided to report the transaction as an abandonment of the partnership interest on the part of the Watts brothers, claiming an ordinary loss for the full remaining tax basis in the partnership interest.

A Painful Lesson

Upon examination, the IRS contended that the parties chose the form of the transaction to be a sale of the partnership, not an abandonment. The fact that the Watts brothers received no cash from the sale did not prevent the transaction as being cast as a sale. The IRS contended — and the Court agreed — that since the Watts brothers selected the form of the transaction, they were bound to live with it and report the transactions as they had cast them. Under the Internal Revenue Code, a sale of a partnership interest produces a capital gain or loss, except in very limited circumstances — none of which applied in this case. The IRS’ position was that a capital loss had occurred.

A true abandonment of a partnership interest does result in an ordinary loss. The benefit of an ordinary loss is that the entire loss can be offset against other ordinary income. A capital loss, on the other hand, may only be used to offset other capital gains.

It’s clear the Watts brothers were trying to protect the value of their real estate in the selection of the buyer of the operating business. They gave up something of value (i.e., their interest in the operating partnership) for something else of value (i.e., their rental income stream from the Edwin Watts free-standing stores). If they had structured the transaction as a sale of the partnership interest for its real fair market value, they presumably would have had little or no gain. They would have been able to amortize the other leg, generating ordinary deductions, rather than being trapped with long-term capital losses.

The moral of this story? The Watts brothers’ failure to involve their tax advisor early on in the process was a fatal error in their transaction. Don’t make the same mistake with your business.