CURRENT DEVELOPMENTS IN TAX SHELTERS By Matthew D. Lerner and Jean Baxley
Current Developments in Tax SheltersOverview • Recent Tax Shelter Cases • What Taxpayers and Their Advisors Need to Know About the American Jobs Creation Act • Revisions to Circular 230 • IRS Requests for Tax Accrual Workpapers • Recent Developments in Privilege
RECENT TAX SHELTER CASES
Recent Tax Shelter Cases:Long-Term Capital Holdings v. United StatesFacts • Onslow Trading and Commercial (“OTC”), a U.K. company, engaged in lease stripping transactions involving the sale and leasing of computers (CHIPS) and long-haul truck tractors (TRIPS). OTC received tax-free prepayments of rent, which it had a future obligation to pay to third parties. • OTC contributed its leasehold interests, the lease payment obligations, and the prepaid rent collections to U.S. corporations in exchange for preferred stock, thereby purportedly giving the preferred stock a high basis (due to the contributed rent collections) and low value (due to the contributed lease payment obligations).
Recent Tax Shelter Cases:Long-Term Capital Holdings v. United StatesFacts (continued) • At the same time, a U.K. entity controlled by the owners of Long-Term Capital Management (“LTCM”), i.e. LTCM-U.K., made a $5 million recourse loan to OTC. • A foreign bank made a loan to LTCM. • LTCM contributed the loan proceeds to Long Term Capital Partners LP (“LTCP”), a U.S. limited partnership, in exchange for a partnership interest in LTCP. • OTC contributed the high basis preferred stock received in the CHIPS and TRIPS transactions (and a portion of the proceeds from the LTCM-U.K. loan) to LTCP in exchange for a partnership interest in LTCP.
Recent Tax Shelter Cases:Long-Term Capital Holdings v. United StatesFacts (continued) • LTCP contributed the preferred stock (and the proceeds from both loans) to P, a hedge fund. • OTC sold its interest in LTCP to LTCM via the exercise of a put option. • P sold the preferred stock, for which it claimed basis of just over $100 million, for approximately $1 million in cash to affiliates of Merrill Lynch, thereby triggering the built-in losses.
Recent Tax Shelter Cases:Long-Term Capital Holdings v. United StatesFacts (continued) 3 GE Loan CHIPS OTC(U.K.) LTCM(U.S.) Loan UBS 1 LTCP P/S Int. 3 NB 4 TRIPS 3 LoanProceeds 3 Leasehold Interests, Lease Obligations &Prepaid Rent Collections 2 PreferredStock PreferredStock & LoanProceeds LTCP(U.S.) U.S.Corp. 3 LoanProceeds 3 PreferredStock & LoanProceeds P(CaymanIslands) ML 5 PreferredStock
Recent Tax Shelter Cases:Long-Term Capital Holdings v. United StatesArguments • The government argued that the transaction lacked economic substance, and was merely a tax ploy to create artificial capital losses. • The taxpayer argued that the transaction had economic substance, and offered proof that Long-Term expected to realize a pre-tax profit from the transaction.
Recent Tax Shelter Cases:Long-Term Capital Holdings v. United StatesOutcome • The United States District Court for the District of Connecticut disallowed the claimed capital losses, holding that the transaction engaged in by OTC and the Long-Term entities lacked economic substance. • The court held in the alternative that the transaction should be recast under the step transaction doctrine and treated as a sale of preferred stock by OTC to the Long-Term entities, resulting in a downward adjustment to the stock basis.
Recent Tax Shelter Cases:Long-Term Capital Holdings v. United StatesEvidence of Lack of Economic Substance • The court treated the following facts as evidence of lack of economic substance: • The transactions were brought to Long-Term as a “tax product” rather than as an investment. • Long-Term’s purported primary business purpose of generating additional investment fees from the contribution of the preferred stock (and cash) to P was disingenuous. • There was no reasonable expectation of profit from the transaction. • Several “side agreements” provided hidden fees to the parties structuring the transactions. • Long-Term permitted OTC to make the contribution of preferred stock (and cash) in contravention of the taxpayer’s investing requirements.
Recent Tax Shelter Cases:Long-Term Capital Holdings v. United StatesPenalties • The court upheld imposition of penalties, despite the legal opinion obtained by Long-Term from King & Spalding. Indeed, the court stated that Long-Term failed to satisfy its burden to establish the applicability of the reasonable cause defense since it could not prove it received King & Spalding’s written opinion prior to the filing of its return. • The court determined that the opinion included unreasonable factual assumptions (e.g., it was assumed that the taxpayer had a valid business purpose and reasonably expected to earn a material pre-tax profit), and that the opinion contained a “selective discussion of authority . . . which bolsters its appearance as an advocacy piece not a balanced reasoned opinion with the objective of guiding a client’s decisions.” • The court also concluded that the taxpayer tried to hide the loss on its tax return by combining lines of Schedule M-1, and that this demonstrated a “lack of good faith” for purposes of the reasonable cause exception. • The penalty issue is on appeal to the Second Circuit (Case No. 04-5687, filed October 22, 2004).
Recent Tax Shelter Cases:Black & Decker Corporation v. United StatesFacts • The transaction was structured in similar fashion to the listed transaction described by the Internal Revenue Service (“IRS”) in Notice 2001-17, 2001-1 C.B. 730. The transaction involved the centralization of the management and administration of the taxpayer’s employee and retiree healthcare benefit plans in a separate subsidiary. • B&D and certain of its subsidiaries exchanged cash of approximately $561 million for stock in a separate subsidiary, Black & Decker Healthcare Management, Inc. (“BDHMI”), and the assumption by BDHMI of certain employee and retiree healthcare liabilities with a value of $560 million. • B&D and its subsidiaries later sold stock in BDHMI in an arm’s length sale to an independent third-party for $1 million. • B&D claimed a $560 million capital loss, based on the position that the cost basis of the BDHMI shares (i.e., $561 million) was unreduced by the contingent liabilities assumed by BDHMI.
Recent Tax Shelter Cases:Black & Decker Corporation v. United StatesArguments • The government argued that the transaction was merely a tax avoidance vehicle that must be disregarded for tax purposes. • B&D argued that the transaction had economic substance, that its basis in the BDHMI stock was $561 million, and that it realized a bona fide capital loss of $560 million on the sale of the BDHMI stock. B&D conceded, for purposes of the motion for summary judgment, that tax avoidance was its sole motivation for the transaction.
Recent Tax Shelter Cases:Black & Decker Corporation v. United StatesOutcome • The United States District Court for the District of Maryland granted summary judgment in favor of B&D and upheld B&D’s $560 million capital loss. The court held that the transaction “[could not] be disregarded as a sham” and concluded that the transaction had “very real economic implications” for the beneficiaries of B&D’s employee benefits programs, B&D, and BDHMI. • The court applied the Fourth Circuit’s sham transaction doctrine. In support of its analysis, the court reasoned that "a corporation and its transactions are objectively reasonable, despite any tax-avoidance motive, so long as the corporation engages in bona fide economically-based business transactions."
Recent Tax Shelter Cases:Black & Decker Corporation v. United StatesEvidence of Objective Economic Substance • The court found the following facts as evidence of the objective economic substance of B&D’s transaction: • BDHMI assumed the responsibility for the management, servicing, and administration of plaintiff's employee and retiree health plans; • BDHMI considered and proposed numerous healthcare cost containment strategies since its inception, many of which have been implemented by B&D; • BDHMI has always maintained salaried employees; and • BDHMI became responsible for paying the healthcare claims of B&D’s employees and such claims are paid with BDHMI’s assets.
Recent Tax Shelter Cases:Coltec Industries, Inc. v. United StatesFacts • The transaction was structured in similar fashion to the transaction at issue in Black & Decker. • Coltec and its subsidiary, Garlock, transferred cash, stock of a related company, and an intercompany note to a newly-created subsidiary, Garrison, in exchange for Garrison’s assumption of contingent asbestos litigation liabilities valued at $371 million and Garrison stock. Garrison was formed for the purpose of managing the contingent asbestos liabilities.
Recent Tax Shelter Cases:Coltec Industries, Inc. v. United StatesFacts (continued) • Coltec then sold the Garrison stock received by Garlock in the exchange to Nationsbank and First Union to establish the market price of the stock for subsequent sales to service providers. These sales included “put” and “call” rights exercisable after five years; the options were never exercised, and have expired. • Coltec claimed $370 million in capital losses from these stock sales. • Two years later, Coltec sold additional stock in Garrison to a select group of lawyers involved in defending its asbestos claims to provide these lawyers an additional performance incentive.
Recent Tax Shelter Cases:Coltec Industries, Inc. v. United StatesArguments • The government argued that: (1) Garrison’s assumption of the liabilities reduced Garlock’s basis in the Garrison stock because the principal purpose for Garrison’s assumption of the liabilities was not a bona fide non-tax business purpose; (2) no sale of the Garrison stock occurred because the put and call options negated any transfer of beneficial ownership to the banks; and (3) the transactions lacked economic substance. • Coltec argued that: (1) the Code did not require a reduction in Garlock’s basis in the Garrison stock for the contingent liabilities transferred to Garrison; (2) Garlock’s transfer of Garrison stock to the banks was a sale; (3) no separate business purpose was required for the sale of Garrison stock to the banks; and (4) the transactions had economic substance and were not shams because the Garrison transaction had a legitimate business purpose.
Recent Tax Shelter Cases:Coltec Industries, Inc. v. United StatesOutcome • The Court of Federal Claims upheld Coltec’s $370 million capital loss, holding that Coltec had satisfied all of the statutory requirements for claiming a capital loss from the stock sale (including the tests of section 357(b)). • The court declined to apply the economic substance doctrine so as to “trump” Coltec’s compliance with the Code. Citing Gitlitz v. Commissioner, 531 U.S. 206 (2000), and United States v. Bynum, 408 U.S. 125 (1972). • The court determined that Coltec’s basis in the Garrison stock that was sold to Nationsbank and First Union should not be reduced by the amount of the contingent asbestos liabilities transferred to the subsidiary.
Recent Tax Shelter Cases:Coltec Industries, Inc. v. United StatesOutcome • The court held that contingent liabilities are not “liabilities” for purposes of reducing basis under section 358(d). • The court stated that even if section 358(d) applied to the liabilities, section 357(c)(3) would preclude the liabilities from reducing basis because they “would give rise to a deduction.” The court relied upon the analysis of section 357(c)(3) in Black & Decker, which concluded that there was no authority to limit the application of section 357(c)(3) only to situations where the liabilities would give rise to a deduction to the transferee (as opposed to the transferor). • The court also held that section 357(b) did not apply to reduce Coltec’s basis in the Garrison stock, because there was a valid business purpose for the assumption of the liabilities. In determining that there was a valid business purpose, the court relied upon the testimony of Coltec employees as to the non-tax purposes of the transaction.
Recent Tax Shelter Cases:TIFD-III-E, Inc. (“Castle Harbour”) v. United StatesFacts • In the early 1990’s, General Electric Capital Corporation (“GECC”) sought to reduce the risk associated with its aircraft leasing business. • GECC formed a limited liability company (“LLC”), Summer Street, that was owned by three of its subsidiaries, TIFD III-E, TIFD III-M, and GE Capital AG. GECC, through the subsidiaries, contributed the following to Summer Street: aircraft worth $530 million, subject to $258 million nonrecourse debt (net $272 million); $22 million in receivables; $296 million in cash; and 100% of the stock of another of its subsidiaries, TIFD VI (valued at $0). • TIFD III-E, TIFD III-M, and GE Capital AG sold interests in Summer Street worth $50 million to two foreign banks, ING Bank and Rabo Merchant Bank (collectively, the “Banks”). This sale constituted a sale of 100% of GE Capital AG’s interest in Summer Street. The Banks contributed an additional $67.5 million to Summer Street, bringing their total investment to $117.5 million.
Recent Tax Shelter Cases:TIFD-III-E, Inc. (“Castle Harbour”) v. United StatesFacts (continued) • Summer Street’s name was then changed to Castle Harbour - I LLC (“Castle Harbour”). • As a result of these transactions, TIFD III-E and TIFD III-M owned a combined interest in Castle Harbour of approximately 82 percent, and the Banks owned a combined interest of approximately 18 percent. • Under the terms of the partnership agreement, 98 percent of the “operating income” of the partnership was allocated to the Banks. Operating income was comprised of income less expenses. Depreciation of the airplanes and certain guaranteed payments to the GE entities were treated as expenses that reduced operating income; repayments of principal on the airplane debt were not.Since the aircraft owned by Castle Harbour had already been fully depreciated for tax purposes prior to their contribution to the partnership, only “book” depreciation significantly reduced operating income.
Recent Tax Shelter Cases:TIFD-III-E, Inc. (“Castle Harbour”) v. United StatesFacts (continued) • “Disposition gains and losses” from sales or distributions of assets were allocated as follows: (1) they offset prior disposition losses/gains and/or prior operating income/loss; (2) 90 percent of the remainder of any gain or loss was allocated to the Banks, subject to a specified limit of approximately $3 million; and (3) if the limit was reached, then 99 percent of the balance was allocated to the GE entities, and one percent was allocated to the Banks. • In each year, a substantial part of the income received by the Banks was used to “buy down” portions of the Banks’ interests, thus decreasing their capital accounts. The goal of GE and the Banks was to liquidate the Banks’ interests in Castle Harbour over eight-years. • The expectation of the parties was that the Banks would earn an internal rate of return of just over 9%. • The partnership allocations reduced GECC’s tax liability with respect to operating income by $62.2 million over the life of the partnership.
Recent Tax Shelter Cases:TIFD-III-E, Inc. (“Castle Harbour”) v. United StatesArguments • The government argued that the allocation of Castle Harbour’s income to the Banks should be disallowed on three grounds: (1) the overall transaction lacked “economic substance; (2) the Banks should be treated as lenders, not partners, for tax purposes and, therefore, partnership income could not be allocated to them; and (3) the manner in which the partnership income was allocated violated the “overall tax effect” rule of section 704(b). • GECC maintained that Castle Harbour was a real partnership, established for legitimate, non-tax business reasons.
Recent Tax Shelter Cases:TIFD-III-E, Inc. (“Castle Harbour”) v. United StatesOutcome • The United States District Court for the District of Connecticut granted judgment in favor of the taxpayer for $62.2 million. • The court held in favor of the taxpayer on each of the arguments raised by the government, concluding that although the transaction “sheltered a great deal of income from taxes” it was “legally permissible.” • The court found that the formation of the partnership had “economic substance” under the Second Circuit Court of Appeals’ sham transaction standard, because it had real non-tax economic effects and a non-tax business purpose. • The court held that GECC had a legitimate business purpose for the transaction -- to raise additional capital, and to demonstrate to investors, rating agencies, and GECC senior management that it could raise capital on its aging aircraft.
Recent Tax Shelter Cases:TIFD-III-E, Inc. (“Castle Harbour”) v. United StatesOutcome (continued) • The Banks contributed substantial amounts of cash to the partnership, which was used to purchase aircraft and retire debt, thus establishing a real economic effect to the transaction. • The court declined to decide whether to apply the economic substance test advanced by the taxpayer, i.e. that if the transaction had either a subjective business purpose or an objective economic effect, the transaction should be respected for tax purposes, or the test advocated by the government, i.e. a “flexible” standard where both factors should be considered but neither factor is dispositive. Instead, the court determined that the transaction had both a non-tax economic effect and a non-tax business motivation and so would pass the economic sham test under either approach.
Recent Tax Shelter Cases:TIFD-III-E, Inc. (“Castle Harbour”) v. United StatesEvidence of Economic Substance • Castle Harbour received an “economically real, up-front payment of $117 million” from the Banks; • The Banks participated in the “economically real” upside potential of the aircraft leasing business, despite provisions in the operating agreement that apparently guaranteed them a certain minimum level of return on their investment; • The arrangement allowed GECC to retire some of its commercial paper, thus reducing its debt-to-equity ratio.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerFacts • After Metro-Goldwyn Mayer (“MGM”) was sold to the highest bidder, two individuals and their related entities (collectively, the “Ackerman Group”) attempted to acquire MGM’s parent company, Santa Monica Holding Corporation (“SMHC”), which was owned by the creditors of MGM, the Credit Lyonnais group (“CL Group”). • SMHC had no valuable assets, and owed approximately $1 billion to the CL Group. CL Group also owned stock in SMHC. CL Group’s tax basis in the SMHC debt was approximately $1 billion, and its basis in the SMHC stock was approximately $665 million. • The Ackerman Group (AG) formed an LLC, SMP. The CL Group contributed the SMHC debt and the SMHC stock to SMP in exchange for preferred interests in SMP and $5 million cash. The CL Group acquired a put right, exercisable within five years, with respect to its SMP interests. The put required the AG to purchase the CL Group’s interest for $5 million, and the parties entered into a deposit account agreement that required the $5 million purchase price to be placed in a blocked account to be released when the put was exercised.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerFacts (continued) • At the earliest opportunity, i.e., just three weeks after the CL Group made its contribution to SMP, the CL Group exercised its put rights and received $5 million from the AG for its interest in SMP. • Under the partnership rules, the AG claimed a $1 billion basis in the SMHC debt held by SMP, and claimed a basis of $665 million in the SMHC stock. • In 1997, SMP sold $150 million of the almost $1 billion debt it held to TroMetro, an LLC formed by a long-time associate of one of the individuals who controlled the AG, for approximately $2.5 million. SMP claimed a loss of approximately $147.5 million on the sale on its 1997 return. • In 1998, SMP sold another $81 million of the debt it held to TroMetro for $1.4 million (i.e., cash of $150,000 and a TroMetro note). SMP claimed a loss of approximately $80 million on the sale on its 1998 tax return.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerFacts (continued) • TroMetro and SMHC entered into a distribution agreement with respect to the film library held by SMHC. SMHC reported no income from this arrangement. • One of the individuals who controlled the AG was on the board of directors of Imperial Bank (“Imperial”). In 1997, Imperial realized significant capital gains from the sale of two of its financial services companies; it was looking for losses to offset these gains. • In November of 1997 the AG formed Corona Film Finance Fund, LLC (“Corona”). SMP contributed $250,000 cash and a $79 million receivable in exchange for a 99% interest in Corona. • On December 15, 1997, Imperial purchased a 79% interest in Corona from SMP for $1.25 million, and Imperial’s agreement to pay SMP a fee of 20% of the tax losses received from Corona. SMP claimed a capital loss of $62 million on the sale of the Corona interest to Imperial on its 1997 tax return.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerFacts (continued) • On December 23, 1997, Imperial purchased an additional 14.65% interest in Corona from SMP for approximately $200,000. SMP claimed a capital loss of $11.6 million on the sale of the second Corona interest to Imperial on its 1997 tax return. • Also in December of 1997, Corona sold the $79 million receivable contributed by SMP to TroMetro for $1.1 million (i.e., $120,000 cash and a note). Corona reported a loss of $78 million on its return for 1997. Approximately $74 million of this loss flowed through to Imperial; $4 million flowed through to SMP and its owners. • In accordance with the original agreement between Imperial and SMP and as a result of the $74 million loss realized by Imperial, Imperial contributed $14.5 million cash (i.e., approximately 25% of the amount of the tax loss) to Corona; SMP then received the cash.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerArguments • The government argued that under substance over form principles, i.e. the economic substance and the step transaction doctrines, the transactions should be recast as direct sales of the high basis, low value assets (i.e., the receivables and the SMHC stock) by the CL Group to the AG, resulting in no transfer of built-in losses to SMP and no flow-through of those losses to the Ackerman Group. • The government argued in the alternative that, if the form of the transaction was respected, the capital losses would still be disallowed because SMP’s tax basis in the SMHC receivables was zero, because the receivables were worthless at the time they were contributed to SMP by the CL Group. • The government did not challenge the status of SMP and Corona as bona fide partnerships. • The taxpayer argued that SMP succeeded to the CL Group’s high bases in the receivables and the SMHC stock when those assets were contributed to SMP, and that subsequent transfers of the receivables generated real losses. The taxpayer argued that the form of the transactions should be respected, because the parties had valid, non-tax business reasons for engaging in the transactions.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerOutcome • The Tax Court disallowed the capital losses claimed on the sales of receivables, holding that SMP and Corona never had any basis in the receivables. The court concluded that: (1) the contribution to SMP of receivables and SMHC stock by the CL Group lacked economic substance and cannot be respected for tax purposes; (2) SMP obtained no basis in the receivables contributed by the CL Group because the receivables were worthless or did not represent bona fide indebtedness; and (3) the Corona transaction lacked economic substance. • The court concluded that the “exclusive purpose” for the formation of SMP was to transfer to the AG “enormous” tax attributes associated with the high-basis, low value receivables and SMHC stock.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerOutcome (continued) • The court concluded, based on “economic realities,” that the CL Group entities did not become partners in SMP, but sold their high-basis, low value assets to the AG for $10 million. • In analyzing the objective economic substance of the transaction, the court found that the put right the CL Group obtained, and the CL Group’s exercise of that right on the earliest date possible, negated any economic significance that “might otherwise have attached” to the CL Group’s joining SMP. • In analyzing the objective economic substance of the transaction, the court found that the AG’s up-front payment of $5 million to the CL Group for its contribution of assets (i.e., receivables and SMHC stock) to SMP and the additional $5 million promised upon exercise of the put option far exceeded the value of the contributed assets, and that the AG had no reasonable expectation of recouping the $10 million.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerOutcome (continued) • The court assigned minimal value to the SMHC stock contributed by the CL Group, concluded that certain securities owned by SMHC (the “Carolco securities”) had no value; and concluded that unused net operating losses of SMHC had little or no value. • With respect to the government’s step transaction arguments under the “end result” and “interdependence” tests, the court stated: “[w]hether this contention is viewed as an alternative argument, or merely as a particularization of [the government’s] substance over form argument, the results are identical: We disregard the [CL Group’s] purported contribution to SMP.” Nonetheless, “for the sake of completeness,” the court went through a step transaction analysis and concluded that the CL Group’s contributions of SMHC receivables and SMHC stock to SMP and the AG’s purchase of the CL Group’s interest in SMP three weeks later should be recast as (1) direct sales of the SMHC receivables and SMHC stock from the CL Group to the AG, followed by (2) the AG’s contribution of the SMHC assets to SMP.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerOutcome (continued) • The court addressed the government’s alternative argument that SMP had a zero basis in the SMHC receivables contributed by the CL Group because those receivables were worthless, and held that the receivables were worthless and, thus, did not constitute a “contribution of property” to SMP. • The court addressed the government’s alternative argument that SMP had a zero basis in one of the SMHC receivables contributed by the CL group because that receivable did not arise out of a bona fide debtor/creditor relationship, and concluded that the debt was not bona fide debt. • The court concluded that, in light of the fact that SMP had a zero basis in the SMHC assets, the contribution of those assets to Corona was “devoid of business purpose and economic substance.” • The court rejected the government’s argument that the sales of receivables to TroMetro should be recast as sales by SMP of an option to receive an equity interest in SMHC. However, the court noted that this conclusion did “not ultimately affect [its] decision” because the court had already reached the conclusion (on other grounds) that SMP had no basis in the SMHC receivables.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerEvidence of Lack of Business Purpose • The CL Group had no intention of producing/distributing films with the AG; the AG had no experience in running a film distribution business; the CL Group contributed the film assets to SMHC and knew they were of little value; and the parties did not actively negotiate over the particulars re: the film business. • The AG was clearly interested in the tax attributes the CL Group had in the MGM companies, and its due diligence activities were focused almost entirely on obtaining assurances regarding the CL Group’s high basis in the receivables and the SMHC stock. • The AG faxed a Wall Street Journal article to its counsel that described a transaction similar to the proposed transaction, with a note that the article “gives good support for our business purpose for doing the deal.”
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerMisstatement and Negligence Penalties • The court sustained the section 6662(h) penalty for gross valuation misstatements, based on its determination that SMP had a zero basis in the receivables contributed by the CL Group, concluding that SMP’s and Corona’s claimed basis was “infinitely more than 400 percent of the amount” that the court determined to be the correct basis in the receivables. • The court also sustained the section 6662(a)(1) negligence penalty, observing that the principal of the AG who “personally engineered the plan to transfer built-in losses” was a “highly educated, sophisticated tax attorney” who had worked at a major law firm, at the Tax Court, and at Treasury.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerSubstantial Understatement Penalty • The court sustained the section 6662(a)(2) substantial understatement penalty, holding that the taxpayer “cited no substantial authority” for its position. • The court held that the transaction at issue was a “tax shelter” for purposes of section 6662(d)(2)(C)(iii) since it concluded that the transaction between the CL Group and the AG lacked economic substance and, thus, that the taxpayer must demonstrate “reasonable belief” to prevail. • The court concluded that none of the opinions purportedly relied upon by the taxpayer reached a more likely than not conclusion, and that the taxpayer did not reasonably rely on such opinions.
Recent Tax Shelter Cases:Santa Monica Pictures v. CommissionerSubstantial Understatement Penalty • The court analyzed separately each piece of advice the taxpayer claimed to have relied upon, which included eight legal and accounting memoranda, and determined that none of the memoranda provided reasonable cause. • The court’s complaints with the opinions were that they: • misrepresented the facts of the actual transactions; • assumed certain incorrect facts, e.g. that there was a business purpose for the transactions, that the taxpayer knew were untrue; • were based on “dubious” appraisals of assets; and • analyzed legal issues that were irrelevant to the case.
WHAT TAXPAYERS AND THEIR ADVISORS NEED TO KNOW ABOUT THE AMERICAN JOBS CREATION ACT (“AJCA”)
American Jobs Creation Act (AJCA) Disclosure Penalties Section 6707A • New section 6707A imposes a penalty for failing to disclose a tax shelter transaction. • The amount of the penalty is $10,000 for individuals, and $50,000 for all other taxpayers for “reportable” transactions; and $100,000 for individuals and $200,000 all other taxpayers for “listed” transactions. • Treasury has the authority to define “reportable” and “listed” transactions in regulations under section 6011. • The penalty applies to any taxpayer who participates in a reportable transaction. A taxpayer is a participant in a reportable transaction if his tax return reflects the tax benefit of the reportable transaction. • The section 6707A penalty applies regardless of whether the reportable transaction results in an understatement of tax.
American Jobs Creation Act (AJCA) Disclosure Penalties Section 6707A (continued) • The section 6707A penalty, effective for returns and statements the due date for which is after October 22, 2004, applies in addition to any accuracy-related penalties. • The section 6707A penalty cannot be waived for failing to report a “listed” transaction,” but the taxpayer can argue that the transaction was not a “substantially similar” transaction. • However, Notice 2005-11 grants the IRS authority to rescind the penalty for failing to disclose a “reportable” transaction (other than a listed transaction) based upon: (1) Whether the taxpayer has a history of complying with the tax laws; (2) Whether the violation is due to an unintentional mistake of fact; and (3) Whether imposing the penalty would be against “equity and good conscience” • There is no judicial review of the Commissioner’s determination whether to rescind the section 6707A penalty.
American Jobs Creation Act (AJCA) Disclosure Penalties Section 6707A (continued) • Certain taxpayers have to disclose the payment of certain penalties to the Securities and Exchange Commission (“SEC”). • The penalties which trigger this new reporting obligation are the section 6707A penalty for failure to disclose, the section 6662A penalty for an understatement attributable to an undisclosed listed transaction or undisclosed reportable avoidance transaction, and the 40 percent penalty under section 6662 for gross valuation misstatements if the 30 percent penalty under section 6662A would have applied. • Note that the failure to make the disclosure to the SEC as just described is itself treated as a failure to include information with respect to a listed transaction for which the penalty under section 6707A applies.
American Jobs Creation Act (AJCA) Disclosure Penalties Section 6707A (continued) • Reportable transactions include six different types of transactions. • Listed Transactions; • Confidential Transactions for which the taxpayer has paid an advisor a minimum fee (i.e., $250,000 for corporations, and $50,000 for other taxpayers); • Transactions with Contractual Protection; • Loss Transactions - A transaction that results in a loss of $10 million or more in a single taxable year for corporations, or $20 million or more in multiple years; • Transactions with a Significant Book-Tax Difference - Transactions with a book-tax difference of more than $10 million on a gross basis in any taxable year are considered “significant” for these purposes; and • Transactions Involving a Brief Asset Holding Period - Transactions are reportable if there is a tax credit claimed that exceeds $250,000, and the asset giving rise to the credit is held for 45 days or less.
American Jobs Creation Act (AJCA) Disclosure Penalties Section 6707A (continued) • The two types of reportable transactions that most large corporations will face are loss transactions and transactions involving significant book-tax differences. • For tax years ending on or after December 31, 2004, if a corporate taxpayer is required to file the new Schedule M-3, the reporting of book-tax differences is deemed to be satisfied by the filing of that completed schedule. • If the Schedule M-3 is filed with the return, it does not also have to be filed with OTSA. • If, however, the transaction has significant book-tax differences and falls within another category of reportable transactions (for example, it is substantially similar to a listed transaction or involves a substantial loss), then it would not only be reported on Schedule M-3, but would have to be reported on a Form 8886 filed with the return. A copy of the Form 8886 would then have to be filed with OTSA.
American Jobs Creation Act (AJCA) Accuracy- Related Penalties Section 6662A • In general, section 6662A provides that a 20-percent accuracy-related penalty may be imposed on any reportable transaction understatement. • A “reportable transaction understatement” means: • The amount of the increase in taxable income which results from a difference between the proper tax treatment of an item and the taxpayer’s treatment of such item (as shown on the taxpayer’s return), multiplied by the highest rate of tax imposed by section 1 (section 11 for corporations); plus • The amount of decrease in the aggregate amount of credits determined under subtitle A which results from a difference between the taxpayer’s treatment of an item to which section 6662A applies (as shown on the taxpayer’s return) and the proper tax treatment of such item.
American Jobs Creation Act (AJCA) Accuracy- Related Penalties Section 6662A (continued) • Section 6662A applies to any listed transaction and any reportable transaction (other than a listed transaction) if a significant purpose of such transaction is the avoidance or evasion of Federal income tax. • The section 6662A penalty applies to any increase in taxable income resulting from certain reportable transactions regardless of the amount of the unreported tax liability. This means that it applies even if the taxpayer is in a net operating loss position. • The amount of the section 6662A penalty is 30 percent, rather than 20 percent, if the taxpayer does not adequately disclose the relevant facts affecting the tax treatment of the item giving rise to the understatement.
American Jobs Creation Act (AJCA) Accuracy- Related Penalties Section 6662A (continued) • The reasonable cause and good faith defense is not available with respect to the 30-percent penalty. • Tax treatment on an amended return or a supplement to a return is not taken into account if the amended return or the supplement is filed after the earlier of the date the taxpayer is first contacted by the IRS regarding an examination of the return, or any other date specified by the Secretary. • In general, the section 6662A accuracy-related penalty does not apply to any portion of a reportable transaction understatement if, pursuant to section 6664(d), it is shown that there was reasonable cause and the taxpayer acted in good faith.
American Jobs Creation Act (AJCA) Accuracy- Related Penalties Section 6662A (continued) • The reasonable cause and good faith exception does not apply unless: • The relevant facts affecting the tax treatment of the item are adequately disclosed; • There is or was “substantial authority” for such treatment; and • The taxpayer reasonably believed that such treatment was more likely than not the proper treatment. Section 6664(d)(2). • Under section 6664(d)(2), the requirement to disclose adequately under section 6011 will be treated as satisfied even if the taxpayer did not in fact disclose if the section 6707A penalty is rescinded.