Distressed Asset Trust (DAT) Tax Shelters

LMSB4-0210-008
EFFECTIVE DATE:  MARCH 23, 2010

Coordinated Issue Paper
All Industries
Distressed Asset Trust (DAT) Tax Shelters
UIL: 9300.50-00

INTRODUCTION

This paper addresses a variation on the use of distressed assets (including creditors’ interests in debt) to shift economic losses from a tax-indifferent party to a U.S. taxpayer.  A distressed asset trust (DAT) transaction typically involves the use of trusts to shift built-in losses from a tax-indifferent party to a U.S. taxpayer who has not incurred an economic loss.[1]  

In a DAT transaction, the tax-indifferent party, directly or indirectly through a related entity such as a partnership[2], transfers assets having little or no fair market value (“FMV”) with a purported high tax basis (“distressed assets”) to a trust (“main-trust”).  The parties to the transaction treat the transfer of distressed assets as a non-taxable contribution to the trust.  The tax-indifferent party, or related entity, is described as the grantor and beneficiary of main-trust.  Main-trust relies on I.R.C. § 1015(b) to claim basis in the distressed assets equal to that of the contributing party, which is alleged to be the original face value (debt) or the purported high tax basis (assets).  Shortly thereafter, under the main-trust agreement, the trustee of main-trust creates a sub-trust to which the distressed assets in the main-trust are allocated.  The main-trust agreement further provides that a sub-trust for a beneficiary constitutes a separate and distinct sub-trust of main-trust, with beneficial interest certificates issued and separate records maintained for the sub-trust.

The U.S. taxpayer enters the transaction by transferring cash or a note to main-trust in exchange for an interest in the trust.  The amount of the cash or note transferred to main-trust equals the purported FMV of the distressed assets, plus fees.  The U.S. taxpayer’s cash investment, and economic stake, in the distressed assets is thus equal to a fraction, e.g. 5 percent, of the claimed tax basis in the distressed assets.  Following the investment of the U.S. taxpayer in the trust, the main-trust allocates distressed assets to the newly formed sub-trust.  The U.S. taxpayer is given powers sufficient to be deemed owner of the sub-trust under I.R.C. § 678, such that the tax attributes of the sub-trust are taken into account by the U.S. taxpayer under I.R.C. § 671. 

In the version of DAT transactions in which the distressed assets are debt instruments, the sub-trust declares the debt worthless at the close of that taxable year, usually within a few weeks of entering the transaction.  Consequently, the sub-trust reports a business bad debt deduction under I.R.C. § 166 in an amount nearly equal to the claimed high tax basis[3].  In another version, the sub-trust sells the distressed assets to a third party[4] for FMV, incurring a loss deductible under I.R.C. § 165.  Under either version, the loss is taken into account and reported by the U.S. taxpayer under the grantor trust rules.[5] 

In cases involving the I.R.C. § 166 bad debt deduction, the tax benefit to the U.S. taxpayer results from the deduction of an amount nearly equal to the claimed transferred high basis in the debt (e.g. 97 percent of the original face value of the debt, which approximates the loss in value prior to the transfer of the debt to the trust) rather than an amount related to the reduction in value of the debt.  Thus the claimed loss substantially exceeds the U.S. taxpayer’s cash investment and economic stake.

This issue paper discusses the reasons why all or a portion of the losses claimed by the U.S. taxpayer as a result of investing in the DAT transaction should be disallowed.

Back to top

ISSUES

1. Whether the trusts and U.S. taxpayer must substantiate the correct amount of the carryover/transferred basis of the contributed distressed assets.
2. Whether there was a transfer in trust of property to the main-trust within the meaning of I.R.C. § 1015(b) so as to cause the trust to take a carryover/transferred basis in such property under that section.[6]
3. Whether the transfer of cash or a note in exchange for a 100 percent beneficial interest in the trust assets was a transfer of the trust assets to the U.S. taxpayer under I.R.C. § 1001.
4. Whether the distressed debt was worthless under I.R.C. § 166 at the time of the contribution to the main-trust and sub-trust.
5. Whether the main-trust and the sub-trust should be characterized as business entities under Treas. Reg. § 301.7701-2.
6. Whether, under judicial doctrines (i.e. step transaction, economic substance, and substance over form) the built-in loss on the disposition (write down, sale, or exchange) of the distressed assets can be disallowed to the U.S. taxpayer.
7. In cases involving a partnership between a tax-indifferent party and a promoter, whether the transfer of the distressed assets from the tax indifferent partner to the partnership was a disguised sale or exchange of property from the partner to the partnership under I.R.C. § 707(a)(2)(B) and Treas. Reg. § 1.707-3, resulting in a cost basis to the partnership in the distressed debt under I.R.C. § 1012.
8. Whether I.R.C. § 482 may apply to allocate losses reported by a U.S. taxpayer to the original contributor of the property where control exists at the time a plan is in place to shift a loss as part of a strategy to reduce artificially income and domestic tax liability. 
9. Whether legal and promoter fees paid by the U.S. taxpayer with respect to a DAT transaction are generally deductible.
10. Whether the trust, sub-trust, and/or U.S. taxpayer are liable for penalties under I.R.C. § 6662.
11. Whether the U.S. Taxpayer is liable for penalties under I.R.C. § 6662A for understatements with respect to DAT transactions.

Back to top

CONCLUSIONS

1. The trusts and U.S. taxpayers must provide adequate documentary proof to substantiate the contributing party’s adjusted basis in the contributed distressed assets.
2. The contribution of worthless debt (the distressed asset) to a trust does not give rise to any carryover/transferred basis in that debt under I.R.C. § 1015(b) on the part of the trust.
3. The transfer of cash or a note in exchange for a 100 percent beneficial interest in the trust assets was a transfer of the distressed assets to the U.S. taxpayer under I.R.C. § 1001.
4. A bad debt deduction under I.R.C. § 166 is allowed for a business-related debt that becomes wholly or partially worthless during the taxable year.  The deduction is allowed to the extent the debt became worthless at the time the debt was owed to the U.S. taxpayer; the U.S. taxpayer is not entitled to the deduction if the debt became worthless before the taxpayer acquired the debt.  Treas. Reg. § 1.166-1(a).
5. The main-trust and the sub-trust should be characterized as business entities under Treas. Reg. § 301.7701-2.
6. Under judicial doctrines, (i.e. step transaction, economic substance, and substance over form) the benefit of the built-in loss claimed upon the disposition (write down, sale, or exchange) of the distressed assets should be disallowed to the U.S. taxpayer.
7. In cases involving a partnership between a tax-indifferent party and a promoter, the transfer of the distressed assets from the tax indifferent partner to the partnership may be a disguised sale of property from the partner to the partnership under I.R.C. § 707(a)(2)(B) and Treas. Reg. § 1.707-3, resulting in a cost basis to the partnership in the distressed debt under I.R.C. § 1012.
8. Section 482 may apply to allocate losses to the original contributor of the property up to the amount of the loss built into the property at the time of contribution.  
9. Legal and promoter fees and other “out-of-pocket expenses” paid by the individual U.S. taxpayer, a trust, or any other entity with respect to a DAT transaction are generally not deductible.
10. The Service should assert the appropriate component(s) of the I.R.C. § 6662 accuracy-related penalties against the U.S. taxpayer who claimed losses from a DAT transaction, unless the taxpayer is able to establish reasonable cause and good faith under I.R.C. § 6664(c)(1) and the applicable regulations.
11. The Service should assert the appropriate I.R.C. § 6662A accuracy-related penalty on understatements with respect to reportable transaction against a U.S. taxpayer who claimed losses from a DAT transaction unless the taxpayer is able to establish reasonable cause and good faith under I.R.C. § 6664(d)(1).

DESCRIPTION OF TRANSACTION

The basic operation of the DAT transaction described in Notice 2008-34 is described below.  Steps 1 to 4 occur within a short period of time, usually within a month or two before the close of the taxable year:

Precursor Activities:  A tax-indifferent party holds distressed assets for which there is no ready market.  The tax-indifferent party, through a U.S. promoter, solicits a U.S. taxpayer interested in acquiring a direct or indirect interest in the distressed assets for purported business purposes.[7]   There is a substantial built-in tax loss in the distressed assets in the hands of the tax-indifferent party (e.g., 97 percent of tax basis).  Advisors, attorneys, and promoters are often involved, and charge fees based on the anticipated tax benefit, i.e. the anticipated loss shifted to the U.S. taxpayer. 

Step 1.  The parties enter into a trust agreement under which the tax-indifferent party or related entity[8], creates a main-trust.  Main-trust is formed as a “business trust” under state law and is characterized by the parties as a simple trust under federal tax law.  The promoter typically becomes trustee of main-trust. 

Step 2.  The tax-indifferent party, or related entity, transfers the distressed assets to main-trust.[9]   The parties to the transaction contend that main-trust is to be taxed as a simple trust and not as a business entity.  They also contend that main-trust receives the same high tax basis in the assets as the tax-indifferent party under I.R.C. § 1015(b).  Thus, the built-in loss in the distressed assets previously held by the tax-indifferent party is transferred to an entity separate from the-tax indifferent party, main-trust.  The tax consequences become relevant in the next steps.

Step 3.  The parties, as authorized by the main-trust agreement, enter into a sub-trust agreement creating a sub-trust.  Such agreement provides that all or part of main-trust’s assets are “allocated” to sub-trust.  The tax-indifferent party or related entity is the 100 percent beneficial owner of the trust assets, i.e. the distressed assets, that are being “allocated” to sub-trust.  Simultaneously, or shortly before or after, a U.S. investor (“Taxpayer”) transfers cash (or a note) to main-trust in an amount equal to the purported FMV of the distressed assets.  In exchange for Taxpayer’s cash/note, main-trust transfers substantially all of the rights in the trust corpus, i.e. the distressed assets, to Taxpayer.[10]   Sub-trust’s claimed basis in the assets remains the same as it had been in the hands of main-trust (and the tax-indifferent party) under I.R.C. § 1015(b).  The parties contend that the high tax basis, and built-in loss, of the distressed assets transfers from tax-indifferent party to main-trust to sub-trust, and thus to the benefit of Taxpayer, by operation of I.R.C. § 1015(b). 

In the sub-trust agreement, Taxpayer is granted powers over the sub-trust assets sufficient to be deemed owner of sub-trust under I.R.C. § 678.  Specifically, the sub-trust agreement entitles the holder of the sub-trust certificates of beneficial interest, the Taxpayer, to direct the trustee to vest the certificate holder’s ratable share of the corpus or income of sub-trust in the certificate holder.[11] Consequently, sub-trust is a grantor trust for federal tax purposes and, as such, sub-trust’s items of income, gain, loss, deductions, and credits are attributed to the Taxpayer as owner of sub-trust under I.R.C. § 671.

Step 4.  The taxable year typically ends within a month or two of the transaction.[12]   Main-trust files a Form 1041, U.S. Income Tax Return for Estates and Trusts, as a simple trust for that year reporting no activity.  Main-trust’s tax return reflects only the Taxpayer as a beneficiary, not the tax-indifferent party or related entity.  Sub-trust files a Form 1041 as a grantor trust, indicating that the Taxpayer is 100 percent owner of the trust.  In the DAT transactions involving bad debt, sub-trust reports a “business bad debt expense on contributed notes” under I.R.C. § 166 in an amount nearly equal to the claimed high basis of the debt.  Taxpayer files a Form 1040, U.S. Individual Income Tax Return, reporting the bad debt expense from sub-trust as a loss on Schedule E.  Under a different scenario, Taxpayer or the trust(s) sell the distressed assets, or beneficial interests therein, for FMV at a loss, and report the loss under I.R.C. § 165.  Under either scenario, Taxpayer realizes a tax benefit well in excess of the Taxpayer’s economic stake.

Subsequent Years:  Each year, the transaction may be repeated.  The tax-indifferent party may contribute, directly or indirectly, additional distressed assets to main-trust, which could allocate the assets to another sub-trust, for Taxpayer to offset other income that year.

Example:  In 2005, Taxpayer anticipates $3 million of income and, thus, requires a $3 million loss.  At the behest of a promoter and via a related entity, the tax-indifferent party transfers distressed assets with a claimed tax basis of $3 million and approximate FMV of $90,000 to main-trust.   Taxpayer invests $150,000 in main-trust.[13]  Taxpayer pays promoters and advisors fees of $300,000.  In return for the $450,000 cash outlay for the investment and fees, Taxpayer receives an I.R.C. § 166 ordinary loss deduction of approximately $3 million, offsetting a like amount of Taxpayer’s income.  Taxpayer’s investment of $150,000 is split between trustees’ fees and payment to the tax-indifferent party.  The tax-indifferent party thus ultimately receives the approximate FMV, $90,000, for the distressed assets.

In 2006, the same Taxpayer may anticipate $1 million of other income.  Main-trust thus obtains from the tax-indifferent party distressed assets with a $1 million tax basis.  Accordingly, Taxpayer invests the required amount in main-trust, pays the fees, and deducts approximately $1 million ordinary loss under I.R.C. § 166 in 2006 to offset the other income.

Back to top

DISCUSSION

ISSUE 1. The trusts and U.S. taxpayers must provide adequate documentary proof to substantiate the contributing party’s adjusted  basis in the contributed distressed assets.

The trusts and U.S. taxpayers have the burden of establishing their basis in the assets making up the portfolio or pool of distressed assets (i.e., the measure of the trust’s carryover/transferred basis under I.R.C. § 1015(b)), including establishing the contributing parties’ bases in such assets at the time of contribution.  See Trigon Insurance Co. v. United States, 215 F.Supp.2d 687 (E.D. Va. 2002) (holding that the taxpayer had not established the FMV of insurance contracts and was not entitled to a deduction); Estate of Andrews v. United States, 850 F. Supp. 1279 (E.D. Va. 1994).

In the distressed debt context, such information includes the continuing existence of the debtor, the existence of other obligors such as guarantors or sureties, the financial viability of any extant debtor or obligor, documentation of the debt at the time contributed, and the collectability of the debt under local law at the time contributed in light of, e.g., the local statute of limitations.

Agents should issue IDRs requesting such basis information and, if it is not forthcoming, should issue Formal Document Requests under I.R.C. § 982 requesting such “foreign based documentation.”[14]  

ISSUE 2. The contribution of worthless debt (the distressed asset) to a trust does not give rise to any carryover/transferred basis in that debt under I.R.C. § 1015(b) on the part of the trust.

A contribution of a worthless asset to a partnership does not constitute a contribution of property within the meaning of I.R.C. § 721 because nothing of value has been contributed.  Santa Monica Pictures, LLC, et al v. Commissioner, T.C. Memo 2005-104 (2005), citing Seaboard Commercial Corp. v. Commissioner, 28 T.C. 1034, 1054 (1957).  Since no property has been contributed to the partnership, the partnership has no carryover basis in the property under I.R.C. § 723 and the partnership receives no basis in the asset as a result of the purported contribution. 
Similarly, a contribution of a worthless asset to a trust does not constitute a contribution of property within the meaning of I.R.C. § 1015(b) because nothing of value has been contributed.  Treas. Reg. § 1.1015-2.[15]   Moreover, the basis in any asset contributed to a U.S. partnership or trust by a foreign entity must be determined under U.S. tax principles.[16]  

Section 166(a)(1) allows a deduction for any debt that becomes worthless within the taxable year.  To give rise to a deduction under the statute, the debt must have value at the beginning of the year and become worthless during the year.  A taxpayer may not claim a deduction for a debt that becomes worthless in a prior year.  Beaumont v. Commissioner, 25 B.T.A. 474, 481 (1932).  When a debt becomes wholly worthless, the owner’s basis in the debt disappears.  There is no basis in the tax law for resurrecting the basis of an asset which has become worthless in the past.  Therefore, to the extent the contributed asset had become worthless in a prior tax period, the contributing partner would have no basis in such asset under U.S. tax principles.

The taxpayer might argue that the relevant asset was the entire portfolio or pool of distressed debts/assets and that such entire pool was not worthless despite the fact that many or most of the assets in such pool may have been worthless.  Nothing in the Code or the regulations attaches any special tax consequences to such a pool of assets.  Each asset in the portfolio or pool must be looked at separately and if any asset is worthless, that asset is not property within the meaning of I.R.C. § 1015(b).  And if such asset had become worthless in a prior period, the contributing foreign entity would have no basis in such asset. [17]

ISSUE 3. The transfer of cash or a note in exchange for a beneficial interest in the trust assets was a transfer of the distressed assets to the U.S. taxpayer under I.R.C. § 1001.

The U.S. taxpayer’s transfer of cash or a note in exchange for an interest in the main-trust and/or sub-trust is characterized for federal income tax purposes as a purchase of the trust’s underlying assets.  See Rev. Rul. 99-5, 1999-1 CB 434 (Situation 1).  Thus, the U.S. taxpayer takes a cost basis in the distressed assets under I.R.C. § 1012.  Consequently, any deductions taken by the sub-trust and taken into account by the taxpayer are limited to the taxpayer’s cost basis in the distressed assets.

To the extent the grantor or another person is the owner of a trust, the trust lacks a separate transactional identity and is disregarded as an entity separate from its owner.  Treas. Reg. § 1.671-3 provides that a person treated as the owner of a trust “takes into account in computing his income tax liability all items of income, deduction, and      credit. . . to which he would have been entitled had the trust not been in existence during the period he is treated as owner.”  (emphasis added).  Thus, it follows that the owner of a trust under subpart E is treated as the owner of the trust property for federal income tax purposes.  See Rev. Rul. 85-13, 1985-1 C.B. 184 (“Because A is treated as the owner of the entire trust, A is considered to be the owner of the trust assets for federal income tax purposes”); Prop. Treas. Reg. § 1.671-2 (“A person who is treated as the owner of any portion of a trust under subpart E is considered to own the trust assets attributable to that portion of the trust for all federal income tax purposes.”); Swanson v. Commissioner, 518 F.2d 59, 63 (8th Cir. 1975) (holding that the grantor of a grantor trust is not merely deemed the owner of the trust for the purpose of taxing trust income, but rather such grantor trusts do not “retain their identity as a separate tax entity. . . .”); Madorin v. Commissioner, 84 T.C. 667 (1985) (holding that owner of grantor trust is not merely “owner” for purposes of tax income and loss, but is the actual owner of its assets, and the conversion of a grantor trust interest into a simple trust resulted in a discharge of indebtedness to the grantor/owner); Estate of O’Conner v. Commissioner, 69 T.C. 165, 174 (1977) (“When a grantor or other person has certain powers in respect of trust property that are tantamount to dominion and control over such property, the Code ‘looks through’ the trust form and deems such grantor or other person to be the owner of the trust property and attributes the trust income to such person.  By attributing such income directly to a grantor or other person, the Code, in effect, disregards the trust entity.”)(emphasis added)(citations omitted).

In DAT cases, the transfer of cash (or a note) in return for a property interest in the main-trust and sub-trust, and/or the distressed assets themselves, constitutes a sale or exchange pursuant to I.R.C. § 1001(a) upon which gain or loss is recognized to the trust under I.R.C. § 1001(c).  The recipient U.S. taxpayer takes a cost basis in the property interest pursuant to I.R.C. § 1012.  To the extent the distressed debt becomes worthless in a given taxable year, and the interest in the distressed debt becomes worthless, the U.S. taxpayer may be entitled to a I.R.C. § 166 bad debt deduction up to the amount of the adjusted (cost) basis of the distressed debt pursuant to I.R.C. § 166(b).

ISSUE 4. A bad debt deduction under I.R.C. § 166 is allowed for a business related debt that becomes wholly or partially worthless during the taxable year.  The deduction is allowed to the extent the debt became worthless at the time the debt was owed to the taxpayer; a taxpayer is not entitled to the deduction if the debt became worthless before the taxpayer acquired the debt.  Treas. Reg. § 1.166-1(a).    

The deductibility of a bad debt depends upon whether the debt is related to the taxpayer’s trade or business, and the time the debt becomes worthless in whole or in part.  If the taxpayer is engaged in a trade or business and the debt was created or acquired in that trade or business, the taxpayer can deduct the debt when and to the extent it becomes wholly or partially worthless.  I.R.C. § 166(a), (d)(2)(A).  If the debt was not created or acquired in the taxpayer’s trade or business, the taxpayer can deduct the debt if the loss that occurs when the debt becomes wholly or partially worthless is proximately related to the conduct of the trade or business.  I.R.C. § 166(a),(d)(2)(B); Treas. Reg. § 1.166-5(b).

The deduction is allowed to the extent of the adjusted basis of the debt (or its worthless portion).  I.R.C. § 166(b).  As noted above, I.R.C. § 166(a)(1) allows a deduction for any debt that becomes worthless within the taxable year.  When a debt becomes wholly worthless, the owner’s basis in the debt disappears.

In DAT cases, the U.S. taxpayer must substantiate that the distressed debt became worthless in the year of the deduction, and the basis for such a position.  Facts should be developed to determine the extent to which the debt decreased in value, and when.  It is the U.S. taxpayer’s burden to establish those variations in value.  Such determinations may require a valuation opinion.

If the debt was a non-business bad debt, and becomes wholly worthless, it is treated as a short-term capital loss.  I.R.C. § 166(d)(1).  A partially worthless non-business bad debt is not deductible.  A business bad debt is not deductible if the bad debt became wholly worthless in an earlier taxable year. 

ISSUE 5. The main-trust and the sub-trust should be characterized as business entities under Treas. Reg. § 301.7701-2.

If the main-trust and the sub-trust are not ordinary trusts under the regulations and case law, then they would be reclassified as business entities under Treas. Reg. § 301.7701-2.  As business entities, each trust would be classified as either a disregarded entity or a partnership, depending on the number of owners.  If the main-trust and the sub-trust are reclassified as disregarded entities, then the investors should be treated as purchasers of the distressed assets, causing the investors to take a basis in the distressed debt equal to the investor’s cost.  I.R.C. § 1012.  If the main-trust or the sub-trust is reclassified as a partnership, the partnership rules would apply to allocate the built-in loss in the distressed debt to the contributing partner, and limit the basis in the debt as to the partner who did not contribute the debt.  I.R.C. §§ 704(c) and (d).  Any business bad debt deduction is limited to the basis in the debt. I.R.C. § 166(b).  Thus, the determination of whether the trusts are taxable as business entities is critical. 

The Service can ignore an entity’s classification of itself as a trust if some other classification is more appropriate.  Treas. Reg. § 301.7701-2(a) and §§ 301.7701-4(b) and (c).  A trust for federal income tax purposes is an arrangement to protect or conserve property for beneficiaries.  An example of such a trust is a testamentary trust.  By contrast, other arrangements that are represented as trusts but are not simply arrangements to protect or conserve property for beneficiaries may be business trusts or investments trusts.  Business trusts (also known as commercial trusts), are generally created simply as a device to carry on a profit-making business that normally would be carried on through business organizations classified as corporations or partnerships.  While such trusts are created and exist under state laws, they are taxed under federal revenue laws.  Morgan v. Commissioner, 309 U.S. 78 (1940); Treas. Reg. § 301.7701-4(b).  Investments trusts are classified as business entities if there is a power under the trust agreement to vary the investment of the certificate holders.  Treas. Reg. § 301.7701-4(c). 

Many DAT trusts were formed under state law as business trusts, alleged to be taxed as trusts under federal law.  When an express trust is used as an agency of commerce, it is commonly known as a “business trust,” “Massachusetts trust,” or “common-law trust.”  See, e.g.,  Schumann-Heink v. Folsom, 159 N.E. 250 (Ill. 1927)(state common law business trust recognized under Illinois law).[18]

The key factor in distinguishing between a trust and a corporation or partnership for federal tax purposes is whether the activity has a business purpose, or purpose to carry on active business operations.  In Morrisey v. Commissioner, 296 U.S. 344 (1935), the Supreme Court addressed the issue of a business trust and whether it should be taxed as a corporation.  The Court observed that business trusts are joint enterprises of associates created for the purpose of transacting business to share in profits, while ordinary trusts are created to conserve property for beneficiaries against the day when the property will be distributed to the beneficiaries.

In Morrisey, a trust was created for the purpose of developing land through construction and operation of golf courses and clubhouses.  The trustees had broad powers to purchase, operate, and sell properties, and the trust documents provided for centralized control, continuity of existence, and limited liability, as well as transferability of beneficial interests.  The beneficial interests were evidenced by certificates for both preferred and common shares.  The Court held this arrangement to be taxable as a corporation, not a trust.  Modern law, including I.R.C. § 7701(a)(3), the regulations, and cases thereunder, follows Morrisey with respect to the intent to conduct a business activity analysis.  See Bedell Trust v. Commissioner, 86 TC 1207 (1986) (testamentary trust not association taxable as corporation)(following Morrissey analysis). 

Another significant factor is whether the trust had associates, joined in a common effort to conduct a business enterprise. Elm Street Realty Trust v. Commissioner, 76 TC 803 (1981) (trust created for estate planning not association taxable as corporation).  The taxpayers prevailed in both Bedell Trust and Elm Street Realty Trust because the trusts did not have associates who “planned a common effort or entered into a combination for the conduct of a business enterprise.”  Bedell Trust, 86 T.C. at 1219-1220.  Rather, the beneficiaries played no active role either in the creation of the trust or in their entrance into a beneficial relationship with the trusts.  Elm Street Realty Trust,  76 T.C. at 817.  The court noted that “the beneficiaries’ purchase of beneficial interests would tend to indicate the presence of associates, since the purchase dignifies a voluntary and affirmative entrance into the enterprise.”  Elm Street Realty Trust, fn. 5.

The DAT taxpayers and promoters assert that the trusts were formed merely to protect and conserve the assets of the investor beneficiaries, not to conduct any particular business operation, and that the distressed debt was merely the asset in which the investors’ funds were invested.  But the available facts in the DAT cases indicate that the trusts were not created merely to protect and conserve the assets of the investor beneficiaries.  The only property in each trust, aside from the cash contributed by the investor, was the distressed debt.  The trusts contracted with collection agencies to collect that debt.  The trusts were marketed to the investor in large part because of the business acumen of the collection agency, i.e. that it would do a much better job of collecting the debts than the foreign creditors who transferred the debt to the trusts.  Under these commonly seen facts, the business purpose of the trusts, via their contracts with the collection agencies, was to collect the non-performing debts.  This arrangement was a debt collection business on its face.  Moreover, as noted above, and while not determinative, the trusts were considered business entities, not trusts, under applicable state law.

In addition, in many, if not all, DAT transactions, there is an internal inconsistency between the characterization of the trusts’ activity for purposes of entity characterization under the check-the-box regulations[19], and a worthless bad debt characterization under I.R.C. § 166.  As discussed above, upon formation the trusts are characterized by the promoter and other parties as non-business entities, i.e. as simple trusts under state law, such as those used for estate planning.  The trusts are characterized as such to avoid partnership or corporate tax treatment, either of which would defeat the tax purpose of the DAT transaction.  However, for purposes of I.R.C. § 166, the trusts are treated by the promoter as being engaged in a trade or business, that of debt collection, in order to take advantage of the business bad debt deduction.  Bad debt losses unrelated to a trade or business are treated as short-term capital losses.  Thus, on formation the trust is alleged not to be in a trade or business, yet shortly thereafter the trust reports a “business bad debt deduction” on its tax return in connection with its debt collection business.  The characterization of the I.R.C. § 166 deduction as a business bad debt deduction, rather than a non-business bad debt deduction, supports the conclusion that the trusts should be classified as business entities and taxed as such.  This inconsistent treatment of whether the trust was engaged in business undermines the taxpayers’ position that they are entitled to a deduction.

Furthermore, under the Tax Court cases (see Bedell Trust, and Elm Street Realty Trust) interpreting I.R.C. § 7701(a) and the corresponding regulations cited above, the DAT trusts may not be trusts taxable under the trust rules.  The facts in the DAT cases show that rather than forming the trusts merely to protect and conserve assets, the U.S. investors associated themselves into a common enterprise with the promoter and promoter-controlled trusts by voluntarily combining to contract with a collection agency to collect the non-performing debts.

Finally, the short duration of each DAT trust enterprise, and immediate deduction of the distressed debt as bad debt under I.R.C. § 166,[20]  indicates that the DAT trusts were not created to protect and conserve assets, but as shams created to facilitate the shift of built-in loss assets from a tax-indifferent entity to U.S. taxpayers in return for cash.

If the main-trust or sub-trust has a power under its respective trust agreement to vary the investment of the investor certificate holder, then it will not be classified as a trust.  Treas. Reg. § 7701-4(c).  Under Rev. Rul. 75-192, 175-1 C.B. 384 (1975), a power to vary the investment of the certificate holders, within the meaning of section 301.7701-4(c) of the regulations, means one whereby the trustee or some other person has some kind of managerial power over the funds in trust that enables him to take advantage of variations in the market to improve the investment of all the beneficiaries.  See Commissioner v. North American Bond Trust, 122 F 2.d 545, 546 (2d Cir. 1941), cert denied, 314 U.S. 701 (1942).  Such a power need not be exercised, for although a trustee may not actually exercise all the powers and discretion granted him under the trust agreement, the parties are not at liberty to say that their purpose was other or narrower than that which they formally set forth in the instrument under which their activities were conducted.  Helvering v. Coleman-Gilbert Associates, 296 U.S. 369, 374 (1935).

In a DAT transaction, if the trust’s trustee has additional powers under the trust agreement such as the power to vary the investments of the trust, the trust will be a business entity which, if it has two or more owners, will be classified as a partnership for federal tax purposes (unless it elects to be classified as a corporation under Treas. Reg. § 301.7701-3).  Rev. Rul.  2004-86, 2004-2 C.B. 191.  The trust documents may claim to elect out of subchapter K in the event the Service treats the trust as a business entity.  However, because the assets of the trust will not be owned by the beneficiary or beneficiaries as co-owners under state law, the trust will not be able to elect to be excluded from the application of subchapter K.  See Treas. Reg. § 1.761-2(a)(2)(i).  If the trust has one owner, it will be classified as a disregarded entity.  Treas. Reg. § 301.7701-3(b).

The Service’s position is that, if the trusts are in the debt collection business by virtue of their contracts with a collection agency, they are not trusts but instead are business entities.  Treas. Reg. §§ 301.7701-2(a) and 301.7701-4(b).  As business entities that did not file an entity classification election, the trusts would be treated under the default entity classification rules as either disregarded entities or partnerships for federal tax purposes, depending on the number of owners each has.  Treas. Reg. § 301.7701-3(b).  If the main-trust is a partnership, then the built-in loss in the distressed debt would be limited to the contributing partner, the tax-indifferent party or related entity.  If the sub-trust is a disregarded entity and the main-trust is either a partnership or a disregarded entity, then the investors would be treated as purchasing the distressed debt directly.  

Therefore, the trusts could be reclassified as either disregarded entities or as partnerships under the authority of Treas. Reg. § 301.7701-2(a) and § 301-7701-4(b) or (c).

ISSUE 6. Under judicial doctrines, (i.e. step transaction, economic substance, and substance over form) the benefit of the built-in loss claimed upon the disposition (write down, sale, or exchange) of the distressed assets should be disallowed to the U.S. taxpayer.

The primary purpose of the DAT transaction is to manipulate the tax rules to shift a built-in loss from a tax-indifferent party to a U.S. taxpayer rather than for the trust to make a profit from the sale of and/or collection on the distressed assets.  Various judicial doctrines may be applicable to DAT transactions.  The arguments have been classified under the general doctrines of step transaction, economic substance and substance over form.[21]

Back to top

A.  Step Transaction Doctrine

In tax avoidance situations such as DAT transactions, the substance of a transaction, rather than its form, governs the federal income tax treatment of the transaction.  Commissioner v. Court Holding Co., 324 U.S. 331 (1945); Gregory v. Helvering, 293 U.S. 465 (1935).  The question of the applicability of the substance over form doctrine and related judicial doctrines requires "a searching analysis of the facts to see whether the true substance of the transaction is different from its form or whether the form reflects what actually happened."  Harris v. Commissioner, 61 T.C. 770, 783 (1974).  See also, Gordon v. Commissioner, 85 T.C. 309, 327 (1985); Gaw v. Commissioner, T.C. Memo. 1995-531, aff’d without published opinion, 111 F.3d 962 (D.C. Cir. 1997).  One such judicially created doctrine is the step transaction doctrine.

Under the step transaction doctrine, a series of formally separate steps may be collapsed and treated as a single transaction if the steps are in substance interrelated and focused toward a particular result.

The step transaction doctrine generally applies in cases where a taxpayer seeks to get from point A to point D and does so by stopping in between at points B and C.  The whole purpose of the unnecessary steps is to achieve tax consequences differing from those which a direct path from A to D would have produced.  In such a situation, courts are not bound by the twisted path taken by the taxpayer, and the intervening steps may be disregarded or rearranged. Smith v. Commissioner, 78 T.C. 350, 389 (1982).  See also Andantech v. Commissioner, T.C. Memo. 2002-97, aff’d in part and remanded in part, 331 F.3d 972 (D.C. Cir. 2003); Long Term Capital Holdings, et al. v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004).  Courts have applied three alternative tests in deciding whether the step transaction doctrine should be invoked in a particular situation: the binding commitment test, the end result test, and the interdependence test.

The binding commitment test is the most limited of the three tests.  It looks to whether, at the time the first step was entered into, there was a binding commitment to undertake the later transactions.  This is the most rigorous test of the step transaction doctrine.  Commissioner v. Gordon, 13 F.3d 577, 583 (2d Cir. 1994).  If there were a moment in the series of the transactions during which the parties were not under a binding obligation, the steps cannot be collapsed under this test.  As a practical matter, the binding commitment test is seldom used.  See, e.g., Andantech v. Commissioner,  supra; Long Term Capital, supra.

The end result test analyzes whether the formally separate steps merely constitute prearranged parts of a single transaction intended from the outset to reach a specific end result.  This test relies on the parties’ intent at the time the transaction is structured.  The intent the courts focus on is not whether the taxpayers intended to avoid taxes, but whether the parties intended from the outset to “to reach a particular result by structuring a series of transactions in a certain way.”  Additionally, they focus on whether the intended result was actually achieved.  True v. United States, 190 F.3d 1165, 1175 (10th Cir. 1999).

Finally, the interdependence test looks to whether the steps are so interdependent that the legal relations created by one step would have been fruitless without a completion of the later series of steps.  See Penrod v. Commissioner, 88 T.C. 1415, 1428-1430 (1987).  Steps are generally accorded independent significance if, standing alone, they were undertaken for valid and independent economic or business reasons.  Green v. United States, 13 F.3d 577, 584 (2d Cir. 1994); Sec. Insurance Company v. United States, 702 F.2d 1234, 1246 - 7 (5th Cir. 1983).

The existence of economic substance or a valid non-tax business purpose in a given transaction does not preclude the application of the step transaction doctrine.

Events such as the actual payment of money, legal transfer of property, adjustment of company books, and execution of a contract all produce economic effects and accompany almost any business dealing.  Thus, the courts do not rely on the occurrence of these events alone to determine whether the step transaction doctrine applies.  Likewise, a taxpayer may proffer some non-tax business purpose for engaging in a series of transactional steps to accomplish a result he could have achieved by more direct means, but that business purpose by itself does not preclude application of the step transaction doctrine.  True v. United States, supra, at 1177.  See also Associated Wholesale Grocers v. United States, 927 F.2d 1517 (1991); Long Term Capital Holdings, supra, at 193.

The three tests are not mutually exclusive and the requirements of more than one test may be met in one transaction.  Further, the circumstances of a transaction need only satisfy one of the tests for the step transaction to operate.  Associated Wholesale Grocers, Inc. v. United States, 927 F.2d 1517, 1527-1528 (10th Cir. 1991) (finding the end result test inappropriate but applying the step transaction doctrine using the interdependence test).  And finally, even if the step transaction doctrine does not apply to an entire transaction, it may allow the Government to collapse a portion of a transaction, which may be sufficient to prevent the intended tax avoidance result.  For a recent detailed discussion of the application of the three alternative tests in lease stripping transactions, see Andantech L.L.C. v. Commissioner, supra, and Long Term Capital, supra.

The step transaction doctrine is particularly tailored to the examination of transactions involving a series of potentially interrelated steps for which the taxpayer seeks independent tax treatment.  True v. United States, 190 F.3d at 1177.  As a general rule, courts have held that in order to collapse a transaction, the Government must have a logically plausible alternative explanation that accounts for all the results of the transaction.  Del Commercial Props. Inc. v. Commissioner, 251 F.3d 210, 213-214 (D.C. Cir. 2001), aff’g T.C. Memo. 1999-411; Penrod v. Commissioner, supra, at 1428-1430; Tracinda Corp. v. Commissioner, 111 T.C. 315, 327 (1998).  The explanation may combine steps; however, some courts have declined to apply the doctrine where the Government’s alternative explanation would invent new steps or simply reorder the actual steps taken by the parties.  “’Useful as the step transaction doctrine may be . . . it cannot generate events which never took place just so an additional tax liability might be asserted.’”  See Grove v. Commissioner, 490 F.2d 241, 247-248 (2d Cir. 1973), aff’g T.C. Memo. 1972-98 (quoting Sheppard v. United States, 176 Ct. Cl. 244; 361 F.2d 972, 978 (1966))); see also Esmark, Inc. & Affiliated Cos. v. Commissioner, 90 T.C. 171, 196 (1988), aff’d without published opinion, 886 F.2d 1318 (7th Cir. 1989); But cf. Long Term Capital, supra, at 196 (footnote 94) (indicating that Esmark may be of limited applicability and distinguishable where all of the parties necessary to achieve the ultimate result are privy to the mutual understanding between the parties.)

The step transaction doctrine may be applicable to a typical DAT transaction, depending, of course, on how the actual transaction is structured.  For example, in cases involving contribution of distressed debt by a foreign party (“FP”) or related entity to a U.S. trust,[22]  the end result test and/or the interdependence test of the step transaction doctrine could be used to disregard the contribution of the distressed assets by FP to the related entity or to the trust and to treat such purported “contribution” as a sale of the assets to the U.S. taxpayer.[23]   Under such a scenario, the U.S. taxpayer would have a cost basis in the assets, FP would sustain the economic loss, and the built-in tax loss would not be transferred to the U.S. taxpayer.  Accordingly, any potential bad debt deduction for the U.S. taxpayer would be limited to that cost basis, at most. 

Examiners should look at the facts (such as all agreements involving the promoter, FP, (partnership), trusts, and U.S. taxpayer, as well as the kind and extent of business activities conducted by the trusts) on a case-by-case basis to determine if the step transaction doctrine would be applicable in their specific case.

Back to top

B.  Economic Substance

Discretion must be exercised in determining whether to utilize an economic substance argument[24]   in all cases.  The doctrine of economic substance should be considered, but only in cases where the facts show that the transaction at issue was primarily designed to generate the tax losses, with little if any possibility for profit, and that such was the expectation of all the parties.  Specifically, in a DAT transaction, the argument should not be raised when taxpayers can demonstrate that the structure of the transaction and the activities of the trust(s) had practical economic effects, i.e., realistic profit potential, other than the creation of income tax losses, or the shifting of losses from a tax indifferent party to a U.S. taxpayer. 

The wide variety of facts required to support its application should be developed at the Exam level.  The sources for these facts will be similar: documents obtained from taxpayers, the promoter and other third parties; interviews with the same; and an analysis of financial data and industry practices.  Examiners must not hesitate to issue summonses if IDRs or other less formal case development efforts are not effective.

Back to top

I.  Background

In order to be respected, a transaction must have economic substance separate and distinct from the economic benefit achieved solely by tax reduction. See Frank Lyon Co. v.  U.S, 435 U.S. 561, 583-84 (1977).  A transaction has economic substance if it is rationally related to a useful nontax purpose that is plausible in light of the taxpayer’s conduct and economic situation and the transaction has a reasonable possibility of profit.  See Rice’s Toyota World v. Commissioner, 752 F.2d 89 (4th Cir. 1993); Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993); ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998).

A transaction’s economic substance is determined by analyzing the subjective intent of the taxpayer entering into the transaction and the objective economic substance of the transaction.  The various United States Courts of Appeals differ on whether the economic substance analysis requires the application of a two-prong test or is a facts and circumstances analysis regarding whether the transaction had a “practical economic effect,” taking into account both subjective and objective aspects of the transaction.  Compare Rice’s Toyota World and Pasternak at 898 (applying the two-pronged test) with Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995) (applying the facts and circumstances analysis).[25]   See also Gilman v. Commissioner, 933 F.2d 143, 148 (2d Cir. 1991) (“The nature of the economic substance analysis is flexible…“).

Moreover, among the United States Courts of Appeals that apply a two-prong test, there is disagreement as to whether the test is disjunctive or conjunctive.  For example, the Fourth Circuit Court of Appeals applies the test disjunctively:  a transaction will have economic substance if the taxpayer had either a nontax business purpose or the transaction had objective economic substance.  Rice’s Toyota World at 91-92.[26]   However, the Sixth Circuit Court of Appeals and Eleventh Circuit Court of Appeals apply the test conjunctively:  a transaction will have economic substance only if the taxpayer had both a nontax business purpose and the transaction had objective economic substance. See Pasternak at 898 and United Parcel Service of America v. Commissioner, 254 F.3d 1014, 1018 (11th Cir. 2001) (citing Kirchman v. Commissioner, 862 F.2d 1486, 1492 (11th Cir. 1989)),

The Fifth Circuit recently upheld the District Court’s decision in Klamath on the economic substance and penalties issue, and also ruled that the objective prong is necessary to determine whether the transaction has economic substance, regardless of whether the taxpayer satisfied the subjective prong.  Klamath Strategic Investment Fund v. United States, LLC, No. 07-40861, 2009 WL 1353118 (5th Cir. May 15, 2009).

Back to top

II.  Subjective Intent – Business Purpose

The subjective business purpose inquiry “examines whether the taxpayer was induced to commit capital for reasons relating only to tax considerations or whether a nontax motive, or legitimate profit motive, was involved.” Shriver v. Commissioner, 899 F.2d 724, 726 (8th Cir. 1990) (citing Rice’s Toyota World, supra).  To determine that intent, the following credible evidence is considered: (i) whether a profit was possible;[27]  (ii) whether the taxpayer had a nontax business purpose;[28]  (iii) whether the taxpayer, or its advisors, considered or investigated the transaction, including market risk;[29]  (iv) whether the entities involved in the transaction were entities separate and apart from the taxpayer doing legitimate business before and after the transaction;[30]   (v) whether all the purported transactions were engaged in at arm’s-length with the parties doing what the parties intended to do;[31]   and (vi) whether the transaction was marketed as a tax shelter in which the purported tax benefit significantly exceeded the taxpayer’s actual investment.[32]

Taxpayers engaging in a DAT transaction will likely assert a profit objective as the non-tax business purpose.  The lack of economic substance argument applies where a transaction did not have a realistic pre-tax profit potential.[33]   Evidence should be sought to demonstrate that the taxpayer and the promoter primarily planned the transaction for tax purposes and that any potential for profit was incidental to that purpose.

Such evidence might include items such as the following: (i) promotional materials or other evidence that the DAT transactions were sold as tax shelters with limited consideration of the underlying economics of the transaction; (ii) evidence that the U.S. taxpayer, or the U.S. taxpayer’s advisors, did not investigate the market risk prior to entering into the DAT transaction; (iii) evidence that the trusts undertook no or minimal activities designed to profit from the sale of and/or collection on the distressed assets, and evidence regarding the trusts’ business plans and activities, or lack thereof, other than those relating to the distressed assets; (iv) such information from the FP and third-party facilitators, e.g., accountants, appraisers, etc., with respect to whether the entire series of steps, including the determination that the debt was worthless shortly after its contribution, were preplanned; and (v) evidence relating to the quality of the distressed asset or debt, and business sophistication and experience of the investor.[34]

A direct source of such evidence regarding the taxpayer’s contention of a nontax business purpose is correspondence between the promoter and the U.S. taxpayer, including, but not limited to, offering memos, letters identifying tax goals, emails and in-house communications at the offices of both the promoter and the accommodating parties.  Written correspondence is the best evidence, but evidence of oral communications regarding tax goals is also useful.  Indirect sources of the same include correlations between tax losses generated and tax losses requested, and between the U.S. taxpayer's income and the tax losses generated, particularly if it can be shown that the income to be sheltered was attributable to an unusual windfall, like the liquidation of stock options, or sale of a business.

Back to top

III.  Objective Economic Substance

Courts have used different measures to determine whether a transaction has objective economic substance.  These measures include whether there is a potential for profit, and whether the transaction otherwise altered the economic relationships of the parties.

This determination is generally made by reference to whether there was a reasonable or realistic possibility of profit.[35]  See e.g., Gilman v. Commissioner, 933 F.2d 143, 146 (2d Cir. 1991) (determine economic substance based on “if the transaction offers a reasonable opportunity for economic profit, that is, profit exclusive of tax benefits.”) The amount of profit potential necessary to demonstrate objective economic substance may vary by jurisdiction.[36]   However, a transaction is not required to result in a profit and similar transactions do not need to be profitable in order for the taxpayer’s transaction to have economic substance.  See Cherin v. Commissioner, 89 T.C. 986, 994 (1987).  See also Abramson v. Commissioner, 86 T.C. 360 (1986) (holding that potential for profit is found when a transaction is carefully conceived and planned in accordance with standards applicable to a particular industry, so that judged by those standards the hypothetical reasonable businessman would make the investment).

The courts have indicated that a minimal profit should not be conclusive in finding economic substance or practical economic effects.  Minimal or no profit has been held to be acceptable in highly risky circumstances, where a chance for large profits also existed.  See Bryant v. Commissioner, 928 F.2d 745 (6th Cir. 1991); Jacobson v. Commissioner, 915 F.2d 832 (2d Cir. 1990).  Conversely, a minimal profit should be less acceptable when a ceiling on profits from a transaction is all but certain.  See ASA, 201 F.3d 505.  The fact that the taxpayer is willing to accept minimal returns in a transaction with little additional profit potential is evidence that the transaction was tax motivated.  See ACM Partnership, 157 F.3d 231.

In developing this prong of the argument, it is not enough to show that the transaction was not profitable or was only nominally profitable.  The facts must support a conclusion that the taxpayer could not reasonably expect to profit from the transaction or, at best, could realize only a nominal profit.  All direct and indirect fees and costs paid by the taxpayer, any offsetting positions related to the overall transaction, any collars or other agreements limiting potential gains or losses, and any indemnity agreements between the accommodating parties and the promoter should be determined.

Certain courts have been willing to recognize the economic substance of a transaction when, in lieu of a reasonable possibility of profit, the taxpayer establishes that the transaction altered the economic relationships of the parties. See Knetsch v. United States, 364 U.S. 361 (1960).  For example, courts have found that objective economic substance existed where the transaction created a genuine obligation enforceable by an unrelated party.  See United Parcel Services, supra, at 1018; Sacks, supra, at 988-990 (the use of recourse debt created a genuine obligation for the taxpayer and this illustrated a genuine economic effect).  However, it does not appear that this secondary standard has been universally accepted.  See, for example, Gilman v. Commissioner, 933 F.2d 143, 147-48 (2d Cir. 1991) in which the court rejected the taxpayer’s argument that the relevant standard for determining economic substance is whether the transaction may cause any change in the economic positions of the parties (other than tax savings) and that where a transaction changes the beneficial and economic rights of the parties it cannot be a sham.  See also Long Term Capital Holdings’ v. United States, 330 F. Supp.2d 122 (D. Conn. 2004), quoting Gilman v. Commissioner.

In some DAT cases, the distressed debt is denominated in a foreign currency.  In such cases, the U.S. taxpayer may claim ordinary losses from foreign currency transactions under I.R.C. § 988.  To determine whether a transaction has economic substance in such cases, courts may consider whether Congress intended to allow the tax advantage being claimed.  The Supreme Court, for example, in considering whether a reorganization was without substance, has stated that “the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended.”  Gregory v. Helvering, 293 U.S. at 469 (1935).  The D.C. Circuit has likewise observed that “the sham transaction doctrine seeks to identify a certain type of transaction that Congress presumptively would not have intended to accord beneficial tax treatment.”  Horn v. Commissioner, 968 F.2d at 1229 (deductibility of losses incurred on straddle transactions).  In many such cases, the legislative history does not address economic substance and courts must interpret what Congress “presumptively” would have intended. 

However, the legislative history of I.R.C. § 988 of the Code indicates an explicit concern about the possibility of tax-motivated transactions.  The Senate Finance Committee Report accompanying the Tax Reform Act of 1986 states that one of the two primary reasons for enacting I.R.C. §§ 985-989 was that the prior law provided opportunities for abuse.[37]   The Senate Report further provides that the bill, “makes clear that the economic substance of a foreign-currency denominated transaction is determinative of the U.S. tax consequences.”[38]Gregory, supra, and thus the economic substance doctrine should be applied to deny such loss. 

In determining in which DAT cases an economic substance argument should be advanced, it would be helpful to show that the promoter controlled critical phases of the underlying transactions and that the U.S. taxpayer’s economic position before and after the disposition of the distressed assets remained unchanged, except for the shift of the built-in loss to the U.S taxpayer.  Direct sources of such evidence will come primarily from the transactional documents as well as correspondence from, and interviews with, all the parties.

If it is determined that the transaction as a whole lacks economic substance, the non-economic deduction claimed by the U.S. taxpayer, whether an I.R.C. § 988 loss or otherwise, should be disallowed.

Back to top

C.  Substance Over Form Doctrine

Transactions that literally comply with the language of the Code but produce results other than what the Code and regulations intend are not given effect.  In Gregory v. Helvering, 293 U.S. 465, 470 (1935), the Supreme Court found that even though the transaction did comply with the Code, “the transaction upon its face lies outside the plain intent of the statute.”  Therefore, the Court found that to give the transaction effect would be to “exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.”  Id.  In Knetsch v. United States, 364 U.S. 361 (1960), the Supreme Court once again found a transaction abusive, even though the transaction met every literal requirement of the Code.  The Court stated that “there was nothing of substance to be realized by Knetsch from this transaction beyond a tax deduction.”  Id. at 366.

A transaction that is entered into solely for the purpose of tax reduction and that has no economic or commercial objective to support the transaction is a sham and is without effect for federal income tax purposes.  Frank Lyon Co. v. United States, 435 U.S. 561 (1978); Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985); Southgate Master Fund LLC v. United States, 2009 WL 2634854 (N.D. Tex. August 18, 2009)[39]; Estate of Franklin v. Commissioner, 64 T.C. 752 (1975); Nicole Rose Corp. v. Commissioner, 117 T.C. 328 (2001). 

When a transaction is treated as a sham, the form of the transaction is disregarded and the proper tax treatment of the transaction must be determined.  Thus, if the DAT transaction is a sham transaction, the form of the transaction should be disregarded.   More particularly, the beneficial interest of the foreign party in the main-trust should be disregarded and the foreign party should be treated as having sold the distressed asset directly to the U.S. taxpayer or the trusts for the FMV of the asset, i.e. the amount paid by the taxpayer.  In disregarding the transaction, the foreign party would recognize the economic loss inherent in the distressed asset and the U.S. taxpayer or the trusts would have a tax basis equal to the FMV or amount paid.  Thus, the shift of the economic loss from the foreign party to the U.S. taxpayer or to a trust, neither of which incurred the loss, would be avoided.

ISSUE 7.     In cases involving a partnership between a tax-indifferent party and a promoter, the transfer of the distressed assets from the tax-indifferent partner to the partnership may be a disguised sale of property from the partner to the partnership under I.R.C. § 707(a)(2)(B) and Treas. Reg. § 1.707-3, resulting in a cost basis to the partnership in the distressed asset under I.R.C. § 1012.

Under I.R.C. § 707, in general, if a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner.  I.R.C. § 707(a)(1).  Section 707(a)(2)(B) provides that if there is a direct or indirect transfer of money or other property by a partner to a partnership, there is a related direct or indirect transfer of money or other property by the partnership to such partner and the transfers, when viewed together, are properly characterized as a sale or exchange of property, such transfers shall be treated as occurring between the partnership and one who is not a partner. 

A transfer treated as a sale under I.R.C. § 707(a)(2)(B) is treated as a sale for all purposes of the Code, including I.R.C. §§ 1001 and 1012.  Treas. Reg. § 1.707-3(a)(2).  Furthermore, with respect to the timing of the sale, the sale is considered to take place on the date that, under general principles of Federal tax law, the partnership is considered the owner of the property.  Id.  There is a presumption that transfers made within two years are sales under this section.  That is, if within a two-year period a partner transfers property to a partnership and the partnership transfers money or other consideration to the partner (without regard to the order of the transfers), the transfers are presumed to be a sale of the property to the partnership unless the facts and circumstances clearly establish that the transfers do not constitute a sale.  Treas. Reg. § 1.707-3(c).  Transfers of money or other consideration to a partner by a partnership and of property by a partnership to a partner more than two years apart are presumed not to be a sale.  Treas. Reg. § 1.707-3(d).  [40]

Section 707 treatment may apply to DAT transactions in two situations: (1) in cases in which the foreign party transfers the distressed debt to a partnership formed by the foreign party and the promoter, I.R.C. § 707 may apply to the transfer of the distressed debt by the foreign party to that partnership; and (2) in cases in which the trust or trusts are recharacterized as partnerships, I.R.C. § 707 may apply to the transfer of the distressed debt to one or both such trusts.  In both situations, where it can be established that the subject partnership acquired the distressed debt within two years of the payment to the contributing partner (whether foreign party or other partner that contributed the distressed debt to the partnership), I.R.C. § 707 treatment can be applied and a sale is presumed.  Moreover, in both situations it is critical to document the payment of cash or other consideration to the contributing partner.

In all DAT transaction cases involving partnerships, I.R.C. § 707 treatment of the transactions is consistent with treating the DAT transactions as tax-avoidance schemes, and I.R.C. § 707 should be raised when appropriate.

Back to top

ISSUE 8.     Section 482 may apply to allocate losses to the original contributor of the property up to the amount of the loss built into the property at the time of contribution.   

Section 482 allows the Service to allocate gross income, deductions, credits, or allowances between related parties as necessary to prevent the evasion of taxes or clearly to reflect income.  Specifically, I.R.C. § 482 provides that:

In any case of two or more organizations, trades or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not
affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades or businesses.

To justify an allocation of income pursuant to I.R.C. § 482, the Service must find that: (1) there are two or more trades, businesses, or organizations; (2) such trades, businesses, or organizations are owned or controlled by the same interests (“controlled taxpayers”); and (3) it is necessary to allocate gross income, deductions, credits, or allowances among such businesses to prevent evasion of taxes or clearly to reflect their income. 

A threshold determination must be made that there is common ownership or control of two or more organizations, trades or businesses before I.R.C. § 482 may be applied.    Control is defined to include any kind of control, direct or indirect, whether legally enforceable, and however exercised.  The analysis of control focuses on the reality of control, rather than rigidly on equity ownership.  Ach v. Commissioner, 42 T.C.114 (1964), aff’d., 358 F.2d 342 (6th Cir.), cert. denied, 385 U.S. 899 (1966).

Courts apply a transactional approach to I.R.C. § 482 control issues and have held that for I.R.C. § 482 purposes, control must exist when the taxpayers deal with each other.  Charles Town, Inc. v. Commissioner, 372 F.2d 415, 419 (4th Cir. 1967); Rooney v. United States, 305 F.2d 681 (9th Cir. 1962).  This transactional approach is illustrated in DHL v. Commissioner, T.C. Memo. 1998-461, 1998 WL 906788 * 36-37, aff’d on this point, 285 F.3d 1210, 1219 (9th Cir. 2002).  In some DAT cases, the facts may demonstrate that control existed at the time of the transfer of the distressed assets or debt when a plan was in place to effect the realization of a loss by the Taxpayer. 

The presence of an uncontrolled party at the time of the loss recognition does not preclude a finding of control if the third party is indifferent to (or supportive of) the terms of the deal.  See 285 F.3d at 1218, citing GAC Produce v. Commissioner, 77 T.C.M. 1790, 1804 (1999) (“Where a third party is indifferent to the terms of the transaction affecting the allocated items, its involvement does not interfere with the application of I.R.C. § 482.”).  This is especially true if, as in DHL, common ownership undoubtedly existed at the time the plan was put in place.  

Once common ownership or control is established, I.R.C. § 482 may potentially apply to clearly reflect income or prevent tax avoidance in cases where a party contributes a virtually valueless asset to a controlled entity which results in an artificial shifting of a loss within a short period of time.  In making allocations under I.R.C. § 482, the Service is not limited to cases involving improper accounting, or cases that are fraudulent, colorable, sham transactions or devices designed to reduce or avoid tax by shifting or distorting income, deductions, credits, or allowances.  Treas. Reg. § 1.482-1(f)(1)(i).  To this end, I.R.C. § 482 may apply to transactions that otherwise qualify for nonrecognition of gain or loss under applicable provisions of the Code if such application is necessary to prevent the avoidance of taxes or clearly to reflect income.  Treas. Reg. § 1.482-1(f)(1)(iii)(A).  In National Securities v. Commissioner, 137 F.2d 600 (3d Cir. 1942), the Third Circuit Court of Appeals sustained the disallowance and allocation of a built-in loss in stock from a subsidiary to its parent in the same taxable year, where the subsidiary disposed of stock it had received from the parent ten months earlier.  The Service will consider the application of I.R.C. § 482 to allocate losses on a case-by-case basis in DAT cases.[41]

ISSUE 9.     Legal and promoter fees and other “out-of-pocket expenses” paid by an individual U.S. taxpayer or a trust with respect to a DAT transaction are generally not deductible.

Generally, fees in small amounts have been reported as expenses by the grantor trusts in the DAT transactions, and as such included in the loss reported by the U.S.  taxpayers.[42]   It is not clear whether deductions for fees are buried on returns of affiliated pass-through entities such as S corporations or partnerships, or are found on inappropriate line items on the return.  It is possible that the fees are being netted against other items, making the fees difficult to identify.

Although, depending on the context, the issue may arise under several different Code provisions, fees and other out-of-pocket expenses incurred in connection with a DAT transaction are generally not deductible by the taxpayer, trust, or partnership.  The expenses are disallowed commonly in the shelter context under I.R.C. § 212(2), which requires a primary non-tax profit motive.  See Agro Science Co. v. Commissioner, 934 F.2d 573, 576 (5th Cir. 1991), cert. denied, 502 U.S. 907 (1991); Simon v. Commissioner, 830 F.2d 499, 500-501 (3d Cir.1987).  Similarly, the courts have repeatedly denied a deduction for a "theft loss" for cash out-of-pocket expenses that are paid to invest in shelter transactions.  See Viehweg v. Commissioner, 90 T.C. 1248 (1988), cert. denied, 502 U.S. 819 (1991); Marine v. Commissioner, 92 T.C. 958 (1989), aff’d 921 F.2d 280 (9th Cir. 1991); Rev. Rul. 70-333, 1970-1 C.B. 38.[43]  Depending on the context, other provisions, such as I.R.C. §§ 162, 183, 195, 263, and 709, may come into play to disallow a deduction.  See, e.g., Surloff v. Commissioner, 81 T.C. 210 (1983); Flowers v. Commissioner, 80 T.C. 914 (1983) ("Offeree representative" fees and costs of tax opinions prepared to promote sale of tax shelter not deductible under I.R.C. §§ 162, 212 and 709).

While the promoter fees and legal fees paid to the law firms issuing the typical boilerplate tax-shelter opinions in a DAT case should be disallowed, certain fees may be deductible.  These include legal fees paid to an attorney or accountant wholly independent from the promoter to analyze the transaction, fees paid to establish entities that are actually used in substantial business activities unrelated to the DAT transaction, and reasonable fees to prepare tax returns reporting the transactions.  In some circumstances, I.R.C. § 183 may allow the deduction of losses and expenses, even without a profit motive, to the extent of the gross income, if any, from the transaction.  Note that when fees incurred by, or passed through to, an individual investor are otherwise deductible, they are itemized deductions, subject to the limits provided by I.R.C. §§ 67 and 68.

Back to top

ISSUE 10.     The Service should assert the appropriate component(s) of the I.R.C. § 6662 accuracy-related penalties against a U.S. taxpayer who claimed losses from a DAT transaction unless the taxpayer is able to establish reasonable cause and good faith under I.R.C. § 6664(c)(1) and the applicable regulations.

Section 6662[44]  imposes an accuracy-related penalty in an amount equal to 20 percent of the portion of an underpayment[45] attributable to, among other things: (1) negligence or disregard of rules or regulations, (2) any substantial understatement of income tax, and (3) any substantial valuation misstatement under chapter 1.  I.R.C. § 6662(b)(1), (2) & (3).  Section 6662(h) provides a penalty of 40 percent of the underpayment attributable to a gross valuation misstatement where the basis of any property is overstated by 400 percent or more.  Treas. Reg. § 1.6662-2(c) provides that there is no stacking of the accuracy related penalty components.  Thus, the maximum accuracy-related penalty imposed on any portion of an underpayment is 20 percent (40 percent in the case of a gross valuation misstatement), even if that portion of the underpayment is attributable to more than one type of misconduct (e.g. negligence and substantial valuation misstatement).  See D.H.L. Corp. v. Commissioner, T.C. Memo. 1998 461, aff’d in part and rev’d on other grounds, remanded by, 285 F.3d 1210 (9th Cir. 2002).   With respect to examinations commencing after July 22, 1998, the Service must first meet the burden of production with respect to all penalties.  I.R.C. § 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446 (2002).

A. Negligence

Section 6662(b)(1) applies where there is negligence or a disregard of the rules or regulations.  Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code or to exercise ordinary and reasonable care in the preparation of a tax return.  See I.R.C. § 6662(c) and Treas. Reg. § 1.6662-3(b).  Negligence also includes a “lack of due care or failure to do what a reasonable and ordinarily prudent person would do in a similar situation.”  See Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), aff’g 43 T.C. 168 (1964); Neely v. Commissioner, 85 T.C. 934, 947 (1985).  Treas. Reg. § 1.6662-3(b)(1)(ii) provides that negligence is strongly indicated where a taxpayer fails to make a  reasonable attempt to ascertain the correctness of a deduction, credit, or exclusion on a return that would seem “too good to be true" under the circumstances to a reasonable and prudent person.

The negligence penalty is appropriate where a taxpayer reports losses from a transaction which greatly exceeded his/her investment.  The Third Circuit, in sustaining the accuracy-related penalty due to negligence explicitly warned “When, as here, a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds at his own peril.”  Neonatology Associates, P.A., et. al. v. Commissioner, 299 F.3d 221 (3d Cir. 2002), aff’g 115 T.C. 43.

The term “disregard” includes any carelessness, reckless or intentional disregard of rules or regulations.  A disregard is careless if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position that is contrary to a rule or regulation.  A disregard is reckless where the taxpayer makes little or no effort to determine whether a rule or regulation exists, under circumstances which are a substantial deviation from the standard of conduct observed by a reasonable person.  Additionally, a disregard is intentional where the taxpayer has knowledge of the rule or regulation that it disregards.  Treas. Reg. § 1.6662-3(b)(2).

“Rules or regulations” include the provisions of the Code, temporary or final Treasury regulations, and revenue rulings or notices (other than notices of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin.  Treas. Reg. § 1.6662-3(b)(2).  Therefore, if the facts indicate that a taxpayer took a return position contrary to any published notice or revenue ruling, the taxpayer may be subject to the accuracy related penalty for an underpayment attributable to disregard of rules and regulations, if the return position was taken subsequent to the issuance of the notice or revenue ruling.

The accuracy related penalty for disregard of rules and regulations will not be imposed on any portion of underpayment due to a position contrary to rules and regulations if: (1) the position is disclosed on a properly completed Form 8275, Disclosure Statement, or Form 8275-R, Regulation Disclosure Statement (the latter is used for a position contrary to regulations) and (2), in the case of a position contrary to a regulation, the position represents a good faith challenge to the validity of a regulation.  Treas. Reg. §1.6662 3(c).  This adequate disclosure exception applies only if the taxpayer has a reasonable basis for the position and keeps adequate records to substantiate items correctly.  Treas. Reg. § 1.6662 3(c)(1).  Moreover, a taxpayer who takes a position contrary to a revenue ruling or a notice has not disregarded the ruling or notice if the contrary position has a realistic possibility of being sustained on its merits.  Treas. Reg. § 1.6662 3(b)(2).

B.  Substantial Understatement

Section 6662(a) and (b)(2) provides that a 20 percent accuracy-related penalty applies to any portion of an underpayment for which there is a substantial understatement of income tax.  A substantial understatement of income tax exists for a taxable year if the amount of understatement exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000 ($10,000 for a corporation, other than an S corporation or a personal holding company).  I.R.C. § 6662(d)(1).[46]   In most DAT cases, the understatement attributable to the disallowance of the losses claimed exceeds this threshold amount.  Therefore, an accuracy-related penalty attributable to a substantial understatement may be applicable.

Specific rules apply to the calculation of the understatement when any portion of the understatement arises from an item attributable to a tax shelter.  For purposes[47] of I.R.C. § 6662(d)(2)(C), a tax shelter is a partnership or other entity, an investment plan or arrangement, or other plan or arrangement where a significant purpose  of such partnership, entity, plan or arrangement is the avoidance or evasion of federal income tax.  I.R.C. §  6662(d)(2)(C)(iii).  Because the purpose of a DAT transaction is tax avoidance, it is a tax shelter pursuant to I.R.C. § 6662(d)(2)(C).  Different rules apply however, depending upon whether the taxpayer is a corporation.[48]

In the case of any item of a non-corporate taxpayer which is attributable to a tax shelter, understatements are generally reduced by the portion of the understatement attributable to the tax treatment of each item for which (1) there was substantial authority for such treatment, and (2) the taxpayer reasonably believed that the tax treatment of the item was more likely than not the proper treatment.  I.R.C. § 6662(d)(2)(C)(i).[49]

Treas. Reg. § 1.6662-4(d)(2) provides the substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts.  It is less stringent than the “more likely than not” standard (the standard that is met when there is a greater than 50 percent likelihood of the position being upheld), but more stringent than the “reasonable basis” standard required to avoid the negligence penalty under Treas. Reg. § 1.6662-3(b)(3).  There is substantial authority for the tax treatment of an item only if the weight of authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment.  All authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, are taken into account in determining whether substantial authority exists.  Treas. Reg. § 1.6662-4(d)(3)(i).  On the basis of the substantive discussion of the DAT structure in the foregoing pages of this document, it is generally unlikely that a DAT transaction would meet the substantial authority test. See Long Term Capital Holdings v. United States, 330  F. Supp. 2d 122, 204-05 (D. Conn. 2004), aff’d, 150 Fed. Appx. 40, (2d Cir. 2005), finding that the transaction is “devoid of objective economic substance and subjective business purpose,” and thus, the taxpayer “has not and cannot cite authority, much less substantial authority, for the proposition that a taxpayer may claim losses from a transaction in which the taxpayer intentionally expends far more than could reasonably be expected to be recouped through non-tax economic returns in a transaction the sole motivation for which is tax avoidance.”

A taxpayer is considered to have reasonably believed that the tax treatment of an item is more likely than not the proper tax treatment if (1) the taxpayer analyzes the pertinent facts and authorities, and based on that analysis reasonably concludes, in good faith, that there is a greater than fifty-percent likelihood that the tax treatment of the item will be upheld if the Service challenges it, or (2) the taxpayer reasonably relies, in good faith, on the opinion of a professional tax advisor, which clearly states (based on the advisor’s analysis of the pertinent facts and authorities) that the advisor concludes there is a greater than fifty percent likelihood the tax treatment of the item will be upheld if the Service challenges it.  Treas. Reg. § 1.6662-4(g)(4).  Moreover, if the taxpayer is relying on tax advice to establish reasonable belief, the taxpayer must also meet the requirements generally applicable to relying on advice to establish good faith and reasonable cause.  See Treas. Reg. § 1.6662-4(g)(4)(ii).  This is discussed further below under “D. Reasonable Cause and Good Faith.”

If the item is attributable to a tax shelter and the taxpayer is a corporation, the understatement cannot be reduced.  I.R.C. § 6662(d)(2)(C)(ii).  Therefore, if a corporate taxpayer has a substantial understatement that is attributable to a tax shelter item (such as a DAT transaction), the accuracy-related penalty applies to the underpayment arising from the understatement unless the reasonable cause and good faith exception applies.

Back to top

C.  Substantial Valuation Misstatement

For the accuracy related penalty attributable to a substantial valuation misstatement to apply, the portion of the underpayment attributable to a substantial valuation misstatement must exceed $5,000 ($10,000 for a corporation, other than an S corporation or a personal holding company).  I.R.C. § 6662(e)(2).

 A substantial valuation misstatement exists if the value or adjusted basis of any property claimed on a return is 200 percent or more of the amount determined to be the correct amount of such value or adjusted basis.  I.R.C. §  6662(e)(1)(A).  If the value or adjusted basis of any property claimed on a return is 400 percent or more of the amount determined to be the correct amount of such value or adjusted basis, the valuation misstatement constitutes a "gross valuation misstatement."  I.R.C. §  6662(h)(2)(A).[50]   If there is a gross valuation misstatement, then the 20 percent penalty under  I.R.C. § 6662(a) is increased to 40 percent.  I.R.C. § 6662(h)(1).

With respect to a DAT transaction, the “property” claimed on the return for the purpose of I.R.C. § 6662(e) is the distressed asset (this may be the original distressed asset contributed by FP or an interest in a trust which holds the original distressed asset).  The disparity in the basis creates a valuation misstatement.  In most, if not all, DAT cases, the adjusted basis claimed for the distressed asset or partnership interest is 400 percent or more of the correct amount.[51]    Thus, the basis overstatement is of such a magnitude that a gross valuation accuracy-related penalty will be appropriate.  See Santa Monica Pictures, LLC v. Commissioner, T.C. Memo. 2005-104.  See also Long Term Capital Holdings v. United States, 330  F. Supp. 2d 122, 204-05 (D. Conn. 2004), aff’d, 150 Fed. Appx. 40, (2d Cir. 2005) (affirming the application of 40 percent penalty for gross valuation misstatement and, in the alternative, a 20 percent penalty for substantial understatement, where the taxpayer claimed inflated basis in the stock and losses from a transaction that lacked economic substance or, in the alternative, should be recast under the step transaction doctrine.)  But see Heasley v. Commissioner, 902 F. 2d 380, 382-83 (5th Cir. 1990), Keller v. Commissioner, 556 F. 3d 1056 (9th Cir. 2009), and Southgate Master Fund LLC v. United States, 2009 WL 2634854 (finding that the valuation misstatement penalties are not applicable if the IRS disallows a claimed deduction or credit in full).  Contrary to these Fifth and Ninth Circuits’ rulings, the Second, Third, Fourth, Sixth and Eighth Circuits have all concluded that when overvaluation is intertwined with a tax avoidance scheme that lacks economic substance, an overvaluation penalty can apply.  See Gilman v. Commissioner, 933 F.2d 143, 149-52 (2d Cir. 1991); Merino v. Commissioner, 196 F.3d 147, 155 (3d Cir. 1999); Zfass v. Commissioner, 118 F.3d 184, 190-91 (4th Cir. 1997); Illes v. Commissioner, 982 F.2d 163, 166-67 (6th Cir. 1992); Massengill v. Commissioner, 876 F.2d 616, 619-20 (8th Cir. 1989).Under Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff'd, 445 F.2d 985 (10th Cir. 1971), the Tax Court will follow the decision of the court of appeals for the circuit to which a case is appealable if the circuit court has already decided the issue.

D.  Reasonable Cause and Good Faith

Section 6664 provides an exception, applicable to all types of taxpayers, to the imposition of the accuracy-related penalty if the taxpayer shows that there was reasonable cause for the underpayment and that the taxpayer acted in good faith.  I.R.C. §  6664(c).  The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all relevant facts and circumstances.  Treas. Reg. §1.6664-4(b)(1) and (f)(1).  All relevant facts, including the nature of the tax investment, the complexity of the tax issues, issues of independence of a tax advisor, the competence of a tax advisor, the sophistication of the taxpayer, and the quality of an opinion, must be developed to determine whether the taxpayer was reasonable and acted in good faith.

Generally, the most important factor to determine reasonable cause and good faith is the extent to which the taxpayer exercised ordinary business care and prudence in attempting to assess his or her proper tax liability.  See Treas. Reg. § 6664-4(b)(1).  See also Larson v. Commissioner, T.C. Memo. 2002-295; Estate of Simplot v. Commissioner, 112 T.C. 130, 183 (1999) (citing Mandelbaum v. Commissioner, T.C. Memo. 1995-255), rev’d on other grounds, 249 F.3d 1191 (9th Cir. 2001).  Circumstances which may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including taxpayer’s experience, knowledge, sophistication, and education.  The taxpayer’s mental and physical conditions, as well as sophistication with respect to the tax laws, at the time the return was filed, are relevant in deciding whether the taxpayer acted with reasonable cause.  See Kees v. Commissioner, T.C. Memo. 1999-41.  If the taxpayer is misguided, unsophisticated in tax law, and acts in good faith, a penalty is not warranted.  See Collins v. Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988); cf. Spears v. Commissioner, T.C. Memo. 1996-341 (court was unconvinced by the claim of highly sophisticated, able, and successful investors that they acted reasonably in failing to inquire about their investment and simply relying on offering circulars and accountant, despite warnings in offering materials and explanations by accountant about limitations of accountant’s investigation).

Reliance upon a tax opinion provided by a professional tax advisor may serve as a basis for the reasonable cause and good faith exception to the accuracy-related penalty.  The reliance, however, must be objectively reasonable, as discussed more fully below.  For example, the taxpayer must supply the professional with all the necessary information to assess the tax matter.  The advice also must be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances.

The advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person.  For example, the advice must not be based upon a representation or assumption which the taxpayer knows, or has reason to know, is unlikely to be true, such as an inaccurate representation or assumption as to the taxpayer’s purposes for entering into a transaction or for structuring a transaction in a particular manner.  Treas. Reg. § 1.6662-4(c)(1)(ii). 

Where a tax benefit depends on nontax factors, the taxpayer has a duty to investigate the underlying factors rather than simply relying on statements of another person, such as a promoter.  See Novinger v. Commissioner, T.C. Memo. 1991-289.  Further, if the tax advisor is not versed in these nontax matters, mere reliance on the tax advisor does not suffice.  See Addington v. United States, 205 F.3d 54 (2d Cir. 2000); Collins v. Commissioner, 857 F.2d 1383 (9th Cir. 1988); Freytag v. Commissioner, 89 T.C. 849 (1987), aff'd, 904 F.2d 1011 (5th Cir. 1990).

Although a professional tax advisor’s lack of independence is not alone a basis for rejecting a taxpayer's claim of reasonable cause and good faith, the fact that a taxpayer knew or should have known of the advisor's lack of independence is strong evidence that the taxpayer may not have relied in good faith upon the advisor's opinion.  Neonatology Assoc., P.A. v. Commissioner, 115 T.C. 43, 98 (2001), aff’d, 299 F.3d 221 (3rd Cir. 2002)(“Reliance may be unreasonable when it is placed upon insiders, promoters, or their offering materials, or when the person relied upon has an inherent conflict of interest that the taxpayer knew or should have known about”); Goldman v. Commissioner, 39 F.3d 402, 408 (2nd Cir. 1994), aff’g T.C. Memo. 1993-480 (“Appellants cannot reasonably rely for professional advice on someone they know to be burdened with an inherent conflict of interest”); Marine v. Commissioner, 92 T.C. 958, 992-93 (1989), aff’d without published opinion, 921 F.2d 280 (9th Cir. 1991).  Such reliance is especially unreasonable when the advice would seem to a reasonable person to be “too good to be true.”  Pasternak v. Commissioner, 990 F.2d 893, 903 (6th Cir. 1993), aff’g Donahue v. Commissioner, T.C. Memo. 1991-181; Gale v. Commissioner, T.C. Memo. 2002-54; Elliot v. Commissioner, 90 T.C. 960, 974 (1988), aff’d without published opinion, 899 F.2d 18 (9th Cir. 1990). See Treas. Reg. § 1.6662-3(b)(2).

Similarly, the fact that a taxpayer consulted an independent tax advisor is not, standing alone, conclusive evidence of reasonable cause and good faith if additional facts suggest that the advice is not dependable.  Edwards v. Commissioner, T.C. Memo. 2002-169; Spears v. Commissioner, T.C. Memo. 1996-341, aff’d. 98-1 USTC ¶ 50,108 (2d Cir. 1997).  For example, a taxpayer may not rely on an independent tax adviser if the taxpayer knew or should have known that the tax adviser lacked sufficient expertise, the taxpayer did not provide the advisor with all necessary information, or the information the advisor was provided was not accurate.  Baldwin v. Commissioner, T.C. Memo. 2002-162; Spears v. Commissioner, T.C. Memo. 1996-341, aff’d 98-1 USTC ¶ 50,108 (2d Cir. 1997).  See also Long Term Capital Holdings v. United States, 330  F. Supp. 2d 122, 204-05 (D. Conn. 2004), aff’d, 150 Fed. Appx. 40, (2d Cir. 2005) (rejecting the taxpayer’s claim of reliance on tax opinions, the court upheld the application of accuracy related penalties.)

Finally, a corporation cannot establish reasonable cause and good faith with respect to legal justification for a tax shelter unless two minimum requirements are met.  There must be substantial authority for the tax treatment of the tax shelter item and the corporation must reasonably believe that the tax treatment was more likely than not correct.  See Treas. Reg. § 1.6664-4(f)(2). 

Back to top

E.  Penalties and Partnerships

Special rules apply in transactions involving a partnership subject to the unified partnership audit and litigation procedures of I.R.C. §§ 6221 through 6234 (which may occur, for example, where the taxpayer forms a partnership that participates directly in the transaction).  For taxable years ending after August 5, 1997, penalties are determined at the partnership level.  I.R.C. § 6221.  Treas. Reg. §  301.6221-1 provides as follows:[52]

(c) Penalties determined at partnership level.  Any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item shall be determined at the partnership level.  Partner-level defenses to such items can only be asserted through refund actions following assessment and payment.  Assessment of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item shall be made based on partnership-level determinations.  Partnership-level determinations include all the legal and factual determinations that underlie the determination of any penalty, addition to tax, or additional amount, other than partner-level defenses specified in Treas. Reg. § 301.6221-1(d).

(d) Partner-level defenses.  Partner-level defenses to any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item may not be asserted in the partnership-level proceeding, but may be asserted through separate refund actions following assessment and payment.  I.R.C. § 6230(c)(4).  Partner-level defenses are limited to those that are personal to the partner or dependent upon the partner's separate return and cannot be determined at the partnership level.  Examples of these determinations are whether any applicable threshold underpayment of tax has been met with respect to the partner or whether the partner has met the criteria of I.R.C. § 6664(b)(penalties applicable only where return is filed), or I.R.C. § 6664(c)(1)(reasonable cause exception) subject to partnership-level determinations as to the applicability of I.R.C. § 6664(c)(2).

Following prior partnership law with respect to partnership items, relevant inquiries into tax motivation and negligence are made with respect to the general partner.  See Santa Monica Pictures, L.L.C. v. Commissioner,  T.C. Memo 2005-104; Jade Trading, L.L.C. v. United States, 80 Fed. Cl. 11, 59-60 (2007); Stobie Creek Invs. L.L.C., v. United States (Stobie Creek II), 82 Fed. Cl. 636, (2008); Stobie Creek Invs., L.L.C. v. United States (Stobie Creek I), 81 Fed. Cl. 358 (2008); Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir. 1993)(focusing on the general partner’s objective in determining profit motive); Fox v. Commissioner, 80 T.C. 972, 1008 (1983), aff'd 742 F.2d 1441 (2d Cir. 1984); aff'd sub nom., Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984).  For instance, one considers whether the general partner acted with reasonable cause and good faith with respect to any partnership item that generates an underpayment subject to accuracy-related penalty.

Partner-level defenses may only be raised through subsequent partner-level refund suits.  See Treas. Reg. §§ 301.6221-1(d) and 301.6231(a)(6)-3.  Good faith and reasonable cause of individual investors pursuant to I.R.C. § 6664 would be the type of partner-level defense that can be raised in a subsequent partner-level refund suit. 

Any questions on the application of the procedural provisions in this paper should be coordinated with Chief Counsel.

Back to top

ISSUE 11.     The Service should assert the appropriate I.R.C. § 6662A accuracy-related penalty on understatements with respect to DAT transactions, against a U.S. taxpayer who claimed losses from a DAT transaction unless the taxpayer is able to establish reasonable cause and good faith under I.R.C. § 6664(d).

An additional penalty under I.R.C. § 6662A may apply to a U.S. taxpayer claiming a loss from a DAT transaction.[53]   I.R.C. § 6662A (a) imposes an accuracy-related penalty in an amount equal to 20 percent of a “reportable transaction understatement” [54]  for any taxable year ending after October 22, 2004.  I.R.C. § 6662A(c) increases the penalty to 30 percent for any portion of a “reportable transaction understatement” if the taxpayer did not adequately disclose, in accordance with the regulations prescribed under section 6011, all the relevant facts affecting the tax treatment of a transaction.[55]    See I.R.C. § 6664(d)(2)(A).  The tax treatment of the reportable transaction on an amended return is disregarded in determining the reportable transaction understatement if the amended return was filed after the date the taxpayer was first contacted for examination.  See I.R.C. § 6662A(e)(3).

The disclosure requirements for transactions entered into before August 3, 2007, are contained in Treas. Reg. § 1.6011-4 in effect prior to August 3, 2007 (See 26 CFR part 1 revised as of April 1, 2007).  For transactions entered into after October 22, 2004, and before August 3, 2007, the general rule is that if a transaction becomes a listed transaction after the filing of the taxpayer's tax return (including an amended return) reflecting either tax consequences or a tax strategy described in published guidance listing the transaction (or a tax benefit derived from tax consequences or a tax strategy described in the published guidance listing the transaction) and before the end of the period of limitations for the final return (whether or not already filed) reflecting the tax consequences, tax strategy, or tax benefits, then a disclosure statement must be filed as an attachment to the taxpayer’s tax return next filed after the date the transaction is listed regardless of whether the taxpayer participated in the transaction in that year.  For transactions entered into on or after August 3, 2007, the general rule is that if a transaction becomes a listed transaction after the filing of a taxpayer’s tax return (including an amended return) reflecting the taxpayer’s participation in the listed transaction and before the end of the period of limitations for assessment of tax for any taxable year in which the taxpayer participated in the listed transaction, then a disclosure statement, Form 8886, Reportable Transaction Disclosure Statement, must be filed, regardless of whether the taxpayer participated in the transaction in the year the transaction became a listed transaction, with the Office of Tax Shelter Analysis (“OTSA”) within 90 calendar days after the date on which the transaction became a listed transaction.  Treas. Reg. § 1.6011-4(e)(2).  A copy of the disclosure statement (Form 8886) must be sent to OTSA whenever a transaction is first disclosed.

The Service released Notice 2008-34, 2008-1 C.B. 645, identifying DAT transactions entered into after October 22, 2004, as listed transactions to the public on February 27, 2008, and published the notice on March 24, 2008.  For  transactions that are the same as, or substantially similar to, the transaction described in Notice 2008-34 that were entered into after October 22, 2004, and before August 3, 2007, taxpayers were required to file a disclosure statement (Form 8886) as an attachment to the taxpayers’ returns that were next filed after February 27, 2008, which for calendar year taxpayers generally would be the taxpayers’ 2007 tax returns.  At the same time, taxpayers were required to send a copy of the disclosure statement (Form 8886) to OSTA.  For transactions entered into on or after August 3, 2007, taxpayers were required to file a disclosure statement (Form 8886) with OSTA within 90 days after February 27, 2008 (May 27, 2008), the date on which the transaction became a listed transaction.  Some taxpayers may have been required to attach the disclosure statement to their 2007 tax returns and send a copy to OTSA at that time, if they participated in the transaction in 2007.  See Treas. Reg. § 1.6011-4(e)(1).  If the taxpayer did not file a disclosure timely, the section 6662A penalty could apply at the 30 percent rate even though the DAT transaction was listed after the taxpayer filed a return reflecting the taxpayer’s participation in the transaction.

The penalty under I.R.C. § 6662A will not apply to any portion of an understatement on which a fraud penalty under I.R.C. § 6663 has been imposed or any portion of an understatement on which a penalty is imposed under Section 6662 if the rate of the penalty is determined under I.R.C. § 6662(h) (gross valuation misstatement).  See I.R.C. § 6662A(e) and discussion under Issue 10, Section C. 

A.  Reasonable Cause and Good Faith for Reportable Transaction Understatements

I.R.C. § 6664(d)(1) provides an exception to the imposition of the accuracy-related penalty under I.R.C. § 6662A if the taxpayer shows that there was reasonable cause for the underpayment and that the taxpayer acted in good faith. 

Special rules under I.R.C. § 6664(d)(2) must be met for this exception to apply to reportable transactions. Those rules are:

1. The taxpayer made proper disclosures in accordance with the regulations under I.R.C. § 6011;
2. There is or was substantial authority for such treatment; and
3. The taxpayer reasonable believed that such treatment was more likely than not the proper treatment.

I.R.C. § 6664(d)(2)(A)-(C).

If a taxpayer fails to provide adequate disclosure of the transaction in accordance with I.R.C. § 6011, the Commissioner may rescind the penalty for failure to disclose under I.R.C.  § 6707A(d).  However, the authority given the Commissioner to rescind the penalty under I.R.C. § 6707A does not apply to a penalty imposed with respect to a listed transaction.  See I.R.C. § 6707A(d).  The Commissioner would not rescind the I.R.C. § 6707A penalty for any taxpayer who entered into a DAT transaction after October 22, 2004.

The substantial authority standard discussed for the I.R.C. § 6662 penalties is applicable to the penalty under I.R.C. § 6662A.  See discussion under Issue 10, Section B.

Section 6664(d)(3) provides that for a reportable transaction understatement, a taxpayer will be treated as having a reasonable belief with respect to the tax treatment of an item only if such belief:

1. Is based on the facts and law existing at the time the return reflecting such treatment is filed; and
2. Relates solely to the taxpayer’s chances of success on the merits of such treatment and does not take into account the possibility that a return will not be audited, that such treatment will be questioned in an audit, or that such treatment will be resolved through settlement if raised in an audit.

In addition, I.R.C. § 6664(d)(3)(B) states that disqualified opinions or opinions from disqualified tax advisors may not be relied upon in establishing reasonable belief.  A disqualified tax advisor may be one of the following:

1. A material advisor within the meaning of I.R.C. § 6011(b)(1) who participates in the organization, management, promotion, or sale of the transaction or is related (within the meaning of I.R.C. §§ 267(b) or 707(b)(1) to any person who so participates;
2. One who is compensated directly or indirectly by a material advisor with respect to the transaction;
3. One who has a fee arrangement with respect to the transaction which is contingent on all or part of the intended tax benefits from transaction being sustained; or
4. One who has a disqualifying financial interest with respect to the transaction as determined under regulations.

Guidance on the definitions of material advisor, disqualified opinions, disqualified tax advisors is provided in Notice 2005-12, 2005-1 C.B. 494, as follows:

A material advisor is defined in Treas. Reg. § 301.6112-1. In addition, the existing rules under Treas. Reg. § 301.6112-1(c)(2), (c)(3) and (d) (without regard to the provisions relating to a transaction required to be registered under former section 6111), including the minimum fee amounts for listed transactions under Treas. Reg. § 301.6112-1(c)(3)(ii), shall apply. See Notice 2004-80, 2004-50 I.R.B. 963 (December 13, 2004).

Pursuant to Notice 2005-12, a material advisor participates in the “organization” of a transaction if the advisor:

(1) devises, creates, investigates or initiates the transaction or tax strategy;
(2) devises the business or financial plans for the transaction or tax strategy;
(3) carries out those plans through negotiations or transactions with others; or
(4) performs acts relating to the development or establishment of the transaction.

The performance of an act relating to the development or establishment of a transaction includes preparing documents that (A) establish the structure used in connection with the transaction, e.g., a partnership agreement or articles of incorporation, (B) describe the transaction for use in the promotion or sale of the transaction, e.g., an offering memorandum, tax opinion, prospectus, or other document describing the transaction, or (C) register the transaction with any federal, state or local government body.

A material advisor participates in the “management” of a transaction if the material advisor is involved in the decision-making process regarding any business activity with respect to the transaction.  Participation in the management of a transaction includes managing assets, directing business activity, or acting as general partner, trustee, director or officer of an entity involved in the transaction.

A material advisor participates in the “promotion or sale” of a transaction if the material advisor is involved in the marketing of the transaction or tax strategy. Marketing activities include:  (1) soliciting, directly or through an agent, taxpayers to enter into a transaction or tax strategy using direct contact, mail, telephone or other means; (2) placing an advertisement for the transaction in a newspaper, magazine, or other publication or medium; or (3) instructing or advising others with respect to marketing of the transaction or tax strategy.

Consistent with the legislative history, a tax advisor, including a material advisor, is not treated as participating in the organization, management, promotion or sale of a transaction if the tax advisor’s only involvement is rendering an opinion regarding the tax consequences of the transaction.  In the course of preparing a tax opinion, a tax advisor is permitted to suggest modifications to the transaction, but the tax advisor may not suggest material modifications to the transaction that assist the taxpayer in obtaining the anticipated tax benefits.  Merely performing support services or ministerial functions such as typing, photocopying, or printing is not be considered participation in the organization, management, promotion or sale of a transaction.

Notice 2005-12 further provides that a tax advisor is treated as a disqualified tax advisor, even if not a material advisor, if the tax advisor has a referral fee or a fee-sharing arrangement by which the advisor is compensated directly or indirectly by a material advisor.  In addition, an arrangement is treated as a disqualified compensation arrangement if there is an agreement or understanding (oral or written) with a material advisor of a reportable transaction pursuant to which the tax advisor is expected to render a favorable opinion regarding the tax treatment of the transaction to any person referred by the material advisor.  A tax advisor is not treated as having a disqualified compensation arrangement if a material advisor merely recommends the tax advisor who does not have an agreement or understanding with the material advisor to render a favorable opinion regarding the tax treatment of a transaction.

In addition, a disqualified compensation arrangement includes a fee that is contingent on all or part of the intended tax benefits from the transaction being sustained, including agreements that provide that (1) a taxpayer has the right to a full or partial refund of fees if all or part of the tax consequences from the transaction are not sustained or (2) the amount of the fee is contingent on the taxpayer’s realization of tax benefits from the transaction.  Transactions described in Treas. Reg. § 1.6011-4(b)(4)(iii) do not give rise to a disqualified compensation arrangement. Thus, the opinion provided by any promoter or anyone related to the promoter may not be relied upon for the reasonable cause exception.

Under I.R.C. § 6664(d)(3)(B), a disqualified opinion is one that:

1. Is based on unreasonable factual or legal assumptions (including assumptions as to future events);
2. Unreasonably relies on representations, statement, findings, or agreements of the taxpayer or any other person;
3. Does not identify and consider all relevant facts; or
4. fails to meet any other requirement as the Secretary may prescribe.

The general rules addressing whether a taxpayer reasonably relied on an opinion for purposes of the I.R.C. § 6662 accuracy-related penalties are equally applicable to the I.R.C. § 6662A penalty.  See discussion under Issue 10, Section D.

While the reasonable cause and good faith rules for the application of the I.R.C. §6662A penalty have more stringent requirements, the general rules for a reasonable cause and good faith exception under I.R.C. § 6664 also apply.  See discussion under Issue 10, Section D.

Back to top

D.  Penalties and Partnerships – See discussion under Issue 10, Section E.

Penalty Determination

A thorough analysis is needed in all cases in order to determine the applicability of the various penalties discussed in relation to the DAT transactions.  The existence of negligence, substantial understatement, substantial overvaluation or a reportable transaction understatement is determined by the existence of reasonable cause, good faith, reasonable basis, substantial authority, reasonable reliance and proper disclosure.  Whether any of these elements exist can only be established through development of specific factual and legal elements discussed above.  Through interviews and IDR’s, the examiners must determine the facts and circumstance of each taxpayer in relation to the DAT transaction such as taxpayer’s background, experience, education, involvement in similar investments; the taxpayer’s relation to the promoter; the timing, source, amount of the fee paid; contents of and reliance on any opinions(s), the qualifications of the party rendering the opinion, the relationship of the party rendering the opinion to the taxpayer or any promoter or sub-promoter of DAT, the qualification of the opinion itself, the circumstances under which the opinion was obtained, the accuracy of the representations of the opinion;  the extent and depth of any analysis of the investment prior to investing, who performed such research and analysis, how and when was the analysis communicated to the taxpayer; the purpose or reason for the transaction, the financial position of the taxpayer at the time of the transaction;  and any other facts that bear on the motivation of the taxpayer and basis for the taxpayer’s belief in the business nature of the transaction.  Examiners should consult with local counsel or technical advisor in application of the accuracy-related penalties.

Back to top

---

Footnotes

[1]  The DAT Transaction is a listed transaction for purposes of I.R.C. §§ 6111 and 6112, and Treas. Reg. § 1.6011-4(b)(2), as set forth in Notice 2008-34, 2008-1 C.B. 645.  Transactions that are the same as or substantially similar to the transactions described in Notice 2008-34 and are entered into after October 22, 2004, are identified as “listed transactions” for purposes of I.R.C. §§ 6111 and 6112, and Treas. Reg. § 1.6011-4(b)(2), effective February 27, 2008.  The DAT Transaction resembles the Distressed Asset/Debt (“DAD”) Tax Shelter, which is described in Coordinated Issue Paper LMSB-04-0407-031, effective date April 18, 2007.  Both DAT and DAD transactions involve the shifting of a built-in loss asset from a tax-indifferent party to a U.S. taxpayer who has not incurred an economic loss.

[2]  In one version of the DAT transaction, (hereinafter referred to as the “promoter partnership scenario”) the tax-indifferent party is a foreign party (“FP”) holding an interest in non-performing or distressed debt.  FP first contributes, prior to October 22, 2004, the claimed high tax basis, low fair market value (“FMV”) debt to a domestic LLC taxed as a partnership.  The FMV of the distressed debt is usually equivalent to a small fraction of the claimed tax basis.  The FP receives an interest in the partnership in exchange for the contribution, and realizes no gain on the exchange under I.R.C. § 721.  The promoter of the DAT transaction contributes cash (or a note) in exchange for an interest in the partnership and status as tax matters partner. The partnership claims the same high tax basis in the debt as the contributing FP under I.R.C. § 723.  The partnership then contributes the debt to a trust. The trust claims the same high tax basis and built-in-loss in the debt as the contributing partnership had in the debt under I.R.C. § 1015(b).

[3]   For example, the I.R.C. § 166 deduction is often equivalent to 97 percent of the claimed tax basis.

[4]  Or the U.S. taxpayer sells interests in the trust to a third party.

[5]  As of the date of this paper, the field has only seen DAT transactions involving business bad debt deductions under I.R.C. § 166.  However, if a sale or exchange triggers the loss, an analysis regarding lack of profit motive under I.R.C. § 165 might apply to disallow the loss.  An argument to disallow the loss under I.R.C. § 165 may require further factual development.  Development of this issue should be coordinated with the appropriate Technical Advisor.

[6]  In the promoter partnership scenario (see footnote 2, infra.), a related issue is whether the contribution of a worthless asset to a partnership was a contribution of property to the partnership by FP within the meaning of I.R.C. § 721 so as to cause the partnership to take a carryover/transferred basis in such property pursuant to I.R.C. § 723.  The contribution of a worthless asset by a partner to a partnership does not constitute a contribution of property under I.R.C. § 721 and thus, the partnership does not have any carryover/transferred basis.  A partnership has no adjusted basis in any asset that was worthless at the time it was contributed to the partnership.

[7]   The promoter partnership scenario involves a foreign party (FP) extending credit denominated in the local currency to foreign debtors outside the U.S. who are not connected with any U.S. trade, business, or investment.  The promoter creates a U.S. LLC taxed as a partnership into which FP contributes the debt in exchange for a partnership interest.  FP recognizes no gain or loss and claims the transaction qualifies for nonrecognition under I.R.C. § 721.  Promoter contributes some assets into the partnership, becoming a partner, and is named tax matters partner.  The partnership claims a carryover basis in the debt under I.R.C. § 723.  The partnership then contributes the debt into a trust, or combination of trusts, for the ultimate benefit of the U.S. investors.

[8]  In the promoter partnership scenario, the FP contributes the debt to a partnership formed with the promoter, and the partnership contributes the debt to main trust in exchange for a certificate of beneficial interest in the distressed assets.  The transactional documents are often internally inconsistent or at variance with other evidence.  For example, some of the documents purport to convey an interest in the main-trust to the U.S. taxpayer, while other documents purport to convey a beneficial interest in the trust assets.  However, the parties’ goal throughout is to shift the built-in loss inherent in the distressed assets from a tax-indifferent party to a U.S. taxpayer by purporting to vest the U.S. taxpayer with enough property rights in the distressed assets to claim the high tax basis and resultant deduction. 

[9]   In the promoter partnership scenario, main trust enters into a contract with a collection agency operating in the FP’s country, the country in which the debt originated and in which the debtors are located.  The collection agency is contracted to commence operations to collect the debt.  The contract provides for a fee of 20 percent or more of face value of debt collected by the collection agency.  Typically, as reported on the sub-trust’s Form 1041 tax return, actual collection activity is de minimis, and actual collections amount to less than 0.1 percent of face value of the debt.  

[10]  However, the documentation of this step in the transaction is unclear in promoter partnership scenario cases seen to date.  In some of those cases, at the moment in the transaction when the main-trust purportedly transfers substantially all of the rights in the distressed assets to Taxpayer, the FP-promoter partnership owns substantially all of the rights in the distressed assets.  Thus, at that moment, main-trust no longer owns anything of substance to transfer to Taxpayer.  Arguably, at this point in this version of the transaction, FP-promoter partnership should be deemed to have sold the distressed assets to Taxpayer, because FP-promoter partnership was the only party who had those assets to sell.  The timing and content of the transactional documents may vary case-to-case.

[11]  This constitutes “a power exercisable solely by himself to vest the corpus or the income therefrom in himself” under the grantor trust rules.  I.R.C. § 678(a)(1).

[12]  It appears that the parties wait until late in the taxable year to conduct the transaction in order to accurately estimate the amount of tax loss needed by Taxpayer to offset other gains for such year, and thereby compute the amount of built-in loss from distressed assets needed to contribute to the trusts to generate that loss.

[13]  This example assumes the distressed assets did not consist of debt that was totally worthless at the time of the transfer.

[14] Foreign Document Requests should be coordinated with the appropriate Technical Advisor to avoid duplication of effort. 

[15]  Note that a transfer of distressed debt from the partnership to the main trust does not constitute a gift, therefore the basis rules of I.R.C. § 1015(a) and Treas. Reg. § 1.1015-1 do not apply (the basis for purposes of determining a loss is the lower of grantor’s basis or the FMV at the time the property was transferred to the trust).

[16]  An asset contributed to a grantor trust has the same basis as the basis in the hands of the grantor.  If that basis is zero when the grantor contributes the asset to the trust, the basis remains zero after the contribution to the trust.

[17]  An argument regarding the worthlessness of distressed assets at the time the assets were contributed by the foreign party to the partnership (or the timing of a worthlessness deduction) requires factual development.  Development of this issue should be coordinated with the appropriate Technical Advisor. 

[18]  Generally, an Illinois business trust is a profit-making device whereby investors contribute capital to an enterprise managed by trustees.  23 Ill. Law and Prac. Joint Stock Co., Etc. § 11.  While the object of an ordinary trust is to hold and conserve property for the benefit of the beneficiaries, an Illinois business trust operates as an arrangement for conducting business and sharing profits.  Carey v. U.S. Industries, Inc., 44 F. Supp. 794 (N.D. Ill. 1976).  Thus, while not determinative of federal tax treatment, including whether there was a business purpose for the DAT trust, the DAT trusts formed in Illinois are considered to be business entities for state law purposes.

[19]  Treas. Reg. §§ 301.7701-2(a) and 301.7701-4.

[20]  See footnote 5 if the loss under I.R.C. § 165 is triggered by a sale or exchange.

[21]  Note that some courts may categorize the doctrines in a different manner.

[22]  See footnote 2 and the discussion of the promoter partnership scenario.  Note that this is a common, but by no means the only possible, DAT scenario. 

[23]  In the promoter partnership scenario, the end result test and/or the interdependence test could additionally be used to disregard the contribution of the distressed assets by FP to the partnership and to treat such purported “contribution” as a sale of the assets to the main trust, sub-trust, or to the U.S. taxpayer for the cash paid by the U.S. taxpayer. 

[24] Some courts refer to this doctrine as the “sham transaction” or “sham in substance “ doctrine.  However, see Southgate Master Fund LLC v. United States, 2009 WL 2634854 (N.D. Tex.) August 18, 2009, in which the court addresses the judicial doctrines of economic substance, sham partnership, and substance over form.  For purposes of this document, the doctrine is referred to as the “economic substance” doctrine.

[25]  In the Third Circuit, in determining “whether the taxpayer’s transactions had sufficient economic substance to be respected for tax purposes”, the analysis “turns on both the ‘objective economic substance of the transactions’ and the ‘subjective business motivation’ behind them.”  ACM Partnership v. Commissioner, 157 F.3d 231, 247 (3d Cir. 1998), aff’g in part and rev'g in part T.C. Memo. 1997-115, cert. denied, 526 U.S. 1017 (1999)(citing Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990) [other citations omitted].  See also In re: CM Holdings, Inc., 301 F.3d 96, 102 (3d Cir. 2002).  However, this analysis does not require a rigid two-step analysis.  See id.  Similarly, in the Tenth Circuit, although the court recognized the two-prong test from Rice’s Toyota World, the court held “The better approach, in our view, holds that ‘the consideration of business purpose and economic substance are simply more precise factors to consider in the [determination of] whether the transaction had any practical economic effects other than the creation of income tax losses.”  James v. Commissioner, 899 F.2d 905, 908-9 (10th Cir. 1990) (citation omitted).

[26]  The Eighth Circuit appears to apply the disjunctive test provided in Rice’s Toyota World, but indicates that a rigid two-part test may not be required.  Shriver v. Commissioner, 899 F.2d 724, 725-8 (8th Cir. 1990).  The DC Circuit and Federal Circuit apply the disjunctive test.  See Horn v. Commissioner, 968 F.2d 1229, 1236 (DC Cir. 1992); Drobny v. U.S., 86 F.3d 1174 (Fed. Cir. 1996) (unpublished opinion).  It is unclear whether the Second Circuit applies the test disjunctively or under a facts and circumstances analysis.  Compare Gilman, supra, at 148 (citing Jacobson v. Commissioner, 915 F.2d 832, 837 (2d Cir. 1990)(additional citations omitted)) (“A transaction is a sham if it is fictitious or if it has no business purpose or economic effect.”) with TIFD III-E Inc. v. U.S., 2004 WL 2471581, 12(D.Conn. Nov 01, 2004) (“The decisions in this circuit are not perfectly explicit on the subject. Recently, for example, Judge Arterton adopted the more flexible standard, but acknowledged some potentially contrary, or at least ambiguous, language in Gilman; Long Term Capital Holdings v. United States, 2004 WL 1924931, 39 n. 68 (D.Conn. Aug.27, 2004). That ambiguity, however, does not affect the decision of this case.  As I will explain, under either reading I would conclude that the Castle Harbour transaction was not a ‘sham.’  The transaction had both a nontax economic effect and a nontax business motivation, satisfying both tests and requiring that it be given effect under any reading of the law.”)  Similarly, in Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001), the Fifth Circuit considered both the standard in Rice’s Toyota World (that there be no business purpose and no reasonable possibility of a profit) [emphasis added] and the test in ACM (that these are mere factors in determining economic substance) and declined to accept one standard over the other.

[27]  See Goldstein v. Commissioner, 364, F.2d 734 (2d Cir. 1966); Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995); Winn-Dixie, Inc. v. Commissioner, 113 T.C. 254 (1999) aff’d in part Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313 (11th Cir. 2001), cert. denied, 535 U.S. 986 (2002).

[28]  See Rose v. Commissioner, 868 F.2d 851 (6th Cir. 1989); Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir 1990); Newman v. Commissioner, 894 F.2d 560, 563 (2d Cir. 1990); Winn-Dixie, Inc. v. Commissioner, 113 T.C. 254 (1999) aff’d in part Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313 (11th Cir. 2001); Salina Partnership v. Commissioner, T.C. Memo 2000-352 (2000).

[29]  See Rose v. Commissioner, 868 F.2d 851 (6th Cir. 1989); Kirchman v. Commissioner, 862 F.2d 1486 (11th Cir. 1989); Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir 1990); Salina Partnership v. Commissioner, T.C. Memo 2000-352 (2000); Nicole Rose Corp. v. Commissioner, 117 TC 328 (2001).

[30]  See IES Industries Inc. v. Commissioner, 253 F.3d 350, 355 - 56 (8th Cir. 2001).

[31]  See Rose v. Commissioner, 868 F.2d 851 (6th Cir. 1989); Kirchman v. Commissioner, 862 F.2d 1486 (11th Cir. 1989); James v. Commissioner, 899 F.2d 905 (10th Cir. 1990); Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993); IES Industries Inc. v. Commissioner, 253 F.3d 350, 356 (8th Cir. 2001).

[32]  See Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993).

[33]   Note the District Court decision in Southgate Master Fund LLC v. United States, 2009 WL 2634854 (N.D.Tex.) August 18, 2009, involving a DAD transaction.  Under the unique facts of this case, the court concluded that the part of the DAD transaction involving the acquisition of the nonperforming loans (the Southgate NPL transaction) had economic substance, but also concluded that the basis-build part of the DAD transaction (the GNMA Repo transaction) lacked economic substance and that the partnership was a sham partnership.  In its final judgment, the court concluded that the Government’s adjustments to the partnership’s tax return in issue were correct.

[34]  In Southgate Master Fund LLC v. United States, 2009 WL 2634854 (N.D. Tex.) August 18, 2009, the court found that the NPL transaction had economic substance and in reaching this conclusion considered the following as part of its economic substance analysis: 1) the investor in the case was far more sophisticated and experienced in the distressed debt business than the typical investor, 2) the particular NPLs (Chinese Category 4 non-performing loans) were of better quality than the debt involved in the typical DAD (or DAT) case (e.g., department store checks or credit card debt), 3) the investor was able to sell some of the NPLs to raise working capital (most DAT cases will not involve such sales), and 4) the collection agent in Southgate (owned/controlled by the Chinese government) was better placed to collect on the debt than the collection agents in DAT cases.

[35]  The appropriate inquiry is not whether the taxpayer made a profit but whether there was an objectively reasonable possibility that the taxpayer could earn a pre-tax profit from the transaction.

[36]  In assessing the role of profit in determining whether a transaction has economic substance, the Third Circuit has held, based on Sheldon, that "a prospect of a nominal, incidental pre-tax profit" would not support a finding that the transaction was designed to serve a nontax profit motive.  ACM Partnership, supra. at 258 (citing Sheldon v. Commissioner, 94 T.C. 738, 768 (1990)).  In making this determination, the court took into account transaction costs.  Id. at 257.  In this evaluation, some courts have considered a small chance of a large payoff to support a finding of economic substance.  See Jacobson v. Commissioner, 915 F.2d 835 (2d Cir. 1990) (citing Treas. Reg. § 1.183-2(a) (1990)).

[37]  S. Rep. No. 313., 99th Cong., 2d Sess. 450 (1986). 

[38]  S. Rep. No. 313., 99th Cong., 2d Sess. 451 (1986). 

[39]  In Southgate, the government contended that the abusive nature of the transaction required the court to reject Southgate’s claimed tax benefits under the judicial doctrines of economic substance, sham partnership, and substance over form.  Although the court found that the Chinese NPL portion of the entire Southgate transaction had economic substance, the court continued its analysis of the entire transaction and concluded that the partnership structure was a sham and that the substance cannot survive judicial scrutiny.

[40]  The party seeking to overcome the presumption has the burden of proof on this issue.

[41]  In Southgate, a United States District Court, in a case involving a DAD transaction, stated in dicta that two entities owned by the Chinese government were not commonly owned or controlled for purposes of I.R.C. § 482, and further found that I.R.C. § 482 was additionally inapplicable because neither entity was subject to US tax.  Southgate, 2009 WL 2634854.  The case was decided in favor of the Government on other grounds.  Neither of the I.R.C. § 482 issues described above is materially similar to the I.R.C. § 482 argument described in this paper.  Therefore, the court's discussion on I.R.C. § 482 in Southgate is not relevant to the determination of whether to assert an I.R.C.  § 482 argument in a DAT transaction case.  If a DAT transaction potentially involves an I.R.C. § 482 argument similar to the argument described in Southgate, coordination with Counsel should be undertaken.

[42]  That is, small expenses have been reported on the trust tax returns.  The taxpayers have incurred much larger expenses in the form of promoters and advisors fees.  Whether those expenses have been reported by the U.S. taxpayers will have to be determined in each case.

[43]  In Nichols v. Commissioner, 43 T.C. 842 (1965), nonacq., 1970-2 C.B. XVII, the Tax Court held that a theft loss was allowable where the shelter promoter fraudulently failed to acquire bonds and perform other promised actions.  Nichols is easily distinguishable from a DAT transaction, in which the shelter transactions are performed as promised and the only "loss" is the investor's failure to achieve the desired tax consequences.

[44]  Section 6662 was amended by both the American Jobs Creation Act of 2004, P.L. 108-357, 118 Stat. 1418 (2004), and the Pension Protection Act of 2006, P.L. 109-280, 120 Stat. 780 (2006).  These amendments apply only to tax years ending after October 22, 2004, and returns filed after August 17, 2006, respectively.  This CIP references I.R.C. § 6662 in effect before and after these amendments, noting relevant differences.

[45]  For purposes of I.R.C. § 6662, the term “underpayment” is generally the amount by which the taxpayer’s correct tax is greater than the tax reported on the return.  See I.R.C. § 6664(a).

[46]  For tax years beginning after October 22, 2004, the rule for corporations other than an S corporation or a personal holding company is different.  For those tax years, there is a substantial understatement of income tax if the amount of the understatement for the taxable year exceeds the lesser of (a) 10 percent of the tax required to be shown on the return (or, if greater, $10,000), or (b) $10,000,000.

[47]  For any transactions entered into before August 5, 1997, the standard to be applied in determining whether a transaction was a tax shelter is “the principle purpose” rather than “a significant purpose.” 

[48]  Note that the AJCA amendments to I.R.C. § 6662, for tax years ending after October 22, 2004, the tax shelter rules applicable to corporations were made applicable to all taxpayers.
 

[49]  Note that the AJCA amendments to I.R.C. § 6662, for tax years ending after October 22, 2004, eliminated the reduction of the understatement for all taxpayers if the item is attributable to a tax shelter.

[50]  For returns filed after August 17, 2006, the 2006 Pension Protection Act reduced the amounts required for substantial and gross valuation misstatements from 200 and 400 percent to 150 and 200 percent, respectively.

[51]  The correct adjusted basis in a DAT transaction is almost always less than 10 percent of the claimed adjusted basis because the correct adjusted basis is equivalent to FMV and adjusted basis is equivalent to face value.  Thus the claimed adjusted basis is in excess of 1000 percent of the correct amount in most cases.

[52]   Although the regulation is effective for years ending after October 3, 2001, it reflects the Service’s litigating position for prior years.

[53]  In general, a section 6662A penalty (20 or 30 percent, depending on whether the taxpayer properly disclosed the transaction) applies to any item that is attributable 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.  See also I.R.C. § 6707A(c). 

[54]  For purposes of I.R.C. § 6662A, the term “reportable transaction understatement” is generally the amount of the increase to taxable income resulting from the difference between the proper tax treatment of a reportable transaction and the taxpayer’s treatment of such transaction multiplied by the highest tax rate imposed by Section 1 plus the amount of decrease in credits resulting from the difference between the proper treatment related to the reportable transaction and the taxpayer’s treatment.  See I.R.C. § 6662A(b).

[55] In addition, a penalty under I R.C. § 6707A may also be applicable if the taxpayer fails to include on any return or statement any information with respect to a reportable transaction which is required under I.R.C. § 6011 to be included with such return or statement.

Back to top