Coordinated Issue- All Industries - Redemption Bogus Optional Basis Tax Shelter
Effective Date: January 31, 2006
UIL NO: 9300.42-00
The purpose of this coordinated issue paper is to discuss the grounds for disallowing an increase in basis that is improperly claimed as a result of I.R.C. §§ 754 and 743(b). Examiners should challenge these transactions on the basis of several alternative legal theories, each of which should be asserted. These positions will result in Notices of Final Partnership Administrative Adjustments to the entity, usually a limited liability company filing as a partnership. There are various statutory and judicial bases that may be used to challenge the taxpayer’s position, but these arguments must be tailored to the specific facts of the case. Because many of the legal arguments are document sensitive, extensive factual development is necessary for each transaction in order to establish and evaluate the appropriate legal positions.
GROUNDS FOR DISALLOWANCE
Any promissory notes given by the partnership to any of its purported partners do not constitute partnership liabilities for purposes of I.R.C. § 752(a). As a result, the purported assumptions of such obligations by the partners of the partnership do not result in an increase of the partners’ bases in the partnership. Consequently, the partnership may not increase the basis of the partnership property pursuant to I.R.C. §§ 754 and 743(b).
Alternatively, pursuant to I.R.C. § 707(a)(2)(B), under appropriate circumstances the contribution of appreciated property and the distribution of the redemption note may be recharacterized as a sale governed by I.R.C. § 453 rather than a liquidating distribution governed by I.R.C. § 736. Because the recharacterized sale of the appreciated property is to a related person within the meaning of I.R.C. § 453(f)(1), the amount realized with respect to the subsequent sale of the contributed property must be treated as realized by the contributing partner at the time of the subsequent sale under I.R.C. § 453(e). If I.R.C. § 707(a)(2)(B) is asserted to challenge the transaction, coordination with the National Office should be undertaken.
Alternatively, the increased basis of the partnership property may be disregarded for Federal tax purposes under judicial doctrines, including the economic substance doctrine and the step transaction doctrine.
The transaction costs incurred in connection with the redemption bogus optional basis transaction, including promoter’s fees, accounting fees, legal fees, and organizational expenses, are not deductible or amortizable under I.R.C. §§ 162, 212 and 709(b).
Treas. Reg. § 1.701-2 should be developed or considered for taxpayers who engaged in the bogus optional basis transaction. Where a partnership is formed in conjunction with the implementation of the transaction (special purpose entity) and the transaction is substantially similar to the facts described below, the National Office has approved the assertion of the partnership anti-abuse rule to challenge the transaction. However, a request for National Office approval for the use of the partnership anti-abuse regulation should be made before such regulation is asserted where the partnership in question is not a special purpose entity or where it is uncertain whether the transaction is substantially similar to the facts described below.
Generally, the accuracy-related penalty under I.R.C. § 6662 for negligence or disregard of rules or regulations and/or a substantial understatement of income tax should be developed and considered for taxpayers who engaged in redemption bogus optional basis transactions. For LMSB taxpayers, assertion or nonassertion of penalties must be approved by the Director of Field Operations.
Briefly, redemption bogus optional basis (“BOB”) transactions purportedly increase the basis of an appreciated asset so that when the asset is sold, the built-in gain is inappropriately deferred. In general, individuals or controlled entities transfer low basis, high value property, such as land, interests in a partnership, or stock, to a newly formed partnership (LTP) in which related parties own the remaining interests. LTP makes an I.R.C. § 754 election with respect to partnership property. This election generally allows a partnership to adjust the basis of its assets (the “inside basis”) with respect to certain partners’ interests in the partnership’s assets to match those partners’ bases in the partnership (the “outside basis”) where a triggering event has occurred under I.R.C. § 743(b). In order to create an I.R.C. § 743(b) adjustment, there must be a sale or exchange of a partnership interest. In general, in the redemption BOB transaction, LTP redeems all or part of one partner's interest in the partnership in exchange for promissory notes which are assumed by the other partners. Hereinafter, the partner receiving the redemption note is referred to as the “Redeemed Partner” and the Redeemed Partner is not included in the group herein after referred to as the remaining partners. According to the parties to the transaction, the notes issued in the redemption are partnership liabilities under I.R.C. § 752 that give rise to an I.R.C. § 752(a) basis increase.
Following the redemption, the remaining partners' interests in LTP are transferred to another newly formed partnership (UTP), triggering a basis adjustment under I.R.C. §§ 754 and 743(b). UTP may then purchase the redeemed partner’s remaining interests in LTP, if any, in exchange for promissory notes. LTP can continue to hold the appreciated asset with the stepped-up basis. However, once LTP makes a distribution of partnership property or sells the assets subject to the step-up in basis, a tax benefit, in the form of gain reduction, is triggered due to the stepped-up basis.
The two steps can, and often do, take place in two different taxable years; the election and subsequent step-up may occur in one year and the tax benefit triggering event may occur in a later year. For the sale year, LTP will indicate that there has been a sale of an asset, but due to the basis adjustment, LTP reports minimal or no gain; with a distribution, the remaining partners do not report gain on a subsequent sale of the appreciated property, also due to the stepped up basis.
Development of the cases has uncovered very few facts that are materially different from those described above. In general, the original investors may include individuals, revocable trusts or S corporations. LTP and the other newly formed entities are usually limited liability companies that elect to be treated as partnerships. Interests in assets are often split into “beneficial” and “record interests,” with one or more investors transferring beneficial interest in an asset while retaining record interest. LTP (the entity making the I.R.C. § 754 election and selling or distributing the asset) is usually known as “Acquisitions.” The partner whose interest is redeemed is sometimes known as “Holdings,” while the newly formed entity receiving interests in the taxpayer following the redemption (UTP) is often known as “Management.” In some instances, the Holdings entity is an S Corporation. Usually, the steps take place in anticipation of a sale of the property contributed to LTP (the Acquisitions partnership). In addition, the promissory notes issued by the entities often remain unpaid. Assets and liabilities may be transferred to other newly created entities, owned by the same investors. Finally, one or more of the newly formed partnerships typically incur transaction costs, including accounting fees and legal fees. There may also be organizational expenses under I.R.C. § 709(b).
1. The redemption obligations are not “liabilities” for purposes of I.R.C. § 752; thus, the purported assumptions of the redemption notes did not cause an increase in outside basis pursuant to I.R.C. § 752.
In these cases, LTP treats the redemption notes issued to one of its partners as a partnership liability. When this liability is allegedly assumed by the remaining partners, this assumption is treated as a contribution by the remaining partners to LTP. LTP argues that as a result of this contribution, the outside bases of the remaining partners are increased by the amount of the promissory note which each remaining partner assumed. This increased outside basis is then carried over to the newly formed partnership (UTP or entity known as Management) when the remaining partners transfer their interests to this new partnership.
I.R.C. § 721 provides that no gain or loss shall be recognized by a partnership or any partners in the case of a contribution of property to the partnership in exchange for a partnership interest. Under I.R.C. § 722, the basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized to the contributing partner at such time.
I.R.C. § 752(a) provides that any increase in a partner’s share of the liabilities of
a partnership, or any increase in a partner’s individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership. Here, LTP claims that the assumption of the redemption notes by the remaining partners constitutes an assumption of liabilities of the partnership. Thus, LTP claims that each remaining partner’s outside basis should increased by their allocable share of the promissory note.
In order to determine the effect (if any) that the assumption of the redemption notes has on each of the remaining partner’s basis in its partnership interest, it is necessary to determine whether the redemption notes given in redemption of the partner’s interest constitute “liabilities of a partnership” or “partnership liabilities” within the meaning of I.R.C. § 752. For transactions entered into after its effective date (June 24, 2003), § 1.752-1(a)(4) defines an obligation of a partnership as a partnership liability to the extent that incurring the obligation creates or increases the basis of any of the obligor's assets (including cash); gives rise to an immediate deduction to the obligor; or gives rise to an expense that is not deductible in computing the obligor's taxable income and is not properly chargeable to capital. Prior to the issuance of § 1.752-1(a)(4), Rev. Rul. 88-77, 1988-2 C.B. 129, addressed the definition of partnership liabilities in the context of a cash basis partnership. In that revenue ruling, the Service concluded that, for purposes of I.R.C. § 752, the terms “liabilities of a partnership” and “partnership liabilities” include an obligation only if and to the extent that incurring the liability creates or increases the basis to the partnership of any of the partnership’s assets (including cash attributable to borrowings), gives rise to an immediate deduction to the partnership, or, under I.R.C. § 705(a)(2)(B), currently decreases a partner’s basis in the partner’s partnership interest. The redemption BOB transactions discovered, to date, were conducted prior to the effective date (June 24, 2003) of § 1.752-1(a)(4), and, therefore, are governed by Rev. Rul. 88-77 and not the new regulation.
The Service applied the definition of partnership liability provided by Rev. Rul. 88-77 in Rev. Rul. 95-26, 1995-1 C.B. 131. In that ruling, the issue was whether a short sale of securities created a partnership liability under I.R.C. § 752 because of the partnership’s obligation to deliver securities to close out the short sale. Relying on the definition of partnership liability found in Rev. Rul. 88-77, Rev. Rul. 95-26 concluded that a partnership obligation was a liability to the extent that incurring the obligation creates or increases the basis to the partnership of any of the partnership’s assets (including cash attributable to borrowings). See also Rev. Rul. 93-13, 1993-1 C.B. 126 (providing that a partnership with a § 754 election makes § 734(b) adjustments at the time when payments are made). Because the cash received in the short sale was an asset of the partnership, the basis of the partnership’s assets increased as a result of incurring the obligation. Accordingly, the ruling concluded that the short sale created a partnership liability for purposes of I.R.C. § 752. Rather than constituting a partnership liability governed by § 752, a redemption note is governed by I.R.C. § 736, which does not characterize the payments until made.
In the redemption BOB transaction, the redemption notes do not affect the partnership’s basis in its assets. The redemption notes also do not give rise to an immediate deduction to the taxpayer (i.e., under Rev. Rul. 88-77, accrued but unpaid expenses of a cash method partnership are not “liabilities” for purposes of I.R.C. § 752). The redemption notes also do not currently decrease the partners’ bases in their partnership interests under I.R.C. § 705(a)(2)(B) (decreasing a partner’s basis for expenses that cannot either be deducted or capitalized, such as syndication fees). In this case, LTP issued the notes to redeem a partner’s interest. A partnership cannot own an interest in itself. Such interest would simply be treated as folded back into the partnership, much as when a corporation buys back its own stock in a stock redemption. Thus, LTP can not create or increase its basis in its assets as a result of a total or partial redemption of a partner’s interest other than through a possible I.R.C. § 734 adjustment when future payments are made on the note. Here, the redemption note is not treated as a current distribution that could give rise to an I.R.C. § 734 adjustment.
In addition, Rev. Rul. 88-77 attempts to maintain equality between the aggregate bases of the partners' interests in the partnership and the partnership's bases in its assets. As an example, if a bank loans $100 cash to a partnership, the partnership will see the total basis of its assets increase by $100 (its basis in the cash it now holds). The rules under I.R.C. § 752 will give the partners in the partnership an additional total basis of $100 due to the partnership liability. By treating the partners as contributing cash in an amount equal to their shares of the debt, inside and outside basis equality is preserved and distortions are avoided. In the redemption BOB transaction, because LTP has no asset the basis of which is increased by the issuance of the redemption note, permitting the remaining partners to treat the redemption note as a § 752(a) liability that is included in their bases would cause a distortion between inside and outside basis.
Consequently, under the analysis of Rev. Rul. 88-77, the redemption notes do not constitute partnership liabilities, and, accordingly, the remaining partners’ outside bases are not increased if these partners assume the obligations created by such notes. As there is no disparity between the inside and outside bases when the remaining partners transfer their interest in LTP to the newly formed partnership (UTP), the increase in the basis of the partnership property pursuant to I.R.C. §§ 754 and 743(b) will be disregarded.
2. Alternatively, the contribution of the appreciated property and the distribution of the redemption note may be, in appropriate circumstances, recharacterized as a sale for all purposes of the Internal Revenue Code, including I.R.C. § 453(e).
Under appropriate circumstances, the contribution of the appreciated property and the distribution(s) of the redemption note may be properly characterized as a sale of the property by the partner to the partnership. See I.R.C. § 707(a)(2)(B); Treas. Reg. § 1.707-3. If it is believed that such a recharacterization is appropriate, coordination with the National Office should be undertaken.
Pursuant to Treas. Reg. § 1.707-3(a)(2), a transfer that is treated as a sale under I.R.C. § 707(a)(2)(B) is treated as a sale for all purpose of the Code, including I.R.C. § 453(e). I.R.C. § 453(e)(1) provides in general that if: (A) any person disposes of property to a related person (the “first disposition”); and (B) before the person making the first disposition receives all payments with respect to such disposition, the related person disposes of the property (the “second disposition”), then, for purposes of I.R.C. § 453, the amount realized with respect to such second disposition shall be treated as received at the time of the second disposition by the person making the first disposition. Thus, because the recharacterized sale will constitute a sale to a related person (see I.R.C. § 453(f)(1)) and the redeemed partner will not receive all payments with respect to such recharacterized sale before the partnership subsequently sells the appreciated assets, the redeemed partner must recognize the amount realized on the subsequent sale at the time of the subsequent sale.
3. Alternatively, the basis step-up pursuant to I.R.C. §§ 754 and 743(b) will be disregarded for Federal tax purposes under judicial doctrines.
A. Economic Substance Doctrine
The decision regarding whether or not to apply the economic substance doctrine must be made on a case-by-case basis.1 The economic substance doctrine should be argued only in cases where the transaction produced tax benefits with no meaningful net economic benefit to the taxpayer, other than the reduction of tax and all parties expected that result. The doctrine should not be argued in cases where the taxpayer can demonstrate that there is an actual possibility that the taxpayer may realize a substantial economic return and substantial pretax profit from the transaction.
The decision regarding whether or not to apply the economic substance doctrine is based on all of the facts available and should be developed at the Exam level. These facts are generally found in documents obtained from taxpayers, the promoters, and other parties; interviews with the same; and an analysis of financial data and industry practices. Summonses should be promptly issued whenever necessary.
To be respected for tax purposes, a transaction must have economic substance separate and distinct from the economic benefit achieved solely by reduction in taxes. If a taxpayer seeks to claim tax benefits by means of transactions that serve no economic purpose other than tax savings, the doctrine of economic substance is applicable. Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1977); United States v. Wexler, 31 F.3d 117, 122, 124 (3d Cir. 1994); Yosha v. Commissioner, 861 F.2d 494, 498-99 (7th Cir. 1988), aff'g Glass v. Commissioner, 87 T.C. 1087 (1986); Goldstein v. Commissioner, 364 F.2d 734
(2d Cir. 1966), aff'g 44 T.C. 284 (1965); ACM Partnership v. Commissioner, T.C. Memo. 1997-115, aff'd in part and rev'd in part 157 F.3d 231 (3d Cir. 1998). "It is well settled that the economic substance of transactions, rather than their form, governs for tax purposes." Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1236 (1981) citing Gregory v. Helvering, 293 U.S. 465 (1935). A transaction “entered into solely for tax avoidance without economic, commercial or legal effect other than expected tax benefits constitutes an economic sham without effect for Federal income tax purposes.” Nicole Rose Corp. v. Commissioner, 117 T.C. No. 27 (2001).
Whether a transaction has economic substance is a factual determination. United States v. Cumberland Pub. Serv. Co., 338 U.S. 451, 456 (1950). This determination turns on whether the transaction is rationally related to a useful nontax purpose that is plausible in light of the taxpayer's conduct and useful in light of the taxpayer's economic situation and intentions. The utility of the stated purpose and the rationality of the means chosen to effectuate it must be evaluated in accordance with commercial practices in the relevant industry. ACM Partnership v. Commissioner, T.C. Memo 1997-115; see also Cherin v. Commissioner, 89 T.C. 986, 993-94 (1987). A rational relationship between purpose and means ordinarily will not be found unless there was a reasonable expectation that the nontax benefits would be at least commensurate with the transaction costs. ACM Partnership v. Commissioner, T.C. Memo 1997-115; see also Cherin v. Commissioner, 89 T.C. at 994; Yosha v. Commissioner, 861 F.2d at 500-502. doctrine.
In determining if a transaction has economic substance, both the objective economic substance of the transaction and the subjective business motivation of the taxpayer must be determined. ACM Partnership v. Commissioner 157 F.3d at 247; Horn v. Commissioner, 968 F.2d 1229, 1237 (D.C. Cir. 1992); Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990). In order to satisfy the objective component of the doctrine, the taxpayer must demonstrate that the transaction resulted in a meaningful and appreciable enhancement in the net economic position of the taxpayer (other than to reduce its tax). In order to satisfy the subjective component, the taxpayer must demonstrate that it was motivated by the opportunity to profit from the transaction, or at least had a valid business reason for entering into the transaction other than tax savings. In essence, the taxpayer must demonstrate that the transaction had a business purpose.
The United States Courts of Appeals do not agree upon the precise formulation of the economic substance doctrine. Some circuits strictly adhere to the two prong test requiring that both prongs be satisfied before finding that a transaction possesses economic substance. See Pasternak v. Comm’r, 990 F.2d 893, 898 (6th Cir. 1993) (the conjunctive approach). Other circuits require that only one of the two prongs be satisfied before finding that a transaction possesses economic substance (the subjunctive approach). See e.g. Rice’s Toyota World, 752 F.2d 89, 91-92 (4th Cir. 1993). Finally, others interpret the two prongs as interrelated factors used to analyze whether the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes. ACM Partnership v. Commissioner, 157 F.3d at 247-48 (citing Casebeer v. Commissioner, 909 F.2d at 1363); Rose v. Commissioner, 868 F.2d 851, 854 (6th Cir. 1989); Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir. 1988).
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, 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 832 (2d Cir. 1990) (citing §1.183-2(a)).
Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966), aff'g 44 T.C. 284 (965) is an example of a case that lacked both objective economic substance and a business purpose. In that case, the taxpayer won the Irish Sweepstakes. In an attempt to shelter her winnings from tax, she borrowed from two banks and invested the loan proceeds in Treasury notes. The loans required her to pay interest at 4%, while some Treasury notes yielded 0.5% and others yielded 1.5%.
Her financial advisers estimated that these transactions would produce a pretax loss of $18,500 but a substantial after-tax gain. The court disallowed the interest deductions because it found that the taxpayer's purpose in entering into the loan transactions "was not to derive economic gain or to improve here [sic] beneficial interest; but was solely an attempt to obtain an interest deduction as an offset to her sweepstakes winnings." Id. at 738. The Court further found that the transactions entered into by the petitioner had "no realistic expectation of economic profit." Id. at 740. The Court determined that IRC §163 "does not permit a deduction for interest paid or accrued in loan arrangements . . . that cannot with reason be said to have purpose, substance, or utility apart from their anticipated tax consequences." Id. at 740. Goldstein v. Commissioner is significant because unlike many suspect transactions, the tax motivated transactions in that case were not fictitious. Goldstein v. Commissioner, 364 F.2d at 737-738. Rather, the transactions were real and conducted at arm's length. The taxpayer's indebtedness was enforceable with full recourse and her investments were exposed to market risk. Yet, the strategy was not consistent with rational economic behavior in the absence of the expected tax benefits.
On the other hand, United Parcel Service of America, Inc. v. Commissioner, 254
F.3d 1014 (11th Cir. 2001), rev’g T.C. Memo. 1999-268 and Compaq v. Commissioner, 277 F. 3d 778 (5th Cir. 2001), rev’g 113 T.C. 214 (1999), are examples of cases in which the taxpayer’s transaction was found to have economic effect and a business purpose. In United Parcel Service v. Commissioner, 254 F.3d at 1018-20, the Eleventh Circuit reversed the Tax Court, finding that the restructuring by UPS of certain insurance premiums in the context of an ongoing, viable business had both real economic effects and a business purpose. According to the Court, setting up a transaction with tax planning in mind is permissible as long as there is a bona fide, profit-seeking business purpose. Id. at 1019. Unlike the transaction in ACM Partnership v. Commissioner, 157 F.3d 231, the UPS restructuring of its excess-value business had both real economic effects and a business purpose. In Compaq v. Commissioner, 277 F. 3d at 788, the Fifth Circuit also reversed the Tax Court and ruled that the taxpayer’s participation in a foreign dividend strip transaction had economic substance and a business purpose other than to reduce taxes.
The Court determined that the taxpayer realized an economic benefit in the amount of the gross dividend. Id. at 785. It also found that even if Compaq primarily sought to get an otherwise unavailable tax credit to offset its unrelated capital gains, this would not necessarily invalidate the transaction. Id. at 787-88. Ultimately, the Fifth Circuit found insufficient evidence in the record to determine that the transaction was solely motivated by tax considerations, as claimed by the Service. Id. at 787.
1. No Economic Effect
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.2 See e.g., Gilman v. Commissioner, 933 F.2d 143, 146 (2d Cir. 1991) (determining 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.3 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, 9 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).
A nominal economic benefit, when compared to the tax benefits that the transaction generated, may be insufficient to cause the transaction to have economic effect. For example, in ACM Partnership v. Commissioner,157 F.3d 231, the taxpayer entered into a near-simultaneous purchase and sale of debt instruments. Taken together, the purchase and sale "had only nominal, incidental effects on [the taxpayer's] net economic position." 157 F.3d at 250. The taxpayer claimed that, despite the minimal net economic effect, the transaction had economic substance. The Third Circuit Court of Appeals held that transactions that do not "appreciably" affect a taxpayer's beneficial interest, except to reduce tax, are devoid of substance and are not respected for tax purposes. Id. at 248. The court denied the taxpayer the purported tax benefits of the transaction because the transaction lacked any significant economic consequences other than the creation of tax benefits.
In Sheldon v. Commissioner, 94 T.C. 738 (1990), the Tax Court denied the taxpayer the tax benefits of a series of Treasury bill sale-repurchase transactions because they lacked economic substance. The taxpayer bought Treasury bills that matured shortly after the end of the tax year and funded the purchase by borrowing against the Treasury bills. The taxpayer accrued the majority of its interest deductions on the borrowings in the first year while deferring the inclusion of its economically offsetting interest income from the Treasury bills until the second year. The transactions lacked economic substance because the economic consequence of holding the Treasury bills was largely offset by the economic cost of the borrowings. The taxpayer was denied the tax benefit of the transactions because the real economic impact of the transactions was "infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions." Id. at 769.
In contrast to ACM v. Commissioner and Sheldon v. Commissioner, 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. Thus, if tax considerations predominate, the courts will find that an equipment leasing transaction is a sham even if it holds out the promise of minimal profit. See Hines v. Commissioner, 912 F.2d 736 (4th Cir. 1990); Prager v. Commissioner, T.C. Memo. 1993-452. 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.
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 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, and any indemnity agreements between the accommodating parties and the promoter should be determined.
In the absence of evidence that a transaction has the potential to render a pretax profit, Courts have been willing to treat a transaction as having economic effect when the taxpayer establishes that the transaction altered the economic relationships of the parties. See Knetsch v. United States, 364 U.S. 361 (1960). In United Parcel Services v. U.S., 254 F.3d at 1018, the Court recognized the economic effect of the transaction because it created a genuine obligation, enforceable by an unrelated party. See also Sacks v. Commissioner, 69 F.3d at 988-990.
A redemption BOB transaction does not hold any pretax profit potential for its participants. The steps involved in a redemption BOB transaction, particularly the creation of the partnerships and the issuance of the redemption note, also do not alter the economic relationships of the parties. The original owner of the contributed property continues to directly or indirectly control the property throughout the transaction. Within a relatively short period of time after the property is contributed to LTP, LTP redeems all or part of one partner’s interest in exchange for promissory notes, which are purportedly assumed by the remaining partners of LTP. In the cases developed to date, no payments of interest or principal were made. In addition, because the investors usually directly or indirectly own 100 percent of both LTP and the redeemed partner, the notes are (in effect) issued to the same entity that made the notes. Therefore, the notes may not be genuine, enforceable obligations. Usually on the same date as the redemption, the remaining partners transfer their interests in LTP to a newly formed partnership (UTP). In addition, on the same date, UTP may purchase any remaining interest in LTP from the redeemed partner in exchange for a note issued by UTP. Again, the investors generally hold all interests in the UTP and in the redeemed partner, and typically, no payment is made on any notes issued to purchase interests in LTP. These additional steps also do not affect the economic position of LTP and may not create genuine, enforceable obligations. These additional steps do, however, create a significant tax benefit for LTP and the remaining partners. As a result of the transfer of interests in LTP to the newly formed partnership, LTP claims a step-up in basis pursuant to I.R.C. §§ 754 and 743(b).
Unlike Compaq, LTP does not make or even have the possibility to make a pretax profit from the transaction. See Compaq v. Commissioner, 277 F.3d at 785. Rather, LTP merely creates tax benefits by entering into transactions to increase the basis of partnership property. Absent the tax savings resulting from the transactions, there is no economic reason or benefit from entering into the transactions, i.e., there is no reasonable expectation of a future profit. Thus, the transactions lack economic substance and are entered into solely for the attendant tax benefits of an inappropriate deferral, or elimination, of gain on the sale or distribution of an asset.
2. No Legitimate 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, 752 F.2d at 91-92). To determine that intent, the following credible evidence is considered: (i) whether a profit was possible;4 (ii) whether the taxpayer had a nontax business purpose;5 (iii) whether the taxpayer, or its advisors, considered or investigated the transaction, including market risk;6 (iv) whether the entities involved in the transaction were entities separate and apart from the taxpayer doing legitimate business before and after the transaction;7 (v) whether all the purported transactions were engaged in at arm’s-length with the parties doing what the parties intended to do;8 and (vi) whether the transaction was marketed as a tax shelter in which the purported tax benefit significantly exceeded the taxpayer’s actual investment.9 Based on the more recent cases on this issue, it seems clear that the business purpose element of the economic substance analysis will be satisfied, despite tax planning objectives, so as long as there is some bona fide, profit-seeking business purpose to the specific transaction. See United Parcel Service of America, Inc. v. Commissioner, 254 F.3d at 1019; Compaq v. Commissioner, 277 F. 3d at 786-87.
The redemption BOB transactions identified to date have no purpose other than to generate an increase in basis in partnership property to enable the LTP to inappropriately defer or eliminate gains from a distribution or sale and make available the sale proceeds without the current imposition of tax. A redemption BOB transaction is generally not conducted as part of an ongoing business operation. As previously mentioned, the partnerships are usually created in anticipation of a sale or distribution of assets. In general, the newly formed partnerships do not conduct any business (other than the transaction) during the years in issue. The parties engaging in a redemption BOB generally assert that the partnerships were organized in order to protect the contributing partner’s appreciated assets from creditors or to further the contributing partner’s estate planning goals; however, it is unclear how organizing multiple tiers of partnerships and the redemption aspect of the transaction further those goals.
The sole purpose of the transaction is to secure the I.R.C. § 743(b) adjustment in order to defer reporting substantial gains by the original owner of the contributed property on the subsequent sale or distribution of the property. This is not a legitimate business purpose. See ACM Partnership v. Commissioner, 157 F.3d at 253. Information should be sought to rebut the investors’ purported asset protection and estate planning goals and to establish that the transaction was undertaken primarily for tax purposes. Such evidence would include among other things: (i) documents indicating that one or more of the partners in LTP contemplated selling appreciated property prior to organizing the partnerships; (ii) independent analysis establishing that asset protection and estate planning objectives could not have been achieved by this transaction; (iii) evidence indicating that the partners did not investigate the asset protection and estate planning claims regarding the transaction; and (iv) evidence indicating that the redemption notes and the guarantee of those notes were not conducted at arm’s length.
In summary, if after development of the relevant information this series of prearranged transactions, taken as a whole, lacks economic effect, beyond the reduction of taxes, and lacks a bona fide nontax purpose, as discussed above, LTP is not entitled to the increase in basis generated from this transaction.
B. Step Transaction Doctrine
Subchapter K was adopted in part to increase flexibility among partners in allocating partnership tax burdens. See generally Foxman v. Commissioner, 41 T.C. 535, 550-51 (1961), aff’d., 352 F. 2d 466 (3d Cir. 1965). This flexibility, however, is limited by the overarching principle that the substance of the transaction is controlling for tax purposes. Twenty Mile Joint Venture, PND, Ltd. v. Commissioner, 200 F. 3d 1268 (10th Cir. 1999), aff’g. in part and appeal dismissed in part, T.C. Memo. 1996-283. Although the form of a transaction may literally comply with the provisions of a Code section, the form will not be given effect where it has no business purpose and operates simply as a device to conceal the true character of a transaction. See Gregory v. Helvering, 293 U.S. 465, 469-470 (1935). Substance over form and related judicial doctrines all require "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). The issue of whether any of those doctrines should be applied involves an intensely factual inquiry. See Gordon v. Commissioner, 85 T.C. 309, 327 (1985); see also Bowen
v. Commissioner, 78 T.C. 55, 79 (1982), aff’d 706 F.2d 1087 (11th Cir. 1983);
Gaw v. Commissioner, T.C. Memo. 1995-531, aff’d without published opinion 111
F.3d 962 (D. C. Cir. 1997).
Deciding “whether to accord the separate steps of a complex transaction independent significance, or to treat them as related steps in a unified transaction, is a recurring problem in the field of tax law.” King Enters, Inc. v. United States, 189 Ct. Cl. 466, 418 F.2d 511, 516 (Ct. Cl. 1969). Courts utilize a variety of approaches in answering this problem, including a particular incarnation of the basic substance over form principle known as the step transaction doctrine. Simply stated, the step transaction doctrine provides that “interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction.” Commissioner v. Clark, 489 U.S. 726, 738 (1989). The doctrine requires that all interdependent steps with legal or business significance be linked together, rather than taken in isolation, so that "federal tax liability may be based on a realistic view of the entire transaction." Id.
The step transaction doctrine generally applies in cases where a taxpayer seeks to get from point A to point D and does so stopping in between at points B and C. The whole purpose of the unnecessary stops 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 stops may be disregarded or rearranged.
The existence of business purposes and economic effects relating to the individual steps in a complex series of transactions does not preclude application of the step transaction doctrine. True v. United States, 190 F.3d 1165, 1176-1177 (10th Cir. 1999). 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 occurrence of these events alone should not be relied upon 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.
Courts have developed three tests for determining when the step transaction doctrine should operate to collapse the individual steps of a complex transaction into a single integrated transaction for tax purposes: (1) end result, (2) interdependence, and (3) binding commitment. See Associated Wholesale Grocers, Inc. v. United States, 927 F.2d 1517, 1522 (10th Cir.1991). More than one test might be appropriate under any given set of circumstances; however, the circumstances need only satisfy one of the tests in order for the step transaction doctrine to operate. See, e.g., id at 527-28 (finding end result test inappropriate, but applying the step transaction doctrine using the interdependence test). Given the type of transactions involved in this case, only the end result and interdependence tests are relevant to our analysis.
1. End Result Test
The end result test combines "into a single transaction separate events which appear to be component parts of something undertaken to reach a particular result." Kornfeld v. Commissioner, 137 F.3d 1231, 1235 (10th Cir. 1998); Associated Wholesale Grocers, Inc. v. United States, 927 F.2d at1523. Under this test, if the series of closely related steps in a transaction are merely the means to reach a particular result, those steps should not be separated, but rather treated as a single transaction. Kanawha Gas & Utils. Co. v. Commissioner, 214 F.2d 685, 691 (5th Cir.1954). Thus, the end result test focuses on whether the taxpayer intended to reach a particular result by structuring a series of transactions in a certain way. In applying the step transaction doctrine for Federal tax purposes, under the end result test, there is no independent tax recognition of the individual steps unless the taxpayer shows that at the time the parties engaged in the individual step, its result was the intended end result in and of itself. If this is not what was intended, then a court will collapse the series of steps and give tax consideration only to the intended end result. It is a flexible test and bases tax consequences on the substance of the transaction, not on the formalisms chosen by the participants.
In general, the investors in the redemption BOB cases enter into the transactions in anticipation of a sale or distribution of a low basis, high value asset. The investors’ objective is to increase the basis of this property prior to the sale, while still maintaining control of the asset. There is nothing of substance to be realized in this abusive transaction aside from substantial tax savings at the investor level. None of the steps are initiated with other objectives in mind (i.e., the intended end result is not actually one of the intermediate transactional steps).
Ultimately, despite being transferred to different newly created entities, the assets remain within the investors’ control. The sale or distribution takes place as planned. However, as a result of the creation of the various entities and the transfer of assets and partnership interests from one entity to another, LTP claims an increased basis. Thus, the end result is the same (i.e., the sale took place and the investors ultimately receive the proceeds) but the outcome is drastically changed due to the intervening steps. These intervening steps are not meaningful to the end result. Consequently, these steps should be disregarded.
2. Interdependence Test
The interdependence test takes a slightly different approach. The "interdependence" test focuses on whether "the steps are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series." Redding v. Commissioner, 630 F.2d 1169, 1177 (7th Cir. 1980), revg. and remanding 71 T.C. 597 (1979); see also Kass v. Commissioner, 60 T.C. 218 (1973), aff’d without published opinion 491 F.2d 749 (3d Cir. 1974). Thus, this test concentrates on the relationship between the steps, rather than on their "end result." See Sec. Indus. Ins. Co. v. United States, 702 F.2d 1234, 1245 (5th Cir. 1983). The interdependence test requires a court to find whether the individual steps had independent significance or had meaning only as part of the larger transaction. Penrod v. Commissioner, 88 T.C. 17 1415, 1429-1430 (1987). If the steps have "reasoned economic justification standing alone," then the interdependence test is inappropriate. Sec. Indus. Ins. Co. v. United States, 702 F.2d at 1247. If, however, the only reasonable conclusion from the evidence is that the steps have "meaning only as part of the larger transaction," then the step transaction doctrine applies as a matter of law.
Id. at 1246.
In the redemption BOB case, each partnership entity is created for the purpose of increasing the basis of an asset. None of the steps involved in the transaction have any reasoned economic justification standing alone. In general, the entities conduct no other business than what is necessary for the transaction to work. Further, a step-up in basis could not have occurred had not all of different steps (i.e., the formation of the taxpayer, the redemption of one partner’s interest, the transfer of interests to a newly formed partnership, etc.) taken place, and generally, each step is contemplated up front. Thus, it appears that these steps were the investors’ prearranged integrated plan to accomplish indirectly tax advantages that they could not accomplish directly. Accordingly, these meaningless steps should be disregarded.
4. The transaction costs incurred in connection with the redemption bogus optional basis transaction, including promoter’s fees, accounting fees, legal fees and organizational fees, are not deductible or amortizable under I.R.C. §§ 162, 212 or 709(b).
A. I.R.C. § 162
I.R.C. § 162 provides generally for the deduction of ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. However, transaction costs incurred in connection with a transaction designed solely to provide tax benefits for participants are not deductible under I.R.C. § 162. See Brown v. Commissioner, 85 T.C. 968, 1000 (1985), aff’d sub nom. Sochin v. Commissioner, 843 F.2d 351 (9th Cir. 1988); see also Leslie v. Commissioner, 146 F.3d 643, 650 (9th Cir. 1998) (deduction disallowed for fees paid to purchase deductions in tax-motivated transaction, citing Brown); Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254, 294 (1999) (administrative fees disallowed as the product of a sham), aff’d, 254 F.3d 1313 (11th Cir. 2001); Price v. Commissioner, 88 T.C. 860, 886 (1987), aff’d without published opinion, 1990 U.S. App LEXIS 20422 (10th Cir. Oct. 26, 1990) (deduction for fees paid to acquire tax losses disallowed because neither a cost of doing business nor incurred with an intent to make a profit independent of tax consequences, citing Brown).
The transaction costs incurred by LTP, related entities, or the investors in conjunction with the redemption BOB transaction, including promoter’s fees, accounting fees and legal fees, are paid for participation in the transaction. As discussed above, the redemption BOB transaction is crafted to shelter gain otherwise taxable to the original investors and serves no business purpose of either the original investors or LTP. The fees incurred constitute payments to purchase tax benefits for the original investors and, as such, are not deductible under I.R.C. § 162 by either LTP, investors, or related entities.
B. I.R.C. § 212
I.R.C. § 212 generally provides for the deduction by an individual of ordinary and necessary expenses paid or incurred during the taxable year (1) for the production or collection of income, (2) for the management, conservation, or maintenance of property held for the production of income, or (3) in connection with the determination, collection, or refund of any tax. The taxpayer must show that the legal expenses were paid to for the production of income or maintenance of property or for the determination or collection of any tax. Only § 212(3) may be relevant to the instant case. Deductions under § 212(3), however, cannot be taken for costs incurred in obtaining tax advice in furtherance of a sham transaction. See Dooley v. Commissioner, 332 F.2d 463, 468 (7th Cir. 1964); see also Brown v. Commissioner, 85 T.C. at 1000. Accordingly, no deduction under I.R.C. § 212 may be taken for the cost of tax advice obtained in furtherance of a redemption BOB transaction.
C I.R.C. § 709(b)
Under I.R.C. § 709(a), no deduction is allowed for amounts paid to organize a partnership or to promote a partnership interest. I.R.C. § 709(b), however, provides for 60 months’ amortization of organization fees, if they (1) are incidental to creation of the partnership, (2) are chargeable to the capital account, and (3) are of an amortizable character. I.R.C. § 709(b) is available only if properly elected by attaching a statement to the partnership’s return for the taxable year in which the partnership begins business. If no such statement is attached, then any payments for organizational expenses are not amortizable. Landry v. Commissioner, 86 T.C. No. 76 (1986). Further, if the partnerships are disregarded under a judicial doctrine or Treas. Reg. § 1.701-2, I.R.C. § 709(b) amortization should not be allowed.
5. Treas. Reg. § 1.701-2 should be developed or considered for taxpayers who engaged in the redemption BOB transaction. Where a partnership is formed in conjunction with the implementation of the transaction (special purpose entity) and the transaction is substantially similar to the facts described above, the National Office has approved the assertion of the partnership antiabuse rule to challenge the transaction. However, a request for National Office approval for the use of the partnership anti-abuse regulation should be made before such regulation is asserted where the partnership in question is not a special purpose entity or where it is uncertain whether the transaction is substantially similar to the facts described above.
Treas. Reg. § 1.701-2(b) provides that if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter K, the Commissioner can recast the transaction for Federal tax purposes as appropriate to achieve tax results that are consistent with the intent of subchapter K, in light of the applicable statutory and regulatory provisions and the pertinent facts and circumstances. Thus, even though the transaction may fall within the literal words of a particular statutory or regulatory provision, the Commissioner can determine, based on the particular facts and circumstances, that to achieve tax results that are consistent with the intent of subchapter K: (1) The purported partnership should be disregarded in whole or in part, and the partnership’s assets and activities should be considered, in whole or in part, to be owned and conducted, respectively, by one or more of its purported partners; (2) one or more of the purported partners of the partnership should not be treated as a partner; (3) the methods of accounting used by the partnership or a partner should be adjusted to reflect clearly the partnership’s or the partner’s income; (4) the partnership’s items of income, gain, loss, deduction or credit should be reallocated; or (5) the claimed tax treatment should otherwise be adjusted or modified.
By itself, a principal purpose of obtaining a tax reduction will not be enough to invoke the anti-abuse rule. The tax-savings must be achieved in a manner that is inconsistent with the intent of subchapter K. Having a principal purpose of using a bona fide partnership to conduct business activities in a manner that is more tax efficient than any alternative means available does not establish that the resulting tax reduction is inconsistent with the intent of subchapter K.
Subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax. Implicit in the intent of subchapter K are the following requirements:
(1) The partnership must be bona fide and each partnership transaction or series of related transactions (individually or collectively, the transaction) must be entered into for a substantial business purpose;
(2) The form of each partnership transaction must be respected under substance over form principles; and
(3) The tax consequences under subchapter K to each partner of
partnership operations and of transactions between the partner and
the partnership must accurately reflect the partners' economic
agreement and clearly reflect the partner's income. This third requirement is referred to as the “proper reflection of income” requirement.
Recognizing that certain provisions of Subchapter K and its regulations were adopted for administrative convenience or for other policy objectives, if the first two implicit requirements are met, the proper reflection of income requirement is also considered met to the extent that the application of such a provision to the transaction and the ultimate tax results, taking into account all the relevant facts and circumstances, are clearly contemplated by the provision.
The redemption BOB transaction generally violates all three components of the intent of Subchapter K. The transaction uses partnerships that are not bona fide and that engage in transactions with no business purpose to defer the gain recognition that would have occurred in the absence of those partnerships.
Taxpayers engaging in these transactions generally claim to have organized the partnerships for asset protection purposes; however, it is unclear what asset protection purpose is promoted by the transfer of the partnership interests, which ultimately triggers the I.R.C. § 743(b) adjustment.
The transaction is also inconsistent with subchapter K because, as a whole, it cannot be respected under substance over form principles. In particular, as discussed above, it appears that the steps of this transaction cannot be respected under the economic substance or step transaction doctrine. The substance of the transaction seems to be a sale of a highly appreciated asset to a third party. Although we have no information regarding whether the asset sale was negotiated before the parties organized the partnerships, the steps involving the formation of the partnerships and the redemption transaction appear unnecessary to the ultimate sale and seem designed principally to defer gain recognition that otherwise would have occurred as part of that sale.
The transaction is also inconsistent with subchapter K because the partnership’s operations and transactions between the partners and the partnerships do not accurately reflect the partners’ economic agreement and do not clearly reflect the partners’ income. The I.R.C. § 743 adjustments are being used to defer recognition of pre-contribution gain by the original owner of a highly appreciated, low basis asset. I.R.C. § 743 is intended to defer gain only to true transferee partners (e.g., purchasers for value or a decedent’s heirs). Thus, an application of I.R.C. § 743 that defers gain recognition for the party in whose hands the gain accrued is a distortion that clearly is not contemplated by § 754.
In addition to violating the intent of subchapter K, a partnership must have been formed or availed of with a principal purpose of tax reduction. Whether or not a particular transaction runs afoul of the general anti-abuse rule by having a principal purpose of tax reduction is, again, ultimately a question of facts and circumstances. Treas. Reg. § 1.701-2(c) lists several factors to consider in determining whether a partnership was formed with a principal purpose of tax reduction.
Treas. Reg. § 1.701-2(c) lists several factors to consider, including a comparison of the purported business purpose for the transaction and the claimed tax benefits resulting therefrom. Under this factor, apparently even if one has a bona fide business purpose for planning a transaction in a certain way, if the claimed tax consequences are too favorable, the transaction may not be respected. The other factors which may indicate abuse are:
(1) The present value of the partners’ aggregate Federal tax liability is substantially less than it would have been if the partners had owned the partnership’s assets directly;
(2) The present value of the partners’ aggregate Federal tax liability is substantially less than it would have been if purportedly separate transactions are integrated into a single transaction;
(3) One or more partners who are necessary to achieve the desired tax result are substantially protected from loss and have little or no participation in the profits of the partnership;
(4) Substantially all partners are related to one another;
(5) Partnership items are allocated in compliance with the literal language of Treas. Reg. §§ 1.704-1 and 1.704-2 but with results that are inconsistent with the purpose of I.R.C. § 704(b) and those regulations. In this regard, particular scrutiny will be paid to special allocations to partners that are effectively in the zero bracket;
(6) The benefits and burdens of ownership of property nominally contributed to a partnership are substantially retained by the contributor; and
(7) The benefits and burdens of ownership of partnership property are substantially shifted to the distributee partner before or after the property is actually distributed.
Several of the factors listed in § 1.701-2 that indicate abuse are present in a redemption BOB transaction making the application of the anti-abuse rule appropriate. The federal tax liabilities of the remaining partners are always substantially less than they would have been if the partners had owned the partnership’s assets directly. The present value of the partners’ aggregate Federal tax liability is substantially less than it would have been had the purportedly separate transactions been integrated into a single transaction. The entities involved in the transaction are generally ultimately owned by the same investors and act in concert to achieve a reduction in tax liability on the ultimate sale or distribution of an appreciated asset. As a result of the common ownership, the owner of the asset retains control and the benefits of ownership of the asset even after it is contributed to the partnership that sells or distributes the asset. The promissory notes, issued by one partnership to redeem a related partner, and any subsequent assumption agreements and guarantees executed by other related partners with respect to such notes, are issued and executed so that the investors may take advantage of the rules under I.R.C. §§ 752 and 754 and typically remain unpaid.
The parties to the transaction may provide numerous transactional documents to substantiate their claims regarding the business purpose of the transaction. However, as explained by the Supreme Court in Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978) (in discussing the doctrine of substance over form), “[t]he Court has never regarded the simple expedient of drawing up papers as controlling for tax purposes when the objective economic realities are to the contrary. In the field of taxation, administrators of the laws and the courts are concerned with substance and realities, and formal written documents are not rigidly binding.”
As discussed above, for purposes of I.R.C. § 752, the redemption notes do not constitute partnership liabilities; thus the assumption of the redemption notes do not cause an increase in the partners’ outside bases. Further, the transactions have no economic substance. It is clear that under these facts, the transactions are part of a deliberate plan to use the partnership liability and basis adjustment rules to shelter the subsequent gains from a later sale or distribution of an asset. Because the transaction involves a partnership formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter K, it is appropriate to apply the Treas. Reg. § 1.701-2 anti-abuse rule. Where a partnership is formed in conjunction with the implementation of the transaction (special purpose entity) and the transaction is substantially similar to the facts described above, the National Office has approved the assertion of the anti-abuse rule to challenge the transaction. However, a request for National Office approval for the use of the partnership anti-abuse regulation should be made before such regulation is asserted where the partnership in question is not a special purpose entity or where it is unclear whether the transaction is substantially similar to the facts described above.
6. Generally, the accuracy-related penalty under I.R.C. § 6662 for an underpayment attributable to negligence or disregard of rules or regulations, substantial understatement of income tax, and/or valuation misstatement should be developed and considered for taxpayers who engaged in redemption BOB transactions.
Whether penalties apply to underpayments generated by a redemption BOB transaction must be determined on a case-by-case basis, depending on the specific facts and circumstances of each case. The application of a penalty must be based on a comparison of the facts developed with the legal standard for the application of the penalty. Accordingly, examination teams should ensure that the scope of factual development encompasses those matters relevant to penalties. A separate report should be prepared for the penalty issue.
The extent of the investors’ due diligence in investigating the redemption BOB transaction is an important factor to consider in connection with the accuracy related penalty, as well as the reasonable cause exception. Facts need to be fully developed to determine when and how the investors found out about the redemption BOB transaction; details of meetings and correspondence with promoter personnel; the identity of advisors to the investors and the type of advice provided; details of internal memorandums, notes, and meetings; the identity of investors’ personnel that investigated the transaction and/or made the decision to participate; and actions that were taken by investor personnel when the transaction was being considered.
A. The Accuracy-Related Penalty
I.R.C. § 666210 imposes an accuracy-related penalty in an amount equal to 20 percent of the portion of an underpayment11 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. See I.R.C. § 6662(a), (b). The penalty increases to 40 percent of the underpayment if the underpayment is due to a gross valuation misstatement. I.R.C. § 6662(h). 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 understatement). See DHL Corp. v. Commissioner, T.C. Memo. 1998-461, aff’d., rev’d. on a different issue, and rem’d., 285 F.3d 1210 (9th Cir., 2002), where the IRS alternatively determined that either the 40 percent accuracy-related penalty attributable to a gross valuation misstatement under I.R.C. § 6662(h) or the 20 percent accuracy-related penalty attributable to negligence was applicable.
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)(1). Negligence also includes the failure to do what a reasonable and ordinarily prudent person would do under the same circumstances. See Marcello v. Commissioner, 380 F.2d 499 (5th Cir. 1967), aff’g 43 T.C. 168 (1964). 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 to a reasonable and prudent person to be “too good to be true” under the circumstances. The accuracy-related penalty attributable to negligence may be applicable if the taxpayer failed to make a reasonable attempt to evaluate the redemption BOB transaction properly.
2. Substantial Understatement of Income Tax
A substantial understatement of income tax exists for a taxable year if the amount of the understatement exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000 ($10,000 if the taxpayer is a corporation other than an S corporation or personal holding company). I.R.C. § 6662(d)(1). An understatement is the excess of the amount of the tax required to be shown on the return for the taxable year, over the amount of tax imposed which is shown on the return, reduced by any rebate. I.R.C. § 6662(d)(2)(A). Understatements are generally reduced by the portion of the understatement attributable to: (1) The tax treatment of items for which there was substantial authority for the treatment, and (2) any item if the relevant facts affecting the item’s tax treatment were adequately disclosed in the return or an attached statement and there is a reasonable basis for the taxpayer’s tax treatment of the item. I.R.C. § 6662(d)(2)(B).
In the case of items of taxpayers, other than corporations, attributable to tax shelters, exception (2) above does not apply and exception (1) applies only if the taxpayer also 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). In the case of items of corporate taxpayers attributable to tax shelters, neither exception (1) nor (2) above applies. 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, the accuracy-related penalty applies to the underpayment attributable to the understatement unless the reasonable cause exception applies. See Treas. Reg. § 1.6664-4(f) for special rules relating to the definition of reasonable cause in the case of a tax shelter item of a corporation.
In this case, the transaction fits within the definition of a tax shelter.12 Thus, no reduction in the understatement will be available for the shareholder unless there was substantial authority for the tax treatment of the item and the taxpayer reasonably believed that it was more likely than not the proper treatment. The substantial authority standard is an objective standard that requires an application of the law to relevant facts. Treas. Reg. § 1.6662-4(d)(2). 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. Treas. Reg. § 1.6662-4(d)(3)(i). 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). Conclusions reached in legal opinions or opinions rendered by tax professionals are not authority for purposes of the substantial authority standard. Treas. Reg. § 1.6662-4(d)(3)(iii). The authorities underlying such expressions of opinion where applicable to the facts of a particular case, however, may give rise to substantial authority. Id. For further discussion of how to analyze whether there is substantial authority see Treas. Reg. § 1.6662-4(d)(3)(ii).
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 the taxpayer analyzes the pertinent facts and authorities and, based on his or her independent analysis, reasonably concludes in good faith, that there is a greater than 50 percent chance that the tax treatment of the item will be upheld if challenged by the Service. Treas. Reg. § 1.6662-4(g)(4)(A). Alternatively, 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 the taxpayer relies in good faith on the opinion of a professional tax advisor. Treas. Reg. § 1.6662-4(g)(4)(B). The opinion must clearly state that, based on the advisor’s analysis of the facts and authorities, the advisor concludes that there is a greater than 50 percent chance that the tax treatment will be upheld if the Service challenged the position. Id.
3. Valuation misstatement
The Service may assert the accuracy-related penalty attributable to a substantial valuation misstatement against the portion of the underpayment exceeding $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. See I.R.C. § 6662(e)(1)(A). If the actual value or adjusted basis of any property is 400 percent or more of the amount reported on the taxpayer’s return, the valuation misstatement constitutes a "gross valuation misstatement." Section 6662(h)(2)(A). If there is a gross valuation misstatement, then the 20 percent penalty under § 6662(a) is increased to 40 percent. Section 6662(h)(1).
With respect to a redemption BOB transaction, the “property” claimed on the return for the purpose of § 6662(e) is either the partnership interest or the partnership’s asset(s) with the inflated basis. If the facts establish that the adjusted basis of the partnership interest or the asset is 200 percent or more of the correct amount, then there is a substantial valuation misstatement and the 20 percent penalty should be asserted. If the facts establish that the adjusted basis of the partnership interest or the asset is 400 percent or more of the correct amount, then there is a gross valuation misstatement and the 40 percent penalty should be asserted.
B. The Reasonable Cause Exception
The accuracy-related penalty does not apply with respect to any portion of an underpayment with respect to which it is shown that there was reasonable cause and that the taxpayer acted in good faith. I.R.C. § 6664(c)(1). The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances. Treas. Reg. § 1.6664-4(b)(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, and the sophistication of the taxpayer must be developed to determine whether there was reasonable cause and good faith. Generally, the most important factor is the extent of the taxpayer’s effort to assess their proper tax liability. Id. See also Larson v. Commissioner, T.C. Memo. 2002-295.
Reliance on the advice of a professional tax advisor does not necessarily demonstrate reasonable cause and good faith. Treas. Reg. § 1.6664-4(c). Reliance on professional advice constitutes reasonable cause and good faith only if, under all the circumstances, the reliance was reasonable and the taxpayer acted in good faith. Treas. Reg. § 1.6664-4(b)(1). 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, if the taxpayer proves by a preponderance of the evidence that the taxpayer meets each requirement of the following three-prong test: (1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment. Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff'd, 299 F.3d 221 (3d Cir. 2002). In determining whether a taxpayer has reasonably relied on professional tax advice as to the tax treatment of an item, all facts and circumstances must be taken into account. § 1.6664-4(c)(1).
The advice must be based upon how the law relates to the pertinent facts and circumstances. For example, the advice must take into account the taxpayer’s purpose (and the relative weight of those purposes) for entering into a transaction and for structuring a transaction in a particular manner. A taxpayer will not be considered to have reasonably relied in good faith on professional tax advice if the taxpayer fails to disclose a fact it knows, or should know, to be relevant to the proper tax treatment of an item. I.R.C. § 1.6664-4(c)(1)(i). The same facts relevant to the substantive issues will bear on the penalty, including the taxpayer’s reasons for entering into the redemption BOB transaction.
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 that 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. § 1.6664-4(c)(1)(i). Accordingly, examiners should evaluate the accuracy of critical assumptions contained in any opinion letter.
In any tax shelter transaction, the taxpayer has a duty to fully investigate all aspects of the transaction before proceeding. The taxpayer cannot simply rely on statements by another person, such as a promoter. See Novinger v. Commissioner, T.C. Memo. 1991-289. Moreover, if the tax advisor is not versed in the details of the transaction, mere reliance on the tax advisor does not suffice. See Addington v. United States, 205 F.3d 54 (2d Cir. 2000); Freytag v. Commissioner, 89T.C. 849 (1987), aff’d, 904 F.2d 1011 (5th Cir. 1990); Goldman v. Commissioner, 39 F.3d 402 (2d Cir. 1994); and Collins v. Commissioner, 857F.2d 1383 (9th Cir. 1988).
Generally, if a taxpayer is unwilling to produce a copy of its opinion letter, the taxpayer should not be relieved from penalty consideration. Moreover, an opinion letter prepared by a promoter should not be accorded significant weight. See Neonatalogy, 299 F.3d 221 (while good faith reliance on professional advice may establish reasonable cause, “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.”). If a taxpayer did not obtain a legal opinion from anyone other than the promoter in connection with its redemption BOB transaction, the taxpayer’s reliance on the legal opinion may not have been reasonable. In addition, if the taxpayer did not receive the opinion letter until after the return was filed, it could not have reasonably relied on the opinion and thus, should not be relieved of penalties.
1 This doctrine is also referred to by the courts as the “sham transaction” or “sham in substance” doctrine. For purposes of this document, the doctrine is referred to as the “economic substance”
2 The appropriate inquiry is not whether the taxpayer made a profit but whether there was an objective reasonable possibility that the taxpayer could earn a pre-tax profit from the transaction.
3 In assessing the role of profit in determining whether a transaction has economic substance, the Third Circuit has held, based on Sheldon v. Commissioner that “a prospect of a nominal, incidental pre-tax profit which would not support a finding that the transaction was designed to serve a nontax profit motive.” ACM, 157 F.3d 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 832 (2d Cir. 1990) (citing §1.183-2(a) (1990)).
4 See Goldstein v. Commissioner, 364, F.2d 734 (2d Cir. 1966); Sacks v. Commissioner, 69 F.3d 82 (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).
5 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; Salina Partnership v. Commissioner, T.C. Memo 2000-352 (2000); CMA Consolidated, Inc. v. Commissioner, T.C. Memo. 2005-16 (2005).
6 See Rose v. Commissioner, 868 F.2d 851; Kirchman v. Commissioner, 862 F.2d 1486 (11th Cir. 1989); Casebeer v. Commissioner, 909 F.2d 1360; Salina Partnership v. Commissioner, T.C. Memo 2000-352; Nicole Rose Corp. v. Commissioner, 117 TC 328 (2001).
7 See IES Industries Inc. v. Commissioner, 253 F.3d 350, 355 - 56 (8th Cir. 2001).
8 See Rose v. Commissioner, 868 F.2d 851; Kirchman v. Commissioner, 862 F.2d 1486; 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 at 356.
9 See Pasternak v. Commissioner, 990 F.2d 893.
10 Section 6662 was amended by Section 819 of the American Jobs Creation Act of 2004, P.L. 108-357; however, those amendments are effective for tax years ending after October 22, 2004, so they might not apply to every case.
11 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).
12 The definition of tax shelter includes, among other things, any plan or arrangement a significant purpose of which is the avoidance or evasion of Federal income tax. I.R.C. § 6662(d)(2)(C)(iii).
Index for Coordinated Issue Papers - LMSB