The Internal Revenue Service said it would add distressed-asset trust transactions to its list of tax avoidance transactions, signaling that such transactions need to be disclosed and may be subject to penalties.

DAT transactions occur, said the IRS, when a "tax-indifferent party" directly or indirectly contributes one or more distressed assets, such as a creditor's interest in debt, with a high basis and low fair market value to a trust or series of trusts and sub-trusts, and a U.S. taxpayer then acquires an interest in the trust or sub-trusts for the purpose of shifting a built-in loss from the tax-indifferent party to the U.S. taxpayer that has not incurred the economic loss.

Taxpayers have used partnerships improperly in the past to engage in variations of distressed-asset transactions, the IRS and the Treasury Department noted. Several provisions in the American Jobs Creation Act of 2004 made it more difficult to implement these transactions, however. The revisions generally required that a built-in loss could be taken into account only by the contributing partner and not by other partners, and made the basis-adjustment rules mandatory in cases with a substantial basis reduction or substantial built-in loss.

The statutory changes under AJCA prevented taxpayers from shifting a built-in loss to a U.S. taxpayer through the use of a partnership. However, the IRS and the Treasury Department said that a variation of the distressed-asset transaction using a trust is now being promoted to get around the revisions made by AJCA.

As a result, the IRS has now issued Notice 2008-34, identifying the DAT variation as a listed transaction if it was entered into after Oct. 22, 2004. Failure to disclose the transaction may subject taxpayers to a penalty that applies to returns and statements due after that date. Some taxable entities may be subject to disclosure obligations that apply to "prohibited tax shelter transactions."

However, the IRS and the Treasury Department said they recognize that some taxpayers may have filed tax returns taking the position that they were entitled to the purported tax benefits of this type of transaction. Those taxpayers, they said, should take the appropriate corrective action and ensure that their transactions are disclosed properly.