Just as the Internal Revenue Service was becoming increasingly more aggressive in its settlement offers in tax shelter cases, and obtained a few additional weapons for its arsenal in the American Jobs Creation Act of 2004, a series of defeats on the litigation front may force the agency to reevaluate some aspects of its strategy.

While the IRS continues to score some significant judicial victories in the shelter area, when it is trying to push more taxpayers toward coming forward and settling, it is most helpful for it to have a solid record of judicial support behind it.

Black & Decker

The Black & Decker case has looked like trouble for the IRS for a while. In August, the U.S. District Court in Maryland denied an IRS motion for summary judgment. Now, in an opinion issued on Oct. 22, 2004, the same judge has ruled that the transactions entered into by Black & Decker had economic substance and could not be disregarded as a sham for tax purposes. The court granted summary judgment for the taxpayer. (2004-2 USTC ¶50,390.)

Black & Decker had realized significant capital gains from the sale of three of its businesses in 1998. Black & Decker then transferred $561 million in cash and $560 million in contingent employee health care claims to a new wholly owned subsidiary, and then sold the stock to an independent third party for $1 million. Black & Decker next asserted a basis in the stock of $561 million and claimed a $560 million loss to offset the capital gains from the other business sales.

While not questioning that the transaction may have been primarily tax-motivated, the court looked to whether the transaction had economic substance aside from the tax purposes. The court found that it did, because real assets and real liabilities had been transferred to an independent third party. A tax avoidance motive was not enough to disregard the transaction, because economic substance was also present.

Coltec Industries

In Coltec Industries Inc. (2004-2 USTC ¶50402), the U.S. Court of Federal Claims rejected the IRS's claim that a taxpayer's creation of a subsidiary to handle asbestos claims was a tax-motivated transaction. The court gave considerable weight to the testimony of the executives of the company that they were primarily motivated by trying to protect the company from contingent liabilities, rather than the tax benefits of the transaction.

The judge had led off the opinion by citing the Supreme Court for the observation that a taxpayer has a right to order its affairs so as to minimize taxes. The court also pointed out that, even though the economic substance present might not have stood up under some statutory proposals, Congress had not yet codified the economic substance doctrine, so it remained a matter for judicial interpretation.

The IRS has indicated that it will continue to attack contingent liability shelters as abusive corporate tax shelters.

TIFD III-E

In TIFD III-E (2004-2 USTC ¶50,401), sometimes referred to as Castle Harbour, a district court in Connecticut held that a commercial aircraft leasing partnership that included among its partners foreign, tax-neutral partners, was a valid partnership for tax purposes since it had economic substance. The IRS had argued that the partnership was a sham with no tax purpose, that the foreign, tax-neutral partners were really lenders, not partners, and that the allocation of 98 percent of the income to the foreign tax-neutral partners violated the "overall tax effect rule" under Code Sec. 704(b).

Although the structure of the partnership was fairly complex, the court found that the transaction was not a sham, possessing both a non-tax economic effect and a non-tax business motivation. The court found that the foreign, tax-neutral parties had real economic risk in the partnership. The court gave credence to testimony that the transactions were motivated to raise capital and to demonstrate to the markets the ability to raise capital on an aging fleet of aircraft.

The court then found that a partnership with economic substance should not be reclassified as a creditor/debtor relationship where the definition of a partnership under the code is extremely broad and easily met in this case. Finally, the court found that the income allocations need not match the partners' interests, and, if the income allocations are clear and unambiguous and are followed in practice, the "overall tax effect rule" of Code Sec. 704(b) is not violated.

Even though the court acknowledged that tax avoidance was one of the principal purposes for entering into the transaction, the transaction was nevertheless found to be an economically real transaction.

Implications for the IRS

Where do these cases leave the IRS? It appears clear that the agency can only go so far arguing lack of economic substance. Many courts seem willing to uphold transactions that are principally motivated by tax avoidance if there is a real shifting of risk and a transfer of real assets.

If the IRS wants to shut down categories of transactions, such as contingent liability shelters, even where economic substance is present, it may have to go to Congress to do so. Congress, has, however, seldom acted with the retroactivity necessary to catch the first shelter transactions.

The IRS also may be hurting itself with its selection of cases. It is always best to go to trial with the best facts. It has been suggested that the IRS settlement proposals are removing from the table the cases with the best facts from the government perspective, leaving them to litigate and develop case law based on cases with facts more favorable to the taxpayer.

Since one advantage that the government often has is determining exactly which cases it will pursue in court, better case selection for trial may result in more favorable government outcomes.

Taxpayers that infuse their tax-motivated transactions with real economic substance are going to get a very favorable hearing in the courts. The IRS has been most successful where the supposed substance infused into the transaction fell apart on a close examination of the net effect of the transactions in total.

These cases probably at most represent a stumble for the service, and are unlikely to significantly derail its overall pursuit of tax shelters.

George G. Jones, J.D., LL.M, is managing editor, and Mark A. Luscombe, J.D., LL.M, CPA, is principal analyst at CCH Tax and Accounting, a WoltersKluwer Co.

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