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Timestamp: 2019-04-21 20:35:25+00:00

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In recent years the Treasury Department and the Internal Revenue Service have often sought additional statutory and regulatory authority to deal with the growth of corporate tax shelters. In part, government officials have claimed that the proliferation of tax schemes occurs too quickly for the IRS and Treasury to respond. Compounding the problem, tax officials often do not respond adequately to those tax avoidance transactions they know about and have the power to stop. This article will focus on the ongoing attacks by the IRS and Treasury on lease strip transactions. The problems these transactions created and the inadequacy of the IRS's response demonstrates that tax officials need to devote more attention to the most efficient use of the authority they currently possess.
Lease strip transactions were done over a number of years and were most noteworthy for their simplicity. The transactions relied on the historic tax accounting convention that requires a lessor to take into income prepaid rent in the year received.(1) Lease strip transactions intentionally accelerated income by means of the receipt of prepaid rent or the assignment by the property owner of the right to receive future rent payments. The recipient of the accelerated income was not subject to current taxation (by reason of foreign status, tax exempt status or net operating loss carry forwards). Such a party is sometimes referred to as a "tax-neutral party."
Following the acceleration of the rental income, the property was transferred to a party which was subject to tax. The transfer was done in a way that carried over the tax basis of the property and thereby enabled the transferee to utilize the resulting tax benefits (such as future depreciation), purportedly without the obligation to take into account the offsetting rental income previously received by the prior property owner.
The transfers were typically structured in one of two ways. In some cases the property was transferred to a corporation for preferred stock in a Search7RH351 exchange, while the taxable party to the transaction would transfer cash or property for common stock. In other cases, the transaction was structured by the formation of a partnership to hold the property. The prepaid rent was allocated, during the period received, to the partner who was a tax-neutral party. Subsequently, the tax-neutral party would sell its partnership interest (because no Search7RH754 election would be in place, the basis of the property owned by the partnership would remain high). Consequently, the only partners remaining during the years when the deductions occurred were the taxable partners.
Tax officials discovered the widespread use of lease strip transactions over four years ago. In Notice 95-53,(2) the IRS explained that it "understands that certain persons have entered into, or may be considering, multiple- party transactions intended to allow one party to realize rental or other income from property or service contracts and to allow another party to report deductions related to that income...." After describing typical forms of lease strip transactions, the Notice provided that "the Service believes ... that the claimed tax treatment improperly separates income from related deductions and that stripping transactions generally do not produce the tax consequences desired by the parties."
The Service announced its intention to issue regulations under Internal Revenue Code Search7RH7701(l), which authorizes the Secretary to prescribe regulations to recharacterize multiple-party financing arrangements. The regulations would "be effective with respect to stripping transactions any significant element of which is entered into or undertaken on or after October 13, 1995."
The Service also announced that it would challenge the claimed tax treatment of stripping transactions. The Notice primarily described the Service's intent to exercise its authority under Search7RH482. The Notice observed that Search7RH482 permits reallocations between "two or more organizations owned or controlled directly or indirectly by the same interests...." The Notice claimed that, "[f]or purposes of Search7RH482, the parties in these stripping transactions are 'controlled ... by the same interests' because, among other factors, they act in concert with the common goal of arbitrarily shifting income or deductions between the transferor and the transferee."
Finally, the Service warned that, depending upon the facts of a particular transaction the Service may also determine to apply (i) Search7RHSearch7RH269, 382, 446(b), 701 or 704, (ii) authorities that recharacterize certain assignments or accelerations of income as financings, (iii) assignment of income principles, (iv) the business-purpose doctrine or (v) the substance-over-form doctrines.
It is likely that the issuance of the Notice and the proposed regulations eliminated any significant future use of lease strips in their original form. Nonetheless, the Service remained obligated to address the transactions which were completed before the issuance of the Notice. In this regard, over the past several months, the IRS has issued several Field Service Advice memoranda(6) (FSAs) in connection with audits of lease stripping transactions.
Due to redactions required before publication, the terms of the transactions which are the subject of the FSAs cannot be determined. From the discussions in the FSAs, it appears that many of the transactions were structured by third party "promoters," all of the significant transactions, or steps of the transactions, were completed in a relatively short time frame (such as a few months), and the arrangements, taken together, did not provide for meaningful economic risks or benefits to any of the parties aside from the purported tax benefits (and the fees to the promoters).
A few of the FSAs are lengthy and set forth detailed explanations of a number of alternative theories. Some, however, rely solely on Search7RH482 which, for reasons discussed below, is an extremely weak (and most surprising) argument. Before addressing the Search7RH482 issues, the other theories proffered by the IRS will be reviewed.
[T]he Tax Court said that the taxpayer desired to take advantage of a loss that was not economically inherent in the object of the sale, but which the taxpayer created artificially through the manipulation and abuse of the tax laws. The Tax Court also stated that the tax law requires that the intended transactions have economic substance separate and distinct from economic benefit achieved solely by tax reduction.... The opinion demonstrates that the Tax Court will disregard a series of otherwise legitimate transactions, where the Service is able to show that the facts when viewed as a whole have no economic substance.
ASA, a "sham partner/partnership" case, involved a transaction which purported to take advantage of an accounting rule (the allocation of tax basis to an installment sale for contingent payments under the Search7RH453 regulations) to structure a transaction under which gain was accelerated and allocated to a tax-neutral party, while the subsequent offsetting loss was allocated and utilized by a party subject to income tax. Analogies to ACM, ASA and similar cases before the courts are likely to be compelling in a number of lease stripping cases due to substantial similarities in structure.
District Counsel asserts that the facts developed to date support a finding that the transactions are sham transactions in that: ... (4) [a]t no time is the U.S. taxpayer exposed to any significant risk of economic loss as a result of the transaction, by the same token, at no time did the US taxpayer have a significant opportunity to earn an economic profit as a result of the transaction; and (5) the US taxpayer does not provide any detailed explanation of its tax-independent motivation for entering into the transaction, here, a electric and gas utility entering into a handful of computer leasing transactions.
The FSA also acknowledged that the "Service must show that the taxpayer was motivated by no substantial business purpose other than obtaining tax benefits and that the transaction did not have economic substance.... Courts will respect the taxpayer's characterization of the transactions if there is a bona fide transaction with economic substance...."
It is likely that the IRS's ability to challenge successfully taxpayer claims of economic consequences will be more difficult in the lease strip cases than in the installment note cases. The transactions structured with installment notes involved financial instruments where, under many circumstances, the terms of the transactions could be and apparently were set before the transaction occurred. In lease strip cases, the acquirer of the property may have a material economic interest in the residual value of the property acquired and, while the tax benefits may be the overwhelming motivation for all of these transactions, the factual showings needed to support a sham transaction analysis may be difficult to make. Unlike the installment note transactions, there are decades of cases involving taxpayers who engaged in leases of property (including taxpayers whose primary business did not involve leasing) where the overwhelming motivation was tax benefits but where the transactions were structured so that the transactions had sufficient economic features to withstand a sham argument. It is likely that the parties who structured many of the lease strips would have endeavored to incorporate a modicum of economic substance into the transactions.
In CCA 199936012 and FSA 199930004, the Service raised the possibility in some situations of utilizing Code Search7RH269(a), which authorizes the Service to disallow deductions where one or more persons acquire control of a corporation for the principal purpose of evading or avoiding Federal income tax. In most of these cases, however, there is no acquisition of control of a corporation in connection with the transaction.
FSA 199930004 included an intriguing argument under which the sale of future rents by the tax-neutral party may be recharacterized as a financing rather than a sale. The result of this argument, if successful, is that the transferee of the property would be treated as the recipient of the rental payments as made (in a manner similar to that set forth in the Search7RH7701(l) proposed regulations discussed above).
Most of the space in each of the lease strip FSAs and the CCA is devoted to the use of Search7RH482 as the means of eliminating the income shifting of these transactions. Although, as noted earlier, two of the FSAs concluded that the sham theory is the "strongest argument" and the other FSAs emphasized that the use of Search7RH482 does not preclude the IRS from simultaneously arguing that the transactions are shams, the IRS views Search7RH482 as the primary vehicle for challenging lease strips.
A substantial portion of the discussion of Search7RH482 simply addresses the issue of shifting of income. This discussion is far longer than needed since no one would seriously dispute the claim that lease strips are designed to shift income from taxable to tax-neutral parties.
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.
In most of the lease strip FSAs, the IRS has acknowledged that there is no common ownership among the participants to the transaction. The question, as phrased in the FSAs, is whether any of the participants are controlled by the same interests and may be said to be members of the same controlled group.
FSA 199930004 quoted from the regulation the phrase "[i]t is the reality of control that is decisive," then continued by stating "rather than a rigid focus on record ownership of the entities at issue", citing for the latter position Isse Koch & Company, Inc.(16) That case, however, involved two corporations owned 100% and 84% by a single individual. The other cases cited in the FSA for this position are similarly distinguishable. For example, at issue in Pauline Ach v. Comr.(17) was whether a single corporation, owned entirely by one individual, was in actuality two corporations, such that the income of the first corporation could not be offset by the losses of the second. In Granada Industries, Inc. v. Comr.,(18) the question was whether two corporations, each owned in identical measure by four family groups, were "commonly controlled." And Charles Town, Inc. v. Comr.(19) presented the issue of whether two brothers "commonly controlled" if they owned all the voting stock of one and promoted and officered the other.(20) None of these cases support the Service's interpretation, that the "reality of control" encompasses anything other than overlapping record ownership or management (or a combination of the two).
The FSAs also relied on language from the 1968 Regs. Search7RH1.482-1(a)(3) that "a presumption of control arises if income or deductions have been arbitrarily shifted."(21) For example, the FSAs asserted that the court in Dallas Ceramic Co. v. Comr.(22) "held" that the Service properly argued, based on the regulations, that proof of income-shifting between two corporations establishes a presumption of common control. In fact, however, the Dallas Ceramic court never had a chance to "hold" on that issue because it determined that there was no proof of income-shifting to begin with. Further, the Service argued that DHL Corp. v. Comr.(23) supports the position taken in the regulations that "control" may exist as a result of actions of "two or more taxpayers acting in concert with a common goal or purpose."(24) In DHL, however, the "two entities," DHL and DHL International, were found to be under "common control" due to the fact that certain majority DHL shareholders were also directors of DHL International and had veto power over critical DHL International decisions.(25) The FSAs included a "but see" cite to two cases that "contradict" the Service's position, Lake Erie & Pittsburgh Railway Co. v. Comr.(26) and B. Forman v. Comr.(27) Although the FSAs did not discuss the facts of these cases, they demonstrate how far the current IRS position is from existing case law. In both Lake Erie and B. Forman, a corporation was owned 50% by each of two unrelated corporations and the shareholders were arguing that the split ownership was a sufficient block on control. In those cases, the IRS argued, with only marginal success (i.e., the Second Circuit agreed with the IRS while the Tax Court disagreed), that the two 50% owners could be found to have acted in concert sufficient to warrant the exercise of Search7RH482.
The Service's definitional problem continues with its recognition that its power to make adjustments under Search7RH482 is limited to controlled taxpayers, which is defined under the regulations to mean "taxpayers owned or controlled by the same interests." The FSAs conceded that the phrase "same interests" is not defined in the regulations, but claimed that case law provides guidance. The cases cited in this discussion, however, similarly fail to provide meaningful support for the Service's position. For example, in support of the proposition that "different persons with the common goal or purpose for artificially shifting income can constitute the same interests for purposes of section 469," the FSAs cited South Texas Rice Warehouse Co. v. Comr.,(28) in which the "different persons," a corporation and a partnership, were each owned by four families, each family possessing a one-fourth interest in the entities.(29) In support of the proposition that the term "same interests" includes more than "the same persons" or "the same individuals," the FSAs cited Brittingham v. Comr.,(30) in which the Court actually found that the "same interests" standard was not met when a majority ownership interest in two entities was held by two brothers and their mother.
Although the FSAs did not acknowledge how much the Service is attempting to expand the application of Search7RH482, it is instructive to compare the Service's analysis of the "traditional" lease strip in FSA 199936007(31) with that set forth in the above-cited FSAs. FSA 199936007 involved the contribution by a US corporation of "burned-out" leveraged leases (from which all the depreciation deductions had been recognized by the US corporation) to an LLC with a tax-neutral foreign member which was then specially allocated the leases' remaining income stream. The Service, addressing the common control between the U.S. corporation and the new partnership, relied on Rooney v. U.S.(32) in support of the proposition that "section 482 was 'designed [by Congress] to prevent the avoidance of tax or the distortion of income by the shifting of profits from one business to another.'"(33) Rooney involved the application of Search7RH482 to the transfer by a husband and wife of farm assets (including unharvested crops) to a corporation, in exchange for stock in the corporation, in a Search7RH351 exchange. The couple claimed the losses incurred in crop planting, whereas the harvest profits were realized by their corporation. The Rooney court, referring to the relationship between the couple and their corporation, noted that Congress's design "is effected if the taxpayers are commonly controlled when they deal with each other...." In Rooney, there is no indication that the terms "controlled" and "same interests" applies to unrelated parties to a transaction.
Aside from the lack of support in the case authorities, the major defect in the Service's interpretation of Search7RH482 as a basis for attacks on stripping transactions and related transactions is that it would render meaningless much basic tax planning and would eliminate the need for many provisions of the Code.
Much of what all tax professionals consider basic planning technique is to structure transactions in such a way that the tax benefits from the transaction be shifted from parties that do not need them to parties that can use them, with the former compensated economically for the value of the tax benefits forsaken. For example, the entire business of leasing equipment involves the shift of tax deductions attributable to accelerated depreciation from the users of the equipment (who often have insufficient taxable income to utilize the deductions) to lessors who need tax losses. The equipment users obtain a lower cost for the equipment precisely because the lessors are willing to accept a lower economic yield in exchange for a higher return after factoring in tax benefits. Similarly, many real estate partnerships contain allocations of deductions between the partners that is intended to shift tax benefits in exchange for a larger economic interest.
Over time, Treasury officials or members of Congress periodically determine that certain transactions result in excessive shifting of tax benefits and must be limited by amendments to the Code or regulations. Thus, when leases to tax-exempt entities became too prevalent, Search7RH168(g) was enacted; when partnership allocations of income to tax-exempt partners and partners with net operating losses were considered unreasonable, Treasury responded with Search7RH514(c)(9)(E), regulations on the "substantial economic effect" test of Search7RH704(b) and Regs. Search7RH1.701-2 on abusive partnerships. None of these changes would have been needed if the Service could simply challenge, under Search7RH482, any transaction which in its view mismatched or misallocated income or deductions between otherwise unrelated parties.
Tax officials, in their frustration with dealing with the myriad of transactions, both real and artificial, that tax professionals are able to devise, desperately search for the magic spell that can be used as a defense against the dark forces of tax shelters.(34) Section 482 appears almost irresistible in that, if the Service's position were upheld, it could be used anytime and anyplace without fail. However, not even the Service can be trusted with that much power.
The NYSBA Report pointed out that certain cases, such as Hydrometals Inc. v. Comr.(36) and Mapco, Inc. v. United States,(37) may enable the Service to recharacterize as a loan income purportedly accelerated by way of an assignment. The NYSBA Report also suggested that other Tax Court cases created possible analytical frameworks that serve to match income and deductions, discussing I.J. Wagner,(38) Alstores,(39) Steinway(40) and Hyde Park Realty.(41) These cases would effectively eliminate the tax benefits of lease strips directly.
Since the FSAs did not discuss this approach of challenging the accounting underpinnings of the lease strip transactions, it is not clear whether the Service concluded that such an approach would not be successful or would possibly create collateral problems. Nevertheless, the Service, by foregoing a more general accounting approach in favor of a Search7RH482 assault, has taken an enormous gamble. It is almost certain that the Service's claim for unlimited power under Search7RH482 will not prevail in court. In that event, the Service will be unable to succeed in overturning lease strips except in those cases where the facts are so egregious that the entire transaction can be characterized as a sham.
1. See Regs. Search7RH1.61-8(b). All section references herein are to the Internal Revenue Code, as amended, and to the regulations thereunder, unless otherwise stated.
5. See also Prop. Regs. Search7RH1.7701(l)-2(n).
6. Field Service Advice memoranda (FSAs) are prepared in the national office of the IRS Chief Counsel, and provide nonbinding guidance to IRS agents, attorneys, and appeals officers. FSAs are used by these personnel as a tool to help them evaluate substantive and procedural legal issues, and to determine litigation prospects with respect to those issues. See Search7RH6110(i)(1)(A),(B).
9. T.C. Memo 1997-115, aff'd in part, rev'd in part, and rem'd, 157 F.3d 231 (3d Cir. 1998).
11. It is possible that the partnership anti-abuse regulation, Regs. Search7RH1.701-2, may also be available for transactions structured in this manner. The regulation is effective for partnership transactions entered into after May 12, 1994. Significantly, the regulation was not cited in the FSAs, which may mean the transactions involving partnerships pre-date the effective date of Regs. Search7RH1.701-2.
13. Subsequent to the transactions addressed in the FSAs and CCA, Search7RH351(g) was enacted to preclude structuring of Search7RH351 transactions with nonqualified preferred stock. See P.L. 105-34, Search7RH1014(a) (generally effective June 9, 1997).
15. Many of the Service's arguments were previously skewered in Warner, "Control, Causality and Section 482," 28 Tax Mgmt. Int. J., 403 (July 9, 1999).
16. 1 BTA 624 (1925). This case concerned the meaning of the term "control" under Search7RH240(b)(2) of the Revenue Act of 1918.
17. 358 F.2d 342 (6th Cir. 1964), aff'g 42 T.C. 114.
18. 202 F.2d 873 (5th Cir. 1953), aff'g 17 T.C. 231 (1951).
19. 372 F.2d 415 (4th Cir. 1967), aff'g T.C. Memo 1966-15.
20. Charles Town, Inc. had a total of three officers, two of whom were the brothers who owned all the voting stock of the other corporation. The brothers' control over Charles Town, Inc. was reinforced by agreements which gave Charles Town's officers decision-making authority with respect to all major decisions.
21. This phrase is also included in current Regs. Search7RH1.482-1(i)(4).
22. 598 F.2d 1382 (5th Cir. 1979), rev'g 74-2 USTC 9830 (N.D. Tex. 1975).
25. DHL Corp. v. Comr., 76 TCM at 1128.
26. 5 T.C. 558 (1945), acq., 1945 C.B. 5, acq. withdrawn and nonacq. substituted therefor, Rev. Rul. 65-142, 1965-1 C.B. 223.
27. 54 T.C. 912 (1970), rev'd in relevant part, 453 F.2d 1144 (2d Cir. 1972), cert. denied, 407 U.S. 934 (1972), reh'g denied, 409 U.S. 899 (1972), nonacq., 1975-2 C.B. 3.
28. 366 F.2d 890 (5th Cir. 1966), aff'g 43 T.C. 540, 1965.
29. It should be noted, however, that within each family unit there was a varied division of stock and/or partnership interest among the family members.
30. 598 F.2d 1375 (5th Cir. 1979).
32. 307 F.2d 816 (9th Cir. 1962).
33. FSA 199936007, citing Rooney v. U.S., 307 F.2d at 683.
34. By rule, everything written in 1999 must contain at least one reference to the Harry Potter books.
35. Report on Announcement Regarding "Lease Stripping" Set Forth in IRS Notice 95-53, New York State Bar Association - Tax Section, Report No. 877, May 14, 1996, at p. 5 (hereinafter referred to as the "NYSBA Report").
36. T.C. Memo 1972-254, aff'd per curiam, 485 F.2d 1236 (5th Cir. 1973), cert. den., 416 U.S. 938 (1974).
37. 556 F.2d 1107 (Ct. Cl. 1977).
38. I.J. Wagner v. Comr., T.C. Memo 1974-42, rev'd 518 F.2d 655 (10th Cir. 1975).
39. Alstores Realty Corporation v. Comr., 46 T.C. 363 (1955).
40. Steinway & Sons v. Comr., 46 T.C. 375 (1955), acq., 1967-2 C.B. 3.
41. Hyde Park Realty, Inc. v. Comr., 20 T.C. 43 (1953).
42. NYSBA Report at 30.

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