t c memo united_states tax_court dimiter hristov and tzonka bakalova-hristov petitioners v commissioner of internal revenue respondent docket no filed date michael allen lampert for petitioners anne m craig for respondent memorandum findings_of_fact and opinion vasquez judge respondent determined that petitioners were liable for accuracy-related_penalties under sec_6662 of dollar_figure dollar_figure and dollar_figure for and respectively the sole issue for decision is whether petitioners have established a reasonable_cause and good_faith defense to the sec_6662 accuracy-related_penalties findings_of_fact some of the facts have been stipulated and are so found the stipulation of facts and the attached exhibits are incorporated herein by this reference petitioners resided in west palm beach florida when the petition was filed petitioners’ backgrounds petitioners immigrated to the united_states from bulgaria in both are medical doctors dr hristov was educated in bulgaria and that is where he received his medical training dr hristov spoke english before immigrating to the united_states and while in bulgaria he attended an english language high school dr hristov practices medicine through his wholly owned s_corporation dimiter b hristov m d p a from to enrolled_agent katherine fallon prepared petitioners’ form sec_1040 u s individual_income_tax_return as well as the forms 1120s u s income_tax return for an s_corporation for dr hristov’s s_corporation ms unless otherwise indicated all section references are to the internal_revenue_code in effect for the years in issue all amounts are rounded to the nearest dollar fallon considered petitioners to be honest clients because she believed they never wanted her to stretch the rules and always gave her all of the information that she requested adoption of the retirement plans in early petitioners began looking for a way to increase their tax- deductible contributions towards their retirement savings dr hristov learned that william alexander had established a pension_plan for a colleague that allowed the colleague to put away large amounts of money invest in real_estate to earn double or triple the returns and get a portion of the pension fund back shortly thereafter dr hristov and mr alexander spoke on the phone about possible pension plans for petitioners mr alexander told petitioners that they could make larger tax deductible contributions and reduce their tax_liabilities by using a sec_419 welfare_benefit_plan plan and a defined_benefit_plan collectively plans mr alexander provided petitioners with references and a business card that read pension before petitioners saved for their retirement by making contributions to a simplified_employee_pension sep plan petitioners would contribute the maximum amount to the sep plan each year we refer to the plans as a plan and a defined_benefit_plan for the sake of convenience and without attaching any legal significance to the titles administration and tax planning dr hristov spoke with several of the references and they were all happy with mr alexander mr alexander also provided petitioners with a copy of a letter from the internal_revenue_service irs assigning him a centralized authorization file number which authorized him to act on behalf of a taxpayer mr alexander told petitioners that he had successfully represented clients during audit and he showed petitioners letters from the irs regarding successful audits at dr hristov’s request ms fallon met with mr alexander and petitioners at the meeting mr alexander explained the deductions in general but did not discuss the plans themselves or the details regarding the plans ms fallon informed petitioners that her experience with pension plans was limited to sep plans and that she was unfamiliar with and had never worked with plans or defined benefit plans ms fallon did not tell dr hristov that he needed to retain an independent adviser regarding the plans but she did tell him that he should continue to look into the plans petitioners decided to hire mr alexander to create and administer the plans on date mr alexander sent petitioners a dollar_figure invoice for the idea of the plan plan design and plan documents in addition to the setup fee mr alexander charged an annual fee of of the total contributions petitioners made to the plans the overall strategy was for petitioners to contribute money each year to a plan and a defined_benefit_plan with respect to petitioners’ plan contributions they would write a check to lyons pensions inc in the amount of their plan contribution mr alexander would then deposit dollar_figure of the contribution as an annuity take his fee and return the remaining money to petitioners as a loan from lyons pensions mr alexander told dr hristov that the loan would never have to be repaid because the plan would eventually close and that petitioners were free to invest the returned money however they chose for their defined_benefit_plan contributions mr alexander instructed petitioners to make a yearly deposit to a brokerage account petitioners opened a brokerage account at oppenheimer asset management oppenheimer when they opened the see infra pp for discussion of how mr alexander received his of the contributions to plans the record does not establish how mr alexander received his of the contributions to the defined_benefit_plan mr alexander suggested petitioners contribute between dollar_figure and dollar_figure to the plans with dollar_figurek of net_income i would probably put dollar_figurek to dollar_figurek into pension plans because this would get your income_tax down by about dollar_figure account petitioners gave the defined_benefit_plan documents to oppenheimer oppenheimer did not give petitioners an opinion that the plan was valid petitioners’ tax returns for and ms fallon prepared petitioners’ form sec_1040 and dr hristov’s s corporation’s forms 1120s each year petitioners would tell ms fallon the amounts they contributed to the plan and defined_benefit_plan petitioners did not provide any documentation supporting the deductions and ms fallon did not ask for it defined_benefit_plan contributions and deductions for the defined_benefit_plan mr alexander recommended that petitioners deposit dollar_figure per year into the oppenheimer account in dr hristov contributed dollar_figure and deducted dollar_figure for pension profit-sharing etc plans expense on his s corporation’s form_1120s dr hristov also deducted dollar_figure for pension profit-sharing etc plans expense on his s corporation’s and forms 1120s the specific deductions and the amounts of the deductions for each year are discussed below the record does not address whether dr hristov contributed dollar_figure to the defined_benefit_plan in and plan contributions and deductions on date dr hristov wrote a dollar_figure check to lyons pensions for his contribution to the plan mr alexander deposited dollar_figure into an annuity with great american insurance and took his fee in early date petitioners received dollar_figure from lyons pensions dr hristov’s s_corporation claimed a dollar_figure deduction on line employee benefit programs expense on its form_1120s petitioners did not report the dollar_figure they had received from lyons pensions on either their form_1040 or dr hristov’s s corporation’s form_1120s ms fallon did not become aware that petitioners had received money from lyons pensions in until petitioners’ returns were audited in late on date dr hristov wrote a check for dollar_figure to lyons pensions for hi sec_419 plan contribution a few weeks later dr hristov received a check for dollar_figure from lyons pensions mr alexander did not make a contribution to the annuity dr hristov questioned mr alexander about the annuity and mr alexander explained that he had intended to make the deposit but had not while preparing petitioners’ tax_return ms fallon learned from dr hristov that he had received dollar_figure from lyons pensions in ms fallon contacted mr alexander about the returned money and he told her that it was a rollover_distribution on date mr alexander sent the following fax to ms fallon report dollar_figurek paid back to dimiter that he rolled over to other pension dollar_figure here’s the for ‘05 that i filed not filed for nor the form 1099-r distributions from pensions annuities retirement or profit-sharing_plans iras insurance contracts etc issued by lyons pensions showed a dollar_figure gross distribution and a dollar_figure taxable_amount mr alexander also faxed a sample form_1040 showing ms fallon how to report the distribution the sample showed dollar_figure of pension and annuities income and zero taxable pension and annuities income petitioners’ federal_income_tax return shows dollar_figure of pension and annuities income and zero taxable pension and annuities income dr hristov’s s_corporation claimed a deduction of dollar_figure for an employee benefit programs expense on its form_1120s dr hristov did not tell ms fallon that the dollar_figure was used to purchase real_estate the record does not explain why the form 1099-r showed a dollar_figure gross distribution when petitioners received dollar_figure from lyons pensions on date dr hristov wrote a check to nb services10 for dollar_figure in date dr hristov received dollar_figure from nb services again dr hristov noticed that mr alexander did not contribute dollar_figure to the annuity but he decided to not pursue it because he remained able to claim the full tax deduction dr hristov’s s_corporation claimed a deduction of dollar_figure for an employee benefit programs expense on its form_1120s petitioners did not report the dollar_figure they received from nb services on either their form_1040 or dr hristov’s s corporation’s form_1120s ms fallon did not become aware that petitioners had received money from nb services in until petitioners’ returns were audited in late amended returns in addition to generating tax savings by adopting his retirement plans mr alexander told petitioners that they could receive a refund from the irs by amending their form_1040 and dr hristov’s s corporation’ sec_2002 form_1120s mr alexander explained that petitioners could get a refund by recharacterizing large purchases they made between date and date as contributions to a pension_plan for the tax_year for mr alexander instructed dr hristov to make the check payable to nb services instead of lyons pensions example petitioners had purchased a rental triplex for dollar_figure in and mr alexander told them that they could arrange for that amount to be classified as a pension_plan expense for additionally mr alexander instructed petitioners to find checks for down payments on property checks to people investment checks big checks to buy certain things like antique furniture written between date and date petitioners gave checks to mr alexander in date in a date letter mr alexander explained to dr hristov that his accounting partner kathy medina was amending the tax_return for dr hristov’s s_corporation to include a dollar_figure pension contribution deduction thus decreasing his corporate profit from dollar_figure to dollar_figure mr alexander stated that this decrease in corporate profit would flow through to petitioners’ federal_income_tax return and would result in a dollar_figure refund to petitioners to come up with the contributions mr alexander told dr hristov they could use the old checks that they had discussed in a date letter mr alexander discussed the refund process stating that i also think this amendment will move through easily without irs even asking for copies of the checks because we are amending a k-1 but if i am wrong and irs asks for checks we can come up with check s mr alexander assured petitioners about the refund telling them that we are just asking for a refund so the worse thing that could happen is to be denied but typically i get the refund although sometimes it takes a while on date the irs received the amended form_1120s for dr hristov’s s_corporation for on date the irs received an amended form_1040 for dr hristov for the return showed dr hristov’s filing_status as singledollar_figure the amended_return reflected the decrease in dr hristov’s s corporation’s gross_income thereby decreasing petitioners’ tax_liability dr hristov requested a dollar_figure refund even though the return was in only dr hristov’s name both dr hristov and dr bakalova-hristov signed it the irs did not issue a refund based on this amended_return on date the irs received a second amended form_1040 for this time with dr hristov and dr bakalova-hristov filing jointly this amended_return also reflected the decrease in dr hristov’s s corporation’s gross_income thereby decreasing petitioners’ tax_liability petitioners requested a refund of dollar_figure and on date the irs issued the requested refund plus dollar_figure of interest petitioners were married during and their filing_status on the original return for was married_filing_jointly mr alexander and ms medina prepared petitioners’ amended returns and petitioners did not mention any of this to ms fallon the amended form_1120s and the first amended form_1040 both list hal richard as the return preparer petitioners did not know hal richard and assumed he was an associate of mr alexanderdollar_figure mr alexander received of the refund as his fee for preparing the amended_return audit in late the irs began auditing petitioners’ returns the plans and the returns for dr hristov’s s_corporation for tax years and petitioners hired mr alexander to represent them during the audit mr alexander assured petitioners that the deductions would be allowed mr alexander also stated that he was an enrolled_agent which petitioners later found to be untrue during the audit dr hristov learned that mr alexander had never filed the required forms annual return report of employee_benefit_plan additionally at some point during the audit petitioners learned that mr alexander was not responding to the auditor’s requests for documents petitioners terminated in petitioners learned that mr richard died in and thus had not prepared their amended returns when dr hristov subsequently questioned mr alexander about mr richard mr alexander explained that it was a clerical_error and that petitioners did not need to be concerned their relationship with mr alexander in february or date petitioners then hired an enrolled_agent to represent them during the audit and hired a pension_plan administration firm to evaluate the defined_benefit_plan and to prepare the forms at the end of the audit petitioners agreed to a complete disallowance of all deductions for their plan contributions and defined_benefit_plan contributions for and petitioners agreed to increases in tax for and of dollar_figure dollar_figure and dollar_figure respectively petitioners also agreed to return the refund they had received as a result of amending their tax_return mr alexander’s correspondence mr alexander had extensive correspondence with dr hristov regarding the plans dr hristov’s concerns about the plans and mr alexander’s assurances that the plans were legal because the correspondence is relevant to whether petitioners had reasonable_cause and acted in good_faith we include several excerpts from these letters shortly after mr alexander and dr hristov were introduced mr alexander sent dr hristov a letter on date discussing the operation of the plans if i put dollar_figurek into the pension plans you would have no tax but obviously you would have to borrow a lot of money from the pension plans which my clients do as i promote this assets in the money purchase plan can be invested anywhere while i use fixed and variable annuities for the plan you really are not supposed to borrow money from the but i’m aggressive so i have my clients do this i am one of the best tax planners in the country primarily because i have worked with or of the sharpest and most aggressive cpas in the country i have seen how they basically control the amount of tax the clients pays by using these pension plans and corporations in an date letter mr alexander discussed how lawyers and accountants would not recommend the use of his pension plans with most doctors they end up giving about half of their net_income to the government for taxes but you are very fortunate because i can use these pension plans and the corporations to shelter almost all of your net_income to where you can control how much tax you pay what do most accountants and tax attorneys say about all of this most would never advise you to put these plans together and do what i do because they don’t understand and know about what i do why by nature it seems like u s accountants are conservative and backward people that are not creative it’s really easier for them just to have you pay a lot of tax i have been fortunate to work with ten of the sharpest and most aggressive accountants in the country and i have basically copied their styles you have a lady accountant now who is conservative and backward but if she does what i tell her to do you can keep her otherwise use one of my accountants in a date letter mr alexander again discussed borrowing against the plan you really are not supposed to borrow money from the annuity until the plan has been terminated but i am aggressive so i let these clients withdraw money for sic the annuity but it is best to leave the money in there for as long as possible at least days in an date letter mr alexander discussed the possibility of setting up similar pension plans for dr hristov’s colleagues i can also help your partner s but they probably have cpas that are conservative and strong with them and will try and talk them out of doing all this so if they need help i could do the accounting or get them a different accountant because the accountant list that i gave you has very strong accountants except they are aggressive business people and want the client to be able to have some options about saving income_tax instead of giving of the net_income you have to the government in an date letter mr alexander responded to dr hristov’s concerns about the plans dr hristov had spoken with promoters of other pension plans who had indicated that the plan was dead dr hristov then contacted mr alexander to see if there were any new developments regarding the plan mr alexander assured dr hristov that the plan was legal and that the promoters were just saying it was dead in attempts to sell their product mr alexander also discussed the risk of audit in the letter then even worse yet when you talk to accountants cpas and tax attorneys they are extremely conservative about of the time so all of those guys are going to tell you not to do anything and just pay the tax i have never lost a big deduction for a plan or a defined_benefit_plan however in the worse case scenario if a deduction were disallowed how much worse-off would you be than if you just paid the tax anyway like most cpas have you do not much technically we would have to fight to get penalties and interest dropped on taxes that you would owe but you see this scenario and the option that i bring to you of being able to tax defer with these plans and actually even avoid tax with the right set of circumstances and steps in a date letter mr alexander again responded to dr hristov’s concerns about the plans you have people telling you all kinds of bad things about plans this happens all the time i think it’s probably better to keep it as confidential as possible about what you are doing anything new on no sic really they are still legal and will stand up in an audit especially if i conduct the audit but keep in mind these rarely get audited but these plans are legal and third-party loans are legal so in the very remote possibility that you are ever audited on this i would make the presentation in the audit as i would conduct the audit and sell the deductions you have to also keep in mind that typically irs auditors aren’t that bright plus almost none of them even know what plans are permanent injunction against mr alexander on date the u s district_court for the central district of california entered an order of permanent injunction against mr alexander regarding his pension_plan promotions specifically mr alexander was permanently enjoined from providing any advice or assistance regarding the tax treatment of pension plans or welfare-benefit plans including but not limited to iii advising any individuals or entities that they may contribute any amount of money to a defined-benefit pension_plan or welfare- benefit plan without regard to actuarial limits or statutory limits iv advising any individuals or entities that they can use purported third-party loans to claim a deduction for purported contributions to a pension_plan or welfare-benefit plan and still have access to that money v advising any individuals that personal expenses can be re- characterized as pension_plan contributions opinion respondent contends that petitioners are liable for the accuracy-related_penalty under sec_6662 for all three years at issue on alternative grounds the underpayments of tax were attributable to negligence or disregard of rules or regulations under sec_6662 or there were substantial understatements of income_tax under sec_6662 sec_6662 and b authorizes the commissioner to impose a penalty on the portion of an underpayment of income_tax attributable to negligence or disregard of rules or regulations the term negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws and the term disregard includes any careless reckless or intentional disregard sec_6662 sec_1_6662-3 and income_tax regs disregard of rules or regulations is careless if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position and is reckless if the taxpayer makes little or no effort to determine whether a rule_or_regulation exists under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe sec_1_6662-3 income_tax regs see also 85_tc_934 stating that negligence is lack of due care or failure to do what a reasonable person would do under the circumstances sec_6662 and b also authorizes the commissioner to impose a penalty if there is a substantial_understatement_of_income_tax understatement means the excess of the amount of the tax required to be shown on the return over the amount of the tax imposed which is shown on the return reduced by any rebate sec_6662 a substantial_understatement_of_income_tax is defined as an understatement_of_tax that exceeds the greater of of the tax required to be shown on the tax_return or dollar_figure sec_6662 respondent bears the burden of production with respect to petitioners’ liability for the sec_6662 penalty and must produce sufficient evidence indicating that it is appropriate to impose the penalty see sec_7491 once respondent meets his burden of production petitioners must come forward with persuasive evidence that respondent’s determination is incorrect or that they had substantial_authority reasonable_cause and good_faith or disclosure and reasonable basis for their position see 116_tc_438 respondent has met his burden of production respondent established that the amounts of the understatements exceed the greater of of the tax required to be shown on the return or dollar_figure because respondent has met his burden of production petitioners must produce sufficient evidence to prove that respondent’s determination is incorrect see higbee v commissioner t c pincite petitioners argue that the reasonable_cause exception under sec_6664 applies sec_6664 provides an exception to the sec_6662 accuracy-related_penalty with respect to any portion of an underpayment if the taxpayer shows that there was reasonable_cause for such portion and that the taxpayer acted in good_faith with respect to such portion the determination of reasonable_cause and good_faith is made on a case-by-case basis taking into account all pertinent facts and circumstances sec_1_6664-4 income_tax regs the most important factor is the extent of the taxpayer’s effort to assess the proper tax_liability id in order for the reasonable_cause exception to apply the taxpayer must prove that he exercised ordinary business care and prudence as to the disputed item see 115_tc_43 aff’d 299_f3d_221 3d cir petitioners bear the burden of proving that they meet the requirements for relief under the sec_6664 reasonable_cause exception see higbee v commissioner t c pincite reliance upon the advice of a tax professional may establish reasonable_cause and good_faith for the purpose of avoiding liability for the sec_6662 penalty see 469_us_241 reliance on a tax professional is not an absolute defense but merely a factor to be considered 89_tc_849 aff’d 904_f2d_1011 5th cir aff’d 501_us_868 whether reasonable_cause exists when a taxpayer has relied on a tax professional to prepare a return must be determined on the basis of all of the facts and circumstances see neonatology assocs p a v commissioner t c pincite the taxpayer claiming reliance on a tax professional must prove by a preponderance of evidence each prong of the following test the adviser was a competent professional who had sufficient expertise to justify reliance the taxpayer provided necessary and accurate information to the adviser and the taxpayer actually relied in good_faith on the adviser’s judgment id pincite reliance is unreasonable however if the adviser is a promoter of the transaction or suffers from an inherent conflict of interest that the taxpayer knew or should have known about id pincite i reliance on ms fallon petitioners argue that they should not be held liable for the sec_6662 penalty for any year because they relied on their tax_return_preparer ms fallon we analyze petitioners’ claim using the three-prong test stated above with regard to the first prong petitioners have failed to establish that ms fallon had sufficient expertise to justify reliance r eliance may not be reasonable or in good_faith if the taxpayer knew or reasonably should have known that the advisor lacked knowledge in the relevant aspects of federal tax law sec_1_6664-4 income_tax regs ms fallon although likely a competent tax_return_preparer had no expertise with the plan or the defined_benefit_plan ms fallon informed petitioners of her lack of knowledge regarding these pension plans telling them that she did not have the experience to evaluate either the defined_benefit_plan or the plan dr hristov testified that he was aware of ms fallon’s lack of knowledge regarding the plans furthermore with regard to the second prong petitioners must establish that they provided necessary and accurate information with respect to all items reported on their tax returns such that the incorrect returns resulted from errors on the part of the adviser see eg 68_f3d_868 5th cir aff’g tcmemo_1993_634 70_tc_158 59_tc_473 on the basis of the record we conclude that petitioners did not provide ms fallon with all the necessary and accurate information while preparing the and tax returns ms fallon was unaware that petitioners had received money from lyons pensions and nb services also ms fallon was unaware that the money petitioners had received from lyons pensions in was used to purchase real_estate and was not a rolloverdollar_figure petitioners have failed to show that ms fallon was competent to advise them on the plans or that they provided her all the necessary information thus we find that petitioners have not established that their reliance on ms fallon was justified ii reliance on mr alexander petitioners also argue that they should not be held liable for the sec_6662 penalty for any year because they relied on mr alexander respondent argues that it was unreasonable for petitioners to rely on mr alexander because he had a conflict of interest a taxpayer is not reasonable in relying on an advisor burdened with an inherent conflict of interest about which the taxpayer knew or should have known am boat co llc v united_states 583_f3d_471 7th cir citing neonatology assocs p a v commissioner f 3d pincite chamberlin v commissioner 66_f3d_729 5th cir aff’g in part rev’g in part tcmemo_1994_228 990_f2d_893 6th cir see supra p discussing ms fallon’s communication with mr alexander regarding the money petitioners received from lyons pensions in aff’g donahue v commissioner tcmemo_1991_181 and 623_fsupp2d_504 s d n y w hen an adviser profits considerably from his participation in the tax_shelter such as where he is compensated through a percentage of the taxes actually sheltered a taxpayer is much less reasonable in relying on any advice the adviser may provide am boat co llc f 3d pincite ‘in order for reliance on professional tax_advice to be reasonable the advice must generally be from a competent and independent advisor unburdened with a conflict of interest and not from promoters of the investment ’ 132_tc_161 quoting 440_f3d_375 6th cir aff’g t c memo aff’d 408_fedappx_908 6th cir reliance on the professional advice of a tax_shelter promoter is unreasonable when the advice would seem to a reasonable person to be too good to be true edwards v commissioner tcmemo_2002_169 citing pasternak v commissioner f 2d pincite 90_tc_960 aff’d without published opinion 899_f2d_18 9th cir and gale v commissioner tcmemo_2002_54 aff’d 119_fedappx_293 d c cir petitioners’ reliance on mr alexander was unreasonable because mr alexander was a promoter and suffered from an inherent conflict of interest that the taxpayer knew or should have known about see neontalogy assocs p a v commissioner t c pincite see also tigers eye trading llc v commissioner tcmemo_2009_121 defining a promoter as an adviser who participated in structuring the transaction or is otherwise related to has an interest in or profits from the transaction petitioners knew or should have known that any advice they received from mr alexander was not independent because mr alexander benefited financially from their using his plans mr alexander received a percentage each year based on the amounts petitioners contributed to both the plan and the defined_benefit_plan petitioners knew mr alexander profited only if they invested using his plans thus it was not reasonable for them to rely on his assurances that the plans were legal additionally it was unreasonable for petitioners to rely on mr alexander because the advice would seem to a reasonable person to be too good to be true see edwards v commissioner tcmemo_2002_169 petitioners were told that they would receive back most of their contributions to the plans and that they were free to do with the money what they wanted when mr alexander discussed with petitioners how much they should contribute to the plans he focused on how much they would need to contribute to significantly lower their taxes not on the statutory limits imposed on contributions to pension plans at a minimum mr alexander’s statements would cause a reasonable person to seek independent confirmation from a reliable and disinterested adviser familiar with plans and defined benefit plans see eg neonatology assocs p a v commissioner f 3d pincite when a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations he should recognize that he proceeds at his own peril mr alexander was a promoter and had a conflict of interest that petitioners knew or should have known about thus it was not reasonable for petitioners to rely on mr alexander iii reasonable_cause and good_faith even if we were able to find that petitioners relied on ms fallon or mr alexander they would still not be able to show that they had reasonable_cause and acted in good_faith with respect to their understatements see freytag v commissioner t c pincite reliance on adviser is merely factor in considering whether taxpayer acted with reasonable_cause and in good_faith dr hristov argues that he acted with ordinary business care and prudence because he researched the plans and repeatedly questioned mr alexander as to the legitimacy of the plans however there were too many red flags concerning the plans for petitioners to reasonably believe mr alexander’s assurances that the plans were legal and the deductions valid first mr alexander told petitioners that they were really not supposed to borrow from the plan second mr alexander repeatedly stated that most accountants and tax lawyers would not recommend his plans third mr alexander told petitioners that they would have to change accountants if ms fallon did not do what he told her to do fourth mr alexander told dr hristov to keep what he was doing with the plans confidential petitioners have failed to establish that they meet the reasonable_cause and good_faith exception to the sec_6662 accuracy-related_penalty for any year in issue to reflect the foregoing decision will be entered for respondent


department of the treasury internal_revenue_service washington d c date cc intl br tl-n-2596-98 number release date uilc internal_revenue_service national_office field_service_advice memorandum for from branch cc intl br5 subject this field_service_advice responds to your memorandum dated date field_service_advice is not binding on examination or appeals and is not a final case determination this document is not to be cited as precedent legend x y a b vv ww xx yy zz k m date date date date year issues whether the loss incurred on the assignment of a swap and the up-front payment received for a new subsequent swap are subject_to sec_1_446-4 whether the loss incurred on the assignment of a swap can be integrated with the up-front payment received on a subsequent swap under the anti- abuse and substance-over-form rules of sec_1_446-3 and sec_1 f whether the loss incurred on the assignment of a swap and the up-front payment received for a new subsequent swap can be integrated under sec_1_988-5 whether the loss incurred on the assignment of a swap and the up-front payment received for a new subsequent swap can be integrated under sec_1092 conclusions the effective date of sec_1_446-4 prevents its application to this transaction the effective date of sec_1_446-3 prevents its application to this transaction moreover the transactions at issue do not warrant the application of the anti-abuse_rules or the substance-over-form rules of sec_1_988-2 the integration rules of sec_1_988-5 are not applicable to the transactions at issue sec_1092 is not applicable to the transactions at issue facts the following facts have been presented for consideration y is a wholly- owned domestic subsidiary of x a u s entity y uses the u s dollar as its functional_currency for federal_income_tax purposes but uses the swiss franc cf for financial reporting purposes on date y issued a seven-year vv european currency unit ecu bond bearing interest at the fixed rate of k on date two years prior to the maturity of this ecu bond y entered into a seven-year currency swap with a the a swap under the terms of the swap y received periodic_payments based on the fixed rate of k on vv ecu for two years and at libor for the remaining five-year term in exchange y agreed to make periodic_payments based on the fixed rate of m on the principal_amount of cf xx the principal amounts of the swap were to be exchanged at the swap’s maturity y entered into the swap in part to economically convert the last two years of its fixed rate ecu borrowing into a fixed rate swiss franc borrowing it is unclear however why y entered into a seven-year swap rather than a two-year swap that would have terminated at the same time as its ecu borrowing on date y borrowed dollar_figureww at a floating rate from its parent x and converted that amount into ecu at the spot_rate in order to repay its vv ecu loan concurrently y entered into a five-year ecu u s dollar currency swap with b the b swap under this swap y was to receive periodic_payments based on a floating rate on dollar_figureww and was to make periodic_payments based on libor le sec_2_1 basis points on vv ecu the b swap economically converted the u s dollar floating rate borrowing into a ecu floating rate borrowing which the existing a swap effectively converted into a fixed rate swiss francs borrowing finally on date y decided to economically convert its fixed rate cf obligation under the a swap to a floating rate cf obligation to achieve that goal y assigned the a swap to b and entered into a new four-year swap with b under which y received libor on vv ecu as in the a swap but paid libor plu sec_4 basis points instead of a fixed rate on xx swiss francs the new swap the assignment of the a swap to b was costly to y because of changes in interest rates and currency values y was obligated to make to b an assignment payment of dollar_figureyy however the new swap was an off-market swap that was structured in such a way as to require b to make an up-front payment of dollar_figureyy to y in exchange for higher periodic_payments and principal to be paid_by y thus no cash actually changed hands when these transactions were consummated y claimed the assignment payment as a loss in year but amortized the up- front payment because it attributed dollar_figurezz to the principal of the new swap it did not report that amount until the fourth year the remainder of the up-front payment was amortized over the four-year term of the swap the service proposes to treat the up-front payment on the new swap as taxable gain in the same year y deducted the loss on the assignment payment law and analysis sec_1_988-2 provides in part subject_to exceptions not relevant here that any income or loss realized with respect to a currency swap contract shall be characterized as exchange gain_or_loss and not as interest_income or expense any exchange gain_or_loss realized shall be recognized unless otherwise provided in an applicable_section of the code sec_1_988-2 provides in part that if the taxpayer’s method_of_accounting for income expense gain_or_loss attributable to a currency swap does not clearly reflect income the commissioner may apply principles analogous to those of sec_1274 or such other rules as the commissioner deems appropriate to clearly reflect income sec_1_988-2 provides in part that if a taxpayer that enters into a currency swap receives a payment that is the taxpayer enters into the currency swap at a discount swap discount in order to make the present_value of the amounts to be paid equal the amounts to be received such payment shall be amortized in a manner which places the taxpayer in the same position it would have been in had the taxpayer entered into a currency swap contract under which the present values of the amount to be paid equal the amounts to be received thus swap discount shall be amortized as follows - a the amount of swap discount that is attributable to the difference between the swap exchange rate and the spot_rate on the date the contract is entered into or acquired shall be taken into account as income on the date the swap principal amounts are taken into account and b the amount of swap discount attributable to the difference in values of the periodic interim payments shall be amortized in a manner consistent with the principles of economic accrual any amount taken into account pursuant to this paragraph e ii shall be treated as exchange gain sec_1_988-2 provides that any gain_or_loss realized on the disposition or the termination of a currency swap is exchange gain_or_loss sec_1_988-2 provides in part that if the substance of a transaction described in sec_1_988-1 differs from its form the timing source and character of gains or losses with respect to such transaction may be recharacterized by the commissioner in accordance with its substance for example if the taxpayer enters into a transaction that it designates a currency swap contract that requires the prepayment of all payments to be make or to be received but not both the commissioner may recharacterize the contract as a loan in applying the substance over form principle separate transactions may be integrated where appropriate sec_1_988-5 provides rules for the integration of debt instruments and related hedges resulting in the treatment of the combined transactions as a single synthetic_debt_instrument sec_1_988-5 provides that a sec_1_988-5 hedge is a currency swap or series or combination thereof that when integrated with a qualifying_debt_instrument permits the calculation of a yield_to_maturity under principles of sec_1272 in the currency in which the synthetic_debt_instrument is denominated sec_1092 provides rules limiting the recognition of losses in the case of straddles sec_1092 provides that a taxpayer holds offsetting positions with respect to personal_property if there is a substantial diminution of the taxpayer’s risk of loss from holding any position with respect to personal_property by reason of his holding or more other positions with respect to personal_property whether or not of the same kind sec_1_446-3 which provides accounting methods to ensure the clear_reflection_of_income and deductions from notional_principal_contracts applies to contracts entered on or after date furthermore sec_1_446-4 which provides rules to ensure that the method_of_accounting used for hedging_transactions clearly reflects income is applicable to hedging_transactions entered into on or after date inapplicable provisions the a swap was entered into on date and is not subject_to sec_1_446-3 and sec_1_446-4 the assignment of the a swap to b on date does not affect the fact that the a swap was entered into prior to these regulations’ effective dates the hedging rules of sec_1_988-5 are inapplicable because the term of the a swap does not match that of taxpayer’s borrowing making the computation of a yield_to_maturity on a synthetic instrument comprising of the underlying debt and the a swap impossible furthermore even if applicable these rules would allow the commissioner to integrate the qualified borrowing with one or more hedges they would not allow the commissioner to integrate the assignment payment incurred in disposing of the a swap with the up-front payment due to the taxpayer on a the new swap sec_1092 is also inapplicable because the taxpayer did not hold the a swap and the new swap simultaneously the a swap and the new swap therefore cannot be treated as offsetting positions as would have been required under sec_1092 sec_1092 sec_1_988-2 anti-abuse_rules the taxpayer’s treatment of the up-front payment and of the assignment payment when analyzed separately are generally in accord with the rules of the sec_988 regulations under sec_1_988-2 the portion of the up-front payment relating to the periodic_payment should be amortized in a manner consistent with the principles of economic accrual and the amount attributable to the principal of the swap should be taken into account on the date the swap principal amounts are taken into account this methodology was followed by the taxpayer as to the assignment payment the taxpayer is entitled to its immediate realization under sec_1_988-2 and to its recognition under sec_1_988-2 the issue therefore is whether the particular circumstances surrounding these transactions call for the application of the anti- abuse rules of the sec_988 regulations the assignment payment on the a swap to the extent it reflects its value could not have been avoided we consider therefore the structure of the new swap which was designed by the parties to require the up-front payment y had decided to replace a combination of instruments which economically replicated a fixed rate cf liability with a similar combination which replicated a floating rate cf liability as a result of movements in interest rates and in the currency markets y had to make a substantial payment in order to assign its fixed rate cf liability to b to avoid having to make a cash payment y entered into an off-market swap with b that required b to make an up-front payment to y b agreed to make this up-front payment because the periodic_payments that y agreed to make to b and the amount of principal that y agreed to pay to b at the termination of the swap were higher than what the market called for the present_value of these payments in excess of market were represented by the up-front payment that b agreed to make to y the new swap was the equivalent of an on-market swap where the present values of the payments to be made by each parties equal on the date the contract is entered into and a loan from b to y in essence y entered into a new on-market swap and in addition borrowed the cash it needed to make the required_payment so that it could dispose_of the fixed rate swiss franc swap it no longer wanted we believe that the funding of the assignment payment through a loan does not create the type of distortion in income that would allow the successful invocation of the anti-abuse rule_of sec_1_988-2 see generally crane v commissioner 67_sct_1047 depreciation_deductions were computed based on the basis_of_property that included its mortgage similarly the substance over form provision of sec_1_988-2 is not applicable here because as discussed above the recharacterization of the transactions does not affect their tax consequences case development hazards and other considerations finally we stated above that sec_1092 did not apply because the a swap and the new swap were not offsetting positions however unrealized gains on a position offsetting the a swap held by a member of the consolidated_group of which y is a member could be used to deny the loss on the assignment of the a swap see sec_1092 if you have any further questions please call jeffrey l dorfman branch chief branch associate chief_counsel international


department of the treasury internal_revenue_service washington d c date cc dom fs corp tl-n-640-98 uilc number release date internal_revenue_service national_office field_service_advice memorandum for snr attorney cc ner man from subject deborah a butler assistant chief_counsel cc dom fs determining the sec_382 limitation and debt modification this field_service_advice responds to your memorandum dated date your memo field_service_advice is not binding on examination or appeals and is not a final case determination this document is not to be cited as precedent legend x sh1 sh2 sh3 lender acquiring sub a b c d e f g h i j k l m n p q r a b c d e f g h i j k l dollar_figurea dollar_figureb dollar_figurec dollar_figured dollar_figuree dollar_figuref dollar_figureg dollar_figureh dollar_figurei dollar_figurej dollar_figurek dollar_figurel dollar_figurem dollar_figuren dollar_figureo dollar_figurep dollar_figureq dollar_figurer dollar_figures dollar_figuret dollar_figureu dollar_figurev dollar_figurew dollar_figurex dollar_figurey dollar_figurez dollar_figureaa dollar_figurebb dollar_figurecc dollar_figuredd dollar_figureee dollar_figureff dollar_figuregg year year year year year year year year year month month month month date date date date date date date date date issues what facts are necessary to determine whether the debt in this case should be treated as stock for purposes of sec_1_382-2t what facts are necessary to determine whether the warrants issued in this case should be treated as stock for purposes of sec_382 sec_1_382-2t and sec_1_382-4 what facts are necessary to determine whether the stock in this case should be treated as not stock for purposes of sec_382 and sec_1_382-2t whether modifications to the debt_instrument on date are material resulting in a taxable_exchange under sec_1001 and applicable regulations conclusion based on all the facts and circumstances it does not appear that the debt of x to lender can be recharacterized as stock for purposes of sec_1 2t f iii based on all the facts and circumstances it appears that the warrants issued in year do not constitute stock for purposes of sec_382 and sec_1_382-2t the warrants modified on date by x do constitute stock for purposes of sec_382 and sec_1 2t h the warrants issued on date do not constitute stock for purposes of sec_382 and sec_1_382-4 and the warrants issued in year do not constitute stock for purposes of sec_382 and sec_1_382-4 based on all the facts and circumstances it appears that the stock of x in this case constitutes stock for purposes of sec_382 and is not treated as not stock under sec_1_382-2t the principal_amount of the debt_instrument was amended the maturity of the term_loan within the debt_instrument was extended and the interest rate on a portion of the principal was amended these amendments together cause the new instrument to embody legally distinct entitlements and the new debt_instrument is materially different from the old instrument accordingly the old debt_instrument is deemed to have been exchanged for the new amended instrument under sec_1001 facts x purchased its assets in year through a leveraged_buyout the stock of x was originally owned as follows shareholder of shares percentage sh1 sh2 sh3 total j i f n j h e as a part of the leveraged_buyout in month of year x borrowed a total of dollar_figurey from lender pursuant to a loan agreement dated as of date loan agreement or debt_instrument this debt_instrument was divided into three separate loans a term_loan in the amount of dollar_figurex evidenced by the term_loan promissory note a fixed rate loan in the amount of dollar_figures evidenced by the fixed rate promissory note and a commitment for dollar_figureu in revolving credit from lender in conjunction with the leveraged_buyout and concurrent with the loan agreement between x and lender x issued a warrant to purchase k shares to lender the warrant was valued at dollar_figurek on a fully diluted basis the warrant if exercised would constitute a g interest in x this loan agreement for the three loans is the debt_instrument at issue and the modifications to the terms of the fixed rate and term loans within the debt_instrument are the modifications at issue all of these loans arising under this debt_instrument however constitute one general obligation of borrower secured until the termination_date by all of the collateral loan agreement pincite the term_loan was due and payable in full on date the stated_interest on the term_loan was the same as the stated_interest on the revolving credit loan the interest was payable on the first day of each month and payable in an amount equal to the quotient of i an amount equal to a the sum of the daily unpaid principal amounts of the revolving credit loan and the term_loan outstanding on each day during the previous month multiplied by b a rate equal to the index rate plus a the stated rate divided by ii b provided however that upon a days written notice to lender from borrower borrower may direct that the stated rate for the period specified in such notice shall be equal to the libor rate plus b loan agreement pincite the fixed rate loan was due and payable in full on date the stated annual interest on the fixed rate loan was f loan agreement pincite the term of the revolving credit loan was to expire on date but was subject_to one-year renewals thereafter the loan agreement states that it may not be modified altered or amended except by an agreement in writing signed by borrower and lender borrower may not sell assign or transfer any of the loan documents or any portion thereof including without limitation borrower’s rights title interests remedies powers and duties hereunder or thereunder borrower hereby consents to lender’s and each assignee lender’s sale of participations in or assignment transfer or other_disposition of at any time or times any of the loan documents or of any portion thereof or interest therein including without limitation lender’s and each assignee lender’s rights title interests remedies powers or duties thereunder whether evidenced by a writing or not loan agreement pincite the debt_instrument was first amended on date by the first amendment to loan agreement first amendment the first amendment modified the debt ratios to be maintained by x the first amendment added a new definition on base compensation and amended the section concerning compensation of employees in the first amendment the lender waived its enforcement rights against x with respect to certain matters listed in exhibit b to the first amendment which included submission of monthly and quarterly financial statements written confirmation of verbal notices of default projected financial statements sale of assets under dollar_figurea and submissions of other corporate information lender and x agreed in the first amendment that x could issue additional stock to certain individuals the first amendment is limited as specified and shall not constitute a modification acceptance waiver or amendment of any provision of the loan agreement or any other loan document except as specifically provided and limited hereby first amendment pincite x paid approximately dollar_figureq of the term_loan to lender before month of year and the outstanding principal_amount on the term_loan was then dollar_figuret in addition x paid approximately dollar_figurep of the outstanding principal_amount of the fixed rate loan to lender before month of year and the outstanding principal_amount of the fixed rate loan was then approximately dollar_figurer x and lender again modified the debt_instrument on date by the second amendment to loan agreement second amendment as a result of the poor financial condition of x the second amendment made the following changes to the term_loan dollar_figureo of the principal_amount of the fixed rate loan was converted to dollar_figureo in additional principal of the term_loan dollar_figurei of the amount of the revolving credit loan was converted to dollar_figurei in additional principal of the term_loan the new outstanding principal_amount of the term_loan was dollar_figurew the principal payments of the term_loan were rescheduled and the maturity_date of the term_loan was extended from month of year to month of year second amendment pincite the second amendment made the following changes to the fixed rate loan the outstanding principal_amount was reduced by dollar_figureo which was incorporated into the term_loan and the new outstanding principal_amount of the fixed rate loan was now dollar_figuren the maturity_date was accelerated from month of year to month of year and the principal payments of the fixed rate loan were rescheduled in addition the initial commitment term of the revolving credit agreement was extended from year to year and the debt ratios were revised second amendment pincite the capital expenditures that x was allowed to make for the years year through year were reduced second amendment pincite the second amendment is limited as specified and shall not constitute a modification acceptance waiver or amendment of any provision of the loan agreement or any other loan document except as specifically provided and limited hereby second amendment pincite the lease agreement of year contemplated an amendment to its terms that must be in writing and must be signed by x’s lenders to be effective both the first amendment and the second amendment are in writing and appear to have been signed by the lenders and therefore appear to be effective thus when considering the term and the fixed rate loan principals as one obligation a total amount of dollar_figurem in outstanding principal on the term_loan was forgiven by lender the number of shares which could be purchased by lender by exercise of the warrant previously received was increased from k shares to p shares if the warrant was exercised by lender lender would then own i of the shares of x the expiration date of the warrant was extended from date to date the warrant exercise amount was reduced from dollar_figurei to dollar_figureh on date x was in poor financial condition if x were to have liquidated on date there would not have been sufficient value from the sale of its assets to have paid all its liabilities on statement of its year tax_return x stated that it is a loss_corporation as defined in sec_382 which is entitled to use a net_operating_loss_carryover and no testing occurred during the taxable_year with respect to the loss carryover generated in prior years you note that there is no indication that x on its year return stated that the debt would be treated as stock under sec_382 effective date sh1 and sh2 each transferred its x stock to lender lender in turn tendered the shares to x for retirement concurrent with the receipt and retirement of these shares x issued two stock purchase warrants to lender lender then assigned all of its rights in one of the warrants to sh1 and sh2 this warrant was subsequently tendered to x and was reissued to sh1 and sh2 in the form of two separate warrants thus after these series of transactions sh3 was the only shareholder of x on date an agreement and plan of merger was entered into by and among x lender acquiring and sub wholly owned by acquiring the closing took place on date through the merger sub merged into x with x being the surviving corporation acquiring and its affiliates then acquired k of the issued and outstanding common_stock of x equityholders of x at the end of the merger received both cash consideration and stock purchase warrants the warrants are exercisable for an aggregate of d of the outstanding shares of common_stock of x on a fully diluted basis all stock and warrants outstanding prior to the merger were canceled lender continued to own its debt of x the amounts that the equityholders of x received through the merger are entity stock_warrant for stock cash received lender lender warrant lender warrant sh1 sh2 management direct management options total g c h p l d e dollar_figureg dollar_figured dollar_figuree dollar_figurec q dollar_figurej dollar_figuref paid directly to lender and dollar_figureb to their attorneys dollar_figuref dollar_figureb dollar_figureg full amount was m but is reduced by options for c shares total stock if warrants exercised r q h for year and subsequent years x computed its sec_382 limitation as dollar_figurez dollar_figurev multiplied by c the dollar_figurev was the total outstanding lender debt on date nols and credits generated by x for year x generated an nol of dollar_figurel which it used in year and year for year x generated an nol of dollar_figureaa dollar_figurebb of which it used in year for year x generated an nol of dollar_figuredd and for year x generated an nol of dollar_figureee both of which were carried forward thus the total amount of nols being carried forward is dollar_figureff for year sec_1 through and year x generated certain credits in the aggregate amount of dollar_figuregg all of which was carried forward issue - what facts are necessary to determine whether the debt in this case is stock for purposes of sec_1_382-2t taxpayer's position the taxpayer contends that the total outstanding non-revolving debt of x to lender on date is treated as stock for purposes of determining whether an ownership_change occurred and if so the value of the loss_corporation the taxpayer contends that the above-stated debt meets all the requirements of sec_1_382-2t the taxpayer points out that sec_1 2t f iii a requires the debt to offer potential significant participation in the growth of the corporation in order for the debt to be treated as stock under sec_1_382-2t x contends that it restructured the loan agreement on date with lender because of financial difficulties x contends that if it were to have liquidated on the date the debt was modified there would not have been sufficient value for the sale of the assets for x to have paid off the liabilities the taxpayer claims that lender clearly had a vested interest in the growth and well- being of x the taxpayer argues that only by future growth in x would lender be assured that the outstanding debt would be paid in full the taxpayer further contends that lender benefitted from the growth of the corporation by reason of the warrants that were received from x in connection with the new loan agreement on date therefore the taxpayer contends that the debt offers potential significant participation in the growth of the corporation as required by sec_1 2t f iii a the taxpayer claims that by treating the debt as constituting stock an ownership_change has clearly occurred and thus the requirement of sec_1 2t f iii b is satisfied the taxpayer claims that the pre-change_loss at the testing_date in year is greater than twice the amount determined by multiplying the value of the loss_corporation by the long-term tax exempt rate thus the taxpayer claims that the requirement found in sec_1_382-2t is also met the taxpayer contends that the total outstanding debt of x to lender on date of dollar_figurev should be used to determine the value of x in year since the debt was determined to be stock for sec_382 purposes in year the dollar_figurev debt multiplied by the applicable long-term_tax-exempt_rate of c resulted in an annual sec_382 net_operating_loss limitation of dollar_figurez according to the taxpayer the taxpayer used this limitation on the year return and on all subsequent filings law and analysis we do not believe that the debt of x to lender can be recharacterized as stock for purposes of sec_1_382-2t that section provides three tests our focus is on the first test whether the debt offers the lender the potential for significant participation in the growth of x is the most important as noted above x argues that this first test is met because as of date it was unable to repay its debt to lender that is if x had liquidated as of that date it would not have had sufficient assets to pay off all its liabilities including its obligation to lender thus x argues that as of that date lender had a vested interest in the growth of x moreover x argues that only by its future growth would lender be assured that the outstanding debt would be repaid if x were correct then possibly every lender to a debtor that subsequently became insolvent or bankrupt would be considered as automatically having a potential for significant participation in the growth of the debtor this cannot be correct if a debtor exchanged its debt interest in a company for stock or warrants in that company then it may be appropriate to take the position that the former debtor is now participating in the growth of the company in that case it is possible that the former debtor could recover not only the amount it loaned as well as expected interest payments but also additional value depending on the growth of the company on the other hand if the debtor simply modifies the terms of the debt interest eg in order to make it more likely that the debtor can repay its debt then it may be appropriate to take the position that the debtor is not participating in the growth of the company in the instant case it appears lender modified the terms of the debt_instrument to make it more likely that x will repay the debt and lender will not receive more than the amount it loaned plus interest payments also the interest rate on the debt under the circumstances appears to be in a range consistent with treating the debt as debt for sec_382 purposes assumedly x was expected to have sufficient assets in conjunction with the cash_flow from its projected future earnings and proceeds of anticipated additional debt financing to meet all required_payments of principal and interest additionally x’s financial projections used in negotiations with creditors assumedly indicated that the debt holder’s participation over the term of the debt in x’s cumulative net_income prior to any deductions for debt service did not represent a significantly high percentage of that net_income so as to make the risk of the debt holder analogous to that of an equity holder overall we believe it would be difficult for x to argue that lender has the potential to offer significant participation in the growth of x and that the debt is stock for purposes of sec_1_382-2t however we believe a definitive conclusion that the debt is not stock for purposes of sec_1 2t f iii could be dependent upon such facts and circumstances as the reasonableness of the credit risk the reasonableness of the projections of earnings and cash_flow that x used at the time of the debt modification the percentage of projected income and cash_flow that x was required to commit to debt service the security provided for the debt the market interest rates on similar types of debt the terms of the warrant and the likelihood of the exercise of the warrant however even if x were correct that the debt constituted stock for purposes of sec_1_382-2t it does not follow that x’s value for purposes of determining the sec_382 limitation as of date would include the value of the debt sec_382 provides that for purposes of sec_382 any capital_contribution received by an old_loss_corporation as part of a plan a principal purpose of which is to avoid or increase any limitation under sec_382 shall not be taken into account for purposes of sec_382 pursuant to sec_382 x is an old_loss_corporation moreover as explained in the last section of this letter the change in the terms of the debt on date constitutes a modification of that debt for purposes of sec_1001 thus lender is treated as transferring the old debt_instrument to x and receiving a new debt_instrument on date it can be argued that that deemed transfer of the old debt_instrument by lender to x in exchange for an instrument which x believes should be characterized as stock for purposes of sec_382 should be considered a capital_contribution within the meaning of sec_382 certainly if a transferor transfers money to a corporation in exchange for stock that transfer would be characterized as capital_contribution similarly the deemed contribution of the old debt by lender upon the modification of the terms of the debt_instrument should also be a capital_contribution within the meaning of sec_382 sec_382 provides that for purposes of sec_382 any capital_contribution made during the 2-year period ending on the change_date shall except moreover even if the value of the debt were included in determining x’s value that value would be based on the fair_market_value of the debt and not as x contends the face_amount sec_1_382-2t as provided in regulations be treated as part of a plan described in sec_382 additionally the legislative_history notes that except as provided in regulations a capital_contribution made during the 2-year period ending on the change_date is irrebuttably presumed to be part of a plan to avoid the limitations h_r rep no 99th cong 2d sess date ii-189 in this case since the deemed capital_contribution occurred on the change_date the date on which the ownership_change occurred see sec_382 the amount of such capital_contribution would not be included in determining x’s value as of date even if the debt were treated as stock as x argues moreover such amount would also not be included in determining x’s value as of date the date of the second ownership_change because such date is within two years of date case development hazards and other considerations since as explained above x underwent an ownership_change in year we do not know whether note that it is position of the service for the tax years at issue that any nols and credits limited by one ownership_change are treated as pre-change losses for any subsequent ownership changes thus an nol or credit could be subject_to one or more sec_382 limitations but the subsequent ownership changes reduce but never increase the sec_382 limitation with respect to such losses and credits see eg sec_1_382-5t d effective for tax years of a loss_corporation beginning on or after date issue - what facts are necessary to determine whether the warrants issued in this case are stock for purposes of sec_382 sec_1_382-2t and sec_1_382-4 regulations have not been promulgated under sec_382 the legislative_history of this provision cited above provides limited exceptions to this year capital_contribution rule however none of these exceptions appear applicable in this case id taxpayer's position the taxpayer does not address the question of whether the warrants in this case constitute stock for purposes of sec_382 and sec_1 2t h the taxpayer solely treats x's debt to lender as stock for purposes of determining the value of x and states that the value of x is equal to the amount of the outstanding debt of x to lender law and analysis based on all the facts and circumstances it appears that the warrants issued in year do not constitute stock for purposes of sec_382 and sec_1_382-2t the warrants modified on date by x do constitute stock for purposes of sec_382 and sec_1_382-2t the warrants issued on date do not constitute stock for purposes of sec_382 and sec_1_382-4 and the warrants issued in year do not constitute stock for purposes of sec_382 and sec_1_382-4 the warrants issued in year on a fully diluted basis if exercised would constitute a g interest in x therefore exercising the warrants in year would not have resulted in an ownership_change since the change in ownership over the testing_period if lender exercised the warrants would be g which is thus less than a ownership_change therefore under sec_1_382-2t the warrants issued in year would not be treated as stock the warrants for stock in x previously received by lender were modified on date so that lender could own i of the shares of x if the warrants were exercised therefore exercising the warrants on date would result in an ownership_change since the change in ownership over the testing_period if lender exercised the warrants would be i which is a greater than ownership_change therefore under sec_1_382-2t the warrants modified on date would constitute stock effective date sh1 and sh2 surrendered all of the x stock and ultimately received warrants from x lender also received warrants even though it does not appear that lender transferred anything of value to x in exchange therefor thus as of the end of date sh3 owed all of the outstanding_stock of x since this is a greater then change in the ownership of x there is an ownership_change of x moreover treating the warrants received by sh1 sh2 and lender on date as outstanding would prevent this ownership_change from occurring consequently there is no basis for treating these warrants as outstanding on date sub merged into x with x being the surviving corporation acquiring and its affiliates then acquired k of the issued and outstanding common_stock of x equityholders of x received stock purchase warrants exercisable for an aggregate of d of the outstanding shares of common_stock of x on a fully diluted basis all stock and warrants outstanding prior to the merger were canceled since the warrants issued in year were only exercisable for an aggregate of d of the stock of x and acquiring acquired k of x's stock the exercise of the warrants would not create or prevent an ownership_change acquiring became the new owner of x in year and increased its ownership in the stock of x by k of the stock of x under sec_1_382-4 the warrants issued in year would not be treated as stock for purposes of determining whether an ownership_change occurs issue - what facts are necessary to determine whether the stock in this case is not stock for purposes of sec_382 and sec_1 2t f ii taxpayer's position the taxpayer contends that the stock meets all of the tests of sec_1 2t f ii and that all of the outstanding_stock of x is treated as not stock for sec_382 valuation purposes the taxpayer argues that such a treatment is appropriate since according to the taxpayer the total outstanding debt of x was greater than its assets and thus the stock had minimal if any value law and analysis based on all the facts and circumstances the stock of x in this case constitutes stock for purposes of sec_382 and is not treated as not stock under sec_1_382-2t there appears to be no evidence that as of the time of issuance of or transfer of x stock that the likely participation of the stock in future corporate growth is disproportionately small when compared to the value of such stock as a proportion of the total value of the outstanding_stock of the corporation issue - whether modifications to the debt_instrument are material resulting in a taxable_exchange under sec_1001 and applicable regulations taxpayer's position the taxpayer claims that on date when x restructured the loan agreement with lender there was a significant modification of the debt terms because the principal payments of the term_loan and the fixed rate loan were rescheduled the term_loan maturity_date was extended and the fixed rate loan maturity was accelerated under sec_1_1001-3 a significant modification results in a deemed issuance of new debt taxpayer says that treating the debt as stock at that point does result in an ownership_change so that if the other two factors of sec_1_382-2t are met it is proper to treat the debt as stock for purposes of determining the value of the loss_corporation on that date thus it would not matter that lender had the same rights with respect to the new stock as the old as long as those rights met the first factor the interest offers potential significant participation in the growth of the corporation and the third factor is also met law and analysis gain from the sale_or_other_disposition of property is determined under sec_1001 to be the excess of the amount_realized therefrom over the adjusted_basis and the loss is the excess of the adjusted_basis over the amount_realized the amount of gain_or_loss realized from the sale_or_exchange of property is determined under sec_1001 and the entire amount of the gain_or_loss on the sale_or_exchange of property shall be recognized under sec_1001 sec_1_1001-1 reads in relevant part t he gain_or_loss realized from the conversion of property into cash or from the exchange of property for other_property differing materially either in_kind or in extent is treated as income or as loss sustained the amount_realized from a sale_or_other_disposition of property is the sum of any money received plus the fair_market_value of any property other than money received emphasis added if the modified property is deemed sold or exchanged the resulting property is treated as newly issued in 499_us_554 cottage savings had exchanged participation interests in mortgages but not the underlying mortgages themselves for another lender’s participation interests that were made to different obligors and secured_by different homes the court held that for an exchange of properties to be taxable the properties need only represent different property rights and that property rights are different in a material way if their respective possessors enjoy legal entitlements that are different in_kind or extent this decision gave rise to the hair trigger theory that any and all modifications of debt instruments may give rise to a deemed exchange under sec_1001 thereby obviating the de_minimis alterations accepted under prior_law as not giving rise to an exchange determining that sec_1_1001-1 was a reasonable interpretation of sec_1001 and that it was consistent with precedent on realization the court in cottage savings applied the materially different requirement set forth in sec_1_1001-1 the court looked to case law to give meaning to the material difference test and determined that property exchanged for other_property was materially different as long as the exchanged properties embody legally distinct entitlements cottage savings u s pincite the court determined that cottage savings received entitlements that were materially different from those that it gave up because the participation interests that they received were made to different obligors and were secured_by different homes therefore the transaction was taxable and cottage savings realized a loss on the exchange the interests that were exchanged were considered substantially identical for federal banking regulatory purposes but that fact did not affect the tax treatment of the exchanged instruments id cottage savings was decided in date and applies to the second modification of the debt_instrument which occurred on date proposed_regulations relating to the treatment of modification of debt instruments as realization events under sec_1001 were published in a notice of proposed rulemaking on date fi-31-92 1992_2_cb_683 the service and the treasury_department acknowledged that uncertainty exists however with respect to when particular types of modifications result in deemed exchanges of debt instruments 1992_2_cb_683 these proposed_regulations were intended to clarify the confusion created by the cottage savings case the explanation of provisions stated questions have arisen however concerning the court’s interpretation of the material difference standard and its possible application to modifications of debt instruments by issuers and holders it has been suggested that the parties to a debt_instrument should be able to adjust certain terms of their instruments without the modification rising to the level of a deemed exchange 1992_2_cb_683 final regulations on the modification of debt instruments were published in as sec_1_1001-3 t d 1996_2_cb_60 although sec_1_1001-3 addresses whether a sale_or_exchange has occurred when there has been a significant modification to a debt_instrument this regulation applies to alterations to the terms of a debt_instrument that have occurred on or after date and can only be relied on by taxpayers for alterations that occurred after date and before date the debt_instrument at issue was amended in the year pursuant to the first amendment and in year pursuant to the second amendment accordingly x may not rely on the regulations in 204_fsupp_473 s d ohio aff’d 312_f2d_747 6th cir the plaintiffs holders of japanese bonds could not collect on their bonds between the years of and in the japanese government proposed a settlement extending the maturity_date of the bonds for ten years and the plaintiffs accepted the settlement there was no actual exchange of bonds but only an extension of the maturity_date on the bonds the court held that the acceptance of the offer of settlement and presentment did not constitute an exchange of property resulting in gain_or_loss under sec_112 the predecessor to sec_1002 h_r rep 83d cong 2d sess at a265 sec_1002 was repealed by pub_l_no 90_stat_1520 and the language that was repealed was reincorporated for the most part as sec_1001 pub_l_no 90_stat_1520 the court in 166_f2d_27 2d cir determined that the voluntary exchange by the taxpayer of outstanding city of philadelphia bonds for refunding philadelphia bonds was a taxable_exchange the new bonds bore interest at the same rate until the first date at which the old bonds could be called by the city at which point they bore a lower rate of interest the new bonds bore a later redemption date but an earlier maturity_date the new bonds could be converted to registered_form upon the holder’s option and the new bonds had a higher fair_market_value the court looked to the fact that the new bonds were not only legally different but actually had a different financial value emery f 2d pincite the court found that the new bond was not merely evidence of an old obligation but rather it was a taxable_exchange under sec_112 166_f2d_773 3d cir involved a transaction nearly identical to that in emery the taxpayer had surrendered city of philadelphia bonds pursuant to a city of philadelphia refunding plan in exchange the taxpayer received new bonds with an earlier maturity_date and a later optional maturity_date with the same interest rate until maturity and after that with a lower interest rate and with a higher fair_market_value the court determined that these were important basic differences between the old and the new bonds and affirmed the lower court’s finding that the exchange was taxable and did not fit under the like-kind exception of sec_112 in contrast to emery and girard in 184_f2d_161 5th cir the fifth circuit determined that the surrender of defaulted municipal_bonds for refunding municipal_bonds was not a taxable sale_or_exchange of property under sec_112 the court stated that the incidents of changed maturity dates lessened interest rates and provision for a sinking_fund do not under the circumstances here evidence that the refunding bonds were ‘a thing really different’ from the old bonds mutual loan f 2d pincite furthermore the fair market values of the defaulted bonds and the replacement bonds were identical and the transaction was legally equivalent to the transfer of property for property of a like_kind in revrul_73_160 the service determined that when the maturity_date of a note was extended and the holder of the note agreed not to resort to the underlying_security until the other note holders had been paid the mere extension of the maturity of the notes does not constitute in substance the exchange of the outstanding note for a new and materially different note revrul_73_160 1973_1_cb_365 thus this one factor was determined to be insufficient for the modification of the note to qualify as a taxable_exchange under sec_1001 in revrul_81_169 1981_1_cb_429 a municipal_bond with interest with a sinking_fund provision was replaced by a new municipal_bond with interest no sinking_fund and a maturity_date of additional years the holders of the bonds had the choice of either exchanging their instruments or having the provisions of the new bonds stamped onto their old bonds the service determined that the two instruments were materially different and therefore this was a taxable_exchange and gain_or_loss was recognizable on the transaction the service noted that the difference in the fair_market_value of the bonds is not a material factor in determining whether there is a taxable_exchange the service determined that an adjustment to only the interest rate on a bond pursuant to an interest adjustment clause on the bond did not result in an exchange under sec_1001 in revrul_87_19 1987_1_cb_249 the bond holder in revrul_87_19 a bank however had waived its right to receive the higher rate of interest on the bond that was available to it and this waiver of their right represented a material_change in the terms of the bond resulting in an exchange taxable under sec_1001 there was no actual exchange of bonds in this case only the holder’s waiver of a right in revrul_89_122 1989_2_cb_200 a debt_instrument issued by a bank was modified in two different situations in situation the interest rate was reduced from to annually which was not adequate_stated_interest under sec_1274 but the principal_amount of dollar_figure remained unchanged in situation the stated principal_amount was reduced from dollar_figure to dollar_figure the service stated in revrul_89_122 that in general the modification of a debt_instrument constitutes a deemed exchange of debt instruments under sec_1001 if the modified debt_instrument is materially different from the original debt_instrument both modifications represented a material_change in the terms of the obligations and resulted in a deemed exchange of the instruments the holders of the instruments were to realize and recognize gain_or_loss on the exchanges x and lender modified the terms of the debt_instrument that was issued to lender sec_1001 addresses a sale_or_other_disposition of property and sec_1_1001-1 concerns an exchange of property for other_property differing materially either in_kind or in extent but neither directly addresses when a debt_instrument has been modified see eg shafer the service’s position has been that a modification of a debt_instrument can result in a deemed exchange of the old instrument for the new modified instrument if the old and new instruments are materially different in revrul_73_160 the service determined that where the changes to a debt_instrument are so material as to amount virtually to the issuance of a new security the same income_tax consequences should follow as if the new security were actually issued see also g_c_m stating the resolution of this type of issue does not turn on whether or not there was a physical exchange thus if the modifications caused the amended instrument to be materially different from the original instrument the modifications would cause a taxable_exchange of the old debt_instrument for the new debt_instrument in the first amendment there were few substantive amendments to the debt_instrument certain financial covenants were amended mostly debt-to-cash flow ratios were amended requirements on board meetings were amended and employee compensation limitations were amended none of these amendments embody legally distinct entitlements and none of the amendments cause the amended debt_instrument to be materially different from the original debt_instrument the second amendment to the debt_instrument amended more terms of the debt_instrument the maturity_date of the fixed loan was accelerated and the maturity_date of the term_loan was extended under the applicable case and administrative law prior to the adoption of the final regulations in the mere change in the maturity of a debt_instrument without more did not constitute a material_change in the instrument warranting exchange treatment under sec_1001 see revrul_73_160 although the debt_instrument states that all of the loans within the instrument constitute one obligation of x the transfer of dollar_figureo from the fixed rate loan is significant because the term and the fixed rate loans bear different interest rates thus the effect of this transaction is that the interest on the dollar_figureo has been amended an amendment to an interest rate together with an extension of maturity_date causes a new instrument to differ materially from the original instrument and it is generally treated as an exchange see emery girard see also revrul_81_169 more significant than the changes to the maturity are the reductions in the principal_amount of the debt_instrument in the second amendment the net outstanding principal_amount of the term_loan was reduced by approximately dollar_figurem this reduction in principal decreased the principal of the debt_instrument itself the reduction in principal is significant because one of the elements of debt is that it has a sum certain see 823_f2d_1310 9th cir see 248_f2d_399 2d cir because debt principal is a fundamental element to debt any change in the principal will be material thus the new debt_instrument differs materially from the original debt_instrument because of the change in principal also under cottage savings the new instrument embodies a legally distinct entitlement that is the right to a lesser sum of principal the principal_amount of the debt_instrument was amended the maturity of the term_loan within the debt_instrument was extended and the interest rate on dollar_figureo of the principal was amended these amendments together cause the new instrument to embody legally distinct entitlements and the new debt_instrument is materially different from the old instrument accordingly the old debt_instrument is deemed to have been exchanged for the new amended instrument under sec_1001 if the regulations were applicable to this transaction the extension of maturity_date would not fall within the safe-harbor period in sec_1_1001-3 because the three year extension is greater than percent of the original term of the loan case development hazards and other considerations determining whether there has been an exchange of property is highly fact- specific if additional facts are discovered please contact us however based on the facts as currently developed we believe that the debt_instrument was exchanged and that there are few litigating hazards on this issue in that case the amount of loss to lender determined under sec_1001 is the excess of the adjusted_basis of the old instrument over the amount_realized of the new instrument x the issuer is deemed to have paid off the old instrument for an amount equal to the issue_price of the new instrument because the principal_amount of the debt_instrument which x exchanged was reduced by approximately dollar_figurem sec_108 will apply under that section x will either have discharge_of_indebtedness income if it is solvent or reduction of tax_attributes including net operating losses if it is insolvent we recommend that you if you have any further questions please call deborah a butler assistant chief_counsel by mary e goode special counsel corporate cc cc ner tl