department of the treasury int ernal revenue service washington d c o f f i c e o f c h i e f c o u n s e l date number release date cc psi b01 postf-150654-01 uilc internal_revenue_service national_office field_service_advice memorandum for associate area_counsel communications technology and media associate area_counsel financial services cc lm fs li attn halvor adams from associate chief_counsel passthroughs special industries cc psi subject lease_stripping transaction this chief_counsel_advice responds to your memorandum dated date in accordance with sec_6110 this chief_counsel_advice should not be cited as precedent this writing may contain privileged information any unauthorized disclosure of this writing may have an adverse effect on privileges such as the attorney client privilege if disclosure becomes necessary please contact this office for our views legend taxpayer partnership partnership partnership partnership postf-150654-01 partnership partnership corporation corporation corporation corporation corporation corporation corporation corporation corporation corporation corporation corporation corporation equipment group a equipment group b note1 note note note short-term note1 postf-150654-01 short-term note long-term note entity date date date date date date date date date date date date date date date date date year year postf-150654-01 year month 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 postf-150654-01 dollar_figureu dollar_figurev dollar_figurew dollar_figurey dollar_figurez dollar_figureaa dollar_figurebb dollar_figurecc dollar_figuredd dollar_figureee dollar_figureff dollar_figuregg dollar_figurehh dollar_figureii x y z xx yy zz xxx yyy postf-150654-01 issue sec_1 whether the service may challenge taxpayer’s deductions on the grounds that they derived from transactions that lacked economic_substance whether the service can allocate the deductions to partnership pursuant to the authority granted in sec_482 of the internal_revenue_code whether the service can challenge the deductions on the grounds that the transaction between partnership and corporation is not valid under sec_351 of the internal_revenue_code if the transactions are valid whether the service can challenge the deductions on the grounds that any rent payments made by corporation when it assumed partnership 1’s obligations are capital expenses of corporation if the rent payments assumed by corporation from partnership are capital expenditures to what asset would the cost be capitalized and would corporation be entitled to recover any cost of the asset for any of the years in issue whether the service may challenge the deductions that taxpayer reported from corporation 1’s transfers of partial_interests in the long-term note to partnership and corporation in exchange for their assumption of portions of corporation 1’s obligations under the over lease on the grounds that they do not produce the deductions assuming alternatively that corporation would be entitled to the deductions may the service challenge the deductions on the grounds that the economic_performance requirements of sec_461 of the code were not satisfied assuming alternatively that corporation would be entitled to the deductions may the service challenge the deductions referenced above on the grounds that they are limited by sec_467 of the code whether characterizing the transaction between partnership and corporation as an agency arrangement or as a payment by partnership to corporation for assuming partnership 1’s liability under the over lease rather than as a transfer of property in exchange for stock support the disallowance of the deductions postf-150654-01 whether characterizing the transactions between corporation and partnership corporation as agency arrangements rather than as payments by corporation to those entities for assuming corporation 1’s liability under the over lease support the disallowance of the deductions reported by taxpayer from those deductions whether the service can take the position that the accuracy related penalty provided by code sec_6662 applies to deficiencies that result from the deductions conclusion sec_1 under the facts as currently developed the service may challenge partnership 1's deductions as they were derived from transactions that lacked economic_substance from the facts provided we conclude that sec_482 potentially applies to taxpayer and the other parties to this transaction because the participants appear to have acted in concert pursuant to a common plan to shift loss deductions to taxpayer they should be treated as part of the same controlled_group for purposes of applying sec_482 accordingly sec_482 may be applied to reallocate the rental income rental deductions and loss deductions among the participants to prevent the evasion of taxes and to clearly reflect the income of the participants sec_482 may be applied under three alternative theories disregarding the over leases between partnership and corporation so that taxpayer never acquires the obligation to pay rent to corporation and corporation never acquires the purchase obligation upon which long-term note was based which would prevent taxpayer from taking rental and loss deductions allocating the stripped rental income received by corporation from corporation under the master lease back to taxpayer or allocating taxpayer’s rental deductions to partnership and corporation so that the income and deductions attributable to the leases on the equipment are not artificially separated or allocating taxpayer’s rental deductions and losses claimed on the dispositions of the long-term note to partnership on the basis that sec_482 may be applied to allocate deductions attributable to property received in a sec_351 transfer from the transferee corporation back to the contributor to clearly reflect income postf-150654-01 the determination of whether or not the transaction between partnership and corporation qualifies under sec_351 will have no impact on the deductions reported by the taxpayer from the leasehold interest the service may challenge the deductions on the grounds that the payments of the rent obligation corporation assumed from partnership are capital expenses for corporation assuming the answer to issue number four is affirmative the cost would be capitalized to long-term note and corporation would not be entitled to recover any of the cost of long-term note in the years at issue the service may challenge the deductions the taxpayer reported from corporation 1’s transfers of partial_interests in long-term note to partnership and corporation in exchange for their assumption of portions of corporation 1’s obligations under the over lease since they do not produce the deductions assuming alternatively that corporation would be entitled to the deductions economic_performance requirements must be satisfied if such requirements as stated in sec_461 are not met the service may challenge the deductions assuming alternatively that corporation would be entitled to the deductions the service may challenge the deductions on the grounds that they are limited by sec_467 the facts support the argument that partnership transferred long-term note to corporation as payment for corporation assuming partnership 1’s liability under the over lease if this characterization of the transaction is correct partnership rather than taxpayer would be entitled to the rental deduction no facts exist that support the proposition that corporation acted as partnership 1’s agent taxpayer cannot characterize the transactions between corporation and partnership corporation as agency arrangements the facts do not support the existence of an agency relationship between any of these parties if the service prevails in the case our primary position is that the accuracy- related penalty applies to the portion of the underpayment that results from the disallowance of the deductions at the percent rate for gross valuation postf-150654-01 misstatements the service’s secondary position should be that it applies at the percent rate facts the facts as currently developed are as follows prior to date corporation owned equipment group a and equipment group b that was leased to corporation and corporation respectively in addition corporation also owned other_property that was being leased to third parties first leasing transaction corporation sold equipment package to partnership on date partnership paid dollar_figurea comprised of corporation debt assumed by partnership and note as a part of the deal corporation obtained liens on the equipment to secure payment also on date partnership sold the same equipment package to partnership partnership paid dollar_figureb in the form of note in exchange partnership took liens on both the equipment and the amount due under user leases to secure payment in addition on date partnership sold the equipment package to corporation for dollar_figurec as its payment corporation issued two notes note and short-term note note and short-term note were secured_by liens in favor of partnership on the equipment and pre-existing user leases master lease partnership leased back the equipment from corporation on date in what is referred to as the master lease the expiration dates for the master lease were date and date the date ending date was applicable to the equipment leased to corporation while the date ending date applied to the equipment leased to corporation under the terms of the master lease the rental payments that partnership owed to corporation exactly equaled the payments corporation owed to partnership under the terms of note 1these are referred to collectively as user leases the user leases all ended in year 2the equipment package was comprised of equipment group a and equipment group b and other_property postf-150654-01 remarketing agreements finally on date partnership and corporation entered into remarketing agreements with corporation specifically partnership and corporation agreed that corporation would be responsible for remarketing the equipment for the period between the expiration of the user leases and the expiration of the master lease in addition partnership signed a consent to this transaction corporation and corporation agreed that corporation would be responsible for remarketing the equipment after the expiration of the master lease periods the income strip - partnership on date partnership sold the initial lessor rights the rights to the rental income from corporation and corporation during the terms of their leases and rental income from other_property leased to other third parties during the terms of their leases to corporation in exchange for these rights corporation paid dollar_figured which was used by partnership to partially repay the balance owed partnership from note in connection with the sale corporation holder of note partnership holder of the remaining balance on note and partnership holder of note and short-term note agreed to release their liens on the rents due under each of the user leases additionally corporation and partnership but not partnership agreed to subordinate their liens on the equipment packages to the rights of corporation as a result the end users were instructed to pay their money directly to corporation corporation paid a portion of corporation 2’s debt that was incurred to acquire the property included in the equipment package and assumed the remainder of the debt partnership had assumed that debt when it purchased the equipment package from corporation on date finally partnership allocated percent of the income from the sale of the rights to the rents to entity a tax neutral entity which was a percent partner of partnership this resulted in the stripping of the income from that portion of the leasehold interest off to a tax neutral entity thus in summary partnership was left with the right to use the equipment package for the period of time between the end of the user leases and the end of the periods during which partnership had leased the equipment master lease partnership also owned a residual_interest in the equipment package from the end of the terms of the user leases until the end of the master lease corporation owned the equipment package subject_to its obligation to provide the use of the property to partnership until the termination dates of the master lease and subject_to the liens to which the equipment was encumbered postf-150654-01 corporation owned the interest that remained in the equipment package at the end of the master lease second income strip - partnership on date partnership sold its first two years of residual rights to equipment group b to corporation in exchange for the residual rights corporation paid dollar_figuree partnership allocated percent of the income from the sale to its percent partner entity thereby stripping the income from partnership 3's leasehold interest to a tax neutral entity partnership partially repaid its financial obligation to partnership under note with the dollar_figuree it received from corporation transfer of stripped leasehold interest to a taxable entity on date partnership contributed to corporation a subsidiary of corporation partnership 3's remaining rights to equipment package under the master lease partnership 3's obligation to pay rent to corporation pursuant to master lease and partnership 3's offsetting right to payments from corporation note and short-term note in exchange partnership received x shares of preferred_stock in corporation in addition corporation contributed dollar_figureh and received y shares of common_stock in corporation thus corporation claimed rent deductions on its obligation to pay rent to corporation which was satisfied by the payments it was entitled to receive from note second leasing transaction on date corporation sold equipment package and right to receive rent payments from corporation under master lease to partnership in exchange partnership paid dollar_figurei in the form of a promissory note note and assumed corporation 5's obligation to make payments to corporation pursuant to note the obligations to make payments to corporation exactly offset the right to receive rent payments from corporation pursuant to the master lease 3partnership had previously reduced the balance on note to dollar_figuref by applying the proceeds from the rights to rent sale to corporation by applying dollar_figuree to the remaining balance on note it was further reduced to dollar_figureg 4this covers the period between the end of the user leases and the end of the master lease minus the two year interest sold to corporation postf-150654-01 partnership 1’s sale of the equipment to corporation also on date partnership sold the equipment only from equipment group a and equipment group b along with partnership 1’s interest in the master lease to corporation as payment corporation issued two notes long-term note and short-term note the payment totaled dollar_figurej with long-term note being issued for dollar_figurek and short-term note issued for dollar_figurel over lease also on date partnership leased back the same equipment it sold from corporation in the transaction partnership also received the right to the rental payments from corporation due on the equipment under the terms of the master lease the lease between partnership and corporation is referred to as the over lease the payments pursuant to the over lease exactly offset the payments that corporation owed to partnership under long-term note in addition the expiration dates on the over lease match up exactly with the end dates of the master lease thus at the end of the day on date corporation had purchased the residual_interest that remained in the equipment at the end of the master lease for dollar_figurel income strip - partnership on date partnership sold the rights to rental payments on the equipment from equipment group a and equipment group b under the master lease from corporation to corporation corporation in exchange assumed the portion of note relating to the equipment partnership paid corporation dollar_figurem to offset the amount by which the discounted_present_value of the payment obligations corporation assumed under note exceeded the discounted_present_value of the rights corporation received to rental income under the master lease partnership allocated almost all of the income from the sale to entity a tax neutral entity thus at the end of the day on date partnership was left with only the right to receive payments under long-term note and an exactly offsetting obligation to make lease payments to corporation pursuant to the terms of the over lease partnership also obtained or assumed rights or obligations offset as follows partnership had sold the right to rent due on equipment master lease which it had purchased from corporation on date then sold to corporation and leased back from corporation on date and sold to corporation on date 5on date partnership 1’s interest in the master lease was the right to receive rental payments from corporation postf-150654-01 partnership had sold the right to the use of the equipment at the end of the master lease purchased from corporation on date to corporation on date corporation assumed on date the portion of note partnership had assumed on date to purchase the equipment from corporation and corporation had given partnership short-term note on date which offset the portion of partnership 1’s obligation under note that related to the equipment transfer of stripped leasehold interest to corporation on date pursuant to a signed assignment assumption_agreement partnership transferred long-term note and certain of partnership 1's obligations to corporation apparently including partnership 1's obligation to make payments to corporation pursuant to the over lease in exchange corporation transferred to partnership z shares of corporation common_stock the amounts payable to corporation pursuant to the over lease were exactly offset by the payments that were due pursuant to long-term note taxpayer contributed dollar_figuren to corporation and received xx shares of corporation common_stock in exchange corporation reported dollar_figureo carryover_basis in long-term note this figure was arrived at by adding the stated face value of long-term note dollar_figurep and the interest dollar_figureq deductions in year on date corporation transferred to partnership its interest in long-term note to the extent of the pre-existing user leases with corporation in exchange for this partnership assumed corporation 1's obligation to make rental payments to corporation under the terms of the over lease to the extent of the assets leased to corporation taxpayer characterized this partial_disposition of long-term note as constituting a rental expense of dollar_figurer this resulted in a claimed net_operating_loss nol of dollar_figures for taxpayer deductions claimed in year on date corporation transferred to corporation its interest in long-term note to the extent of a yy percentage interest in the pre-existing users leases with corporation in exchange for this corporation gave corporation an unsecured promissory note with a face value of dollar_figuret and assumed corporation 1's 6as the facts are currently developed it is unclear exactly which obligations certain of partnership 1's obligations refers to under this transaction prior to this transaction it appears that the only obligation that partnership retained was the obligation to make payments to corporation postf-150654-01 obligation for rental payments to corporation under the over lease to the extent of the assets leased to corporation taxpayer reported a dollar_figureu cost_basis in the portion of its interest in long-term note transferred to corporation taxpayer claimed a loss on this partial_disposition in the amount of dollar_figurev finally taxpayer also claimed rental expenses of dollar_figurew for rent purportedly paid to corporation deductions claimed in year on date corporation transferred to corporation its interest in long-term note to the extent of a zz percentage interest in the pre-existing user leases with corporation corporation in exchange gave corporation an unsecured promissory note with a face value of dollar_figurey and assumed corporation 1’s obligation for rental payments to corporation under the over lease to the extent of the assets leased to corporation taxpayer reported a cost_basis of dollar_figurez in the portion of its interest in long-term note that it transferred to corporation taxpayer also claimed losses on this partial_disposition in the amount of dollar_figureaa corporation 1’s redemption of partnership 1’s stock on date corporation redeemed from partnership the z shares of its stock that corporation issued to partnership in the transaction on date for dollar_figurebb relationships between the entities it appears that all of the entities involved in setting up the lease_stripping transactions were related through intertwined ownership officers agents and directors corporation was the managing partner of partnership under the facts as currently developed partnership played a significant role in the first lease_stripping transaction entity a percent partner of partnership 1’s percent partner partnership was also a percent limited_partner of both partnership and partnership the president of corporation is the registered agent of corporation furthermore the address given for corporation is exactly the same as the address of taxpayer postf-150654-01 the general_partner of partnership who signed the assignment assumption_agreement with corporation owned corporation additionally this individual along with the president of corporation serve together on the board_of another corporation corporation finally the vice president of corporation is the same individual referenced above who signed the assignment assumption_agreement as a general_partner of partnership corporation and partnership which was a limited_partner of partnership are believed to be related through a common officer in addition the president of corporation and the aforementioned common officer of corporation serve together as officers and directors of five other corporations law and analysis issue one to be respected a transaction must have economic_substance separate and distinct from the economic benefit achieved solely by tax reduction if a taxpayer seeks to claim tax benefits which were not intended by congress by means of transactions that serve no economic purpose other than tax savings the doctrine_of economic_substance is applicable 254_f3d_1313 11th cir aff’g 113_tc_254 31_f3d_117 3d cir 861_f2d_494 7th cir aff’g 87_tc_1087 364_f2d_734 2d cir aff’g 44_tc_284 31_tc_33 aff’d 270_f2d_294 3d cir nicole rose corp v commissioner t c no acm partnership v commissioner tcmemo_1997_115 aff’d in part and rev’d in part 157_f3d_231 3d cir whether a transaction has economic_substance is a factual determination 338_us_451 this determination turns on whether the transaction is rationally related to a useful nontax purpose that is plausible in light of the taxpayer’s conduct and useful in light of the taxpayer’s economic situation and intentions the utility of the stated purpose and the rationality of the means chosen to effectuate it must be evaluated in accordance with commercial practices in the relevant industry 89_tc_986 acm partnership supra a rational relationship between purpose and means ordinarily will not be found unless there was a reasonable expectation that the nontax benefits would be at least commensurate with the transaction costs yosha supra acm partnership supra in determining whether a transaction has economic_substance so as to be respected for tax purposes both the objective economic_substance of the postf-150654-01 transaction and the subjective business motivation must be determined acm partnership f 3d pincite 968_f2d_1229 d c cir 909_f2d_1360 9th cir the two inquiries are not separate prongs but are interrelated factors used to analyze whether the transaction had sufficient substance apart from its tax consequences to be respected for tax purposes acm partnership f 3d pincite casebeer f 2d pincite courts have recognized that offsetting legal obligations or circular cash flows may effectively eliminate any real economic significance of the transaction 364_us_361 in knetsch the taxpayer repeatedly borrowed against increases in the cash_value of a bond thus the bond and the taxpayer’s borrowings constituted offsetting obligations as a result the taxpayer could never derive any significant benefit from the bond the supreme court found the transaction to be a sham as it produced no significant economic_effect and had been structured only to provide the taxpayer with interest deductions in 94_tc_738 the tax_court denied the taxpayer the tax benefits of a series of treasury bill sale-repurchase transactions because they lacked economic_substance in the transactions the taxpayer bought treasury bills that matured shortly after the end of the tax_year and funded the purchase by borrowing against the treasury bills the taxpayer accrued the majority of its interest_deduction on the borrowings in the first year while deferring the inclusion of its economically offsetting interest_income from the treasury bills until the second year the transactions lacked economic_substance because the economic consequence of holding the treasury bills was largely offset by the economic cost of the borrowings the taxpayer was denied the tax_benefit of the transactions because the real economic impact of the transactions was infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions sheldon t c pincite in 157_f3d_231 3d cir the taxpayer entered into a near-simultaneous purchase and sale of debt instruments taken together the purchase and sale had only nominal incidental effects on the taxpayer’s net economic position acm partnership f 3d pincite the taxpayer claimed that despite the minimal net economic_effect the transaction had economic_substance the court held that transactions that do not appreciably affect a taxpayer’s beneficial_interest except to reduce tax are devoid of substance and are not respected for tax purposes acm partnership f 3d pincite the court denied the taxpayer the purported tax benefits of the transaction because the transaction lacked any significant economic consequences other than the creation of tax benefits postf-150654-01 moreover claims of pre-tax profit are not dispositive there has been some precedent that economic_substance for a lease transaction will be satisfied if there is some modicum of economic_substance which may mean some modicum of pretax profit see rice’s toyota world inc v commissioner supra 84_tc_412 ndollar_figure in 912_f2d_736 4th cir the fourth circuit found that a leasing transaction was a sham in doing so it described a dollar_figure profit potential as minimal on an eight-year investment of dollar_figure the fourth circuit also found evidence of tax motivation in the offsetting obligations to pay rent and debt service the transaction also involved the use of related parties to avoid sec_465 under these facts the court found that the tax tail began to wag the dog hines f 2d pincite thus small profits on a lease transaction may be overlooked when tax considerations have taken over the transaction see also pacheco v commissioner tcmemo_1989_296 in nicole rose corp v commissioner t c no the tax_court found that petitioner's acquisition of certain stripped lease interests to shelter gain in an intermediary transaction lacked economic_substance petitioner stepped into the transaction by purchasing the shares of a corporation and merging that corporation into petitioner petitioner then sold assets it had acquired in the merger generating an approximately dollar_figure million gain pursuant to a series of prearranged transactions including several sec_351 transactions petitioner acquired the purported interests and obligations relating to certain leases the majority of the income relating to these interests had been stripped off and placed into a_trust fund upon petitioner’s subsequent transfer of these interests petitioner claimed inter alia an ordinary business_expense deduction of approximately dollar_figure million in holding that the transactions lacked economic_substance the court noted that no credible business_purpose and no viable economic_substance existed for petitioner’s transfer of the lease interests further the court noted that the prearranged transactions leading up to petitioner’s acquisition of the purported interests created a circular flow of funds in imposing the accuracy related penalty the court held that the participation of highly paid professionals did not provide petitioner any protection excuse justification or immunity as discussed transactions devoid of economic_substance are not recognized for federal_income_tax purposes amc partnership v commissioner f 3d pincite as currently developed the facts indicate that the series of transactions in which corporation obtained and sold its interest in both long-term note and rental payment obligations under the over lease lacked economic_substance under both a subjective and objective inquiry as further discussed below the facts also do not suggest a plausible business_purpose for the transactions postf-150654-01 the prearranged series of transactions executed among related parties beginning with the original transfers on date of the leasehold interests and culminating with the transfers from corporation to corporation lacked economic_substance since the series of transactions lacked economic_substance the deductions arising from the transactions are not recognized economically corporation entered the transaction on date after partnership corporation and corporation participated in a prearranged series of transaction which were executed within a one month period among parties that shared common officers managers agents and directors and which stripped the income from the leasehold interest and allocated it to partnership 1’s tax neutral partner entity at the same time partnership was also able to shift the deductions relating to the leasehold interest to corporation corporation realized the deductions by claiming rental expenses which had offsetting payments due under the terms of long-term note against the rent due under the over lease and by transferring offsetting interests in long-term note and the over lease to partnership and corporation it is of some significance that in the final steps of the transactions little consideration was given aside from assuming the obligations of the over lease on the part of corporation and no other consideration was given in the case of partnership furthermore from a subjective business_purpose and an objective perspective it is not readily apparent how either taxpayer or the other parties involved could have reasonably expected to earn a pre-tax profit from this series of transactions based on the transactional documents it appears that corporation received from partnership only long-term note and the exactly offsetting obligation to make rental payments to corporation under the terms of the over lease corporation held the right to the equipment until the end of the master lease having received that right from partnership on date corporation held the right to the equipment at the end of the master lease having received that right from partnership on date accordingly it does not appear that corporation received anything from partnership from which it could have hoped to earn an economic profit independent of tax savings based upon the facts as developed the transactions lack economic_substance and may be disregarded as shams and taxpayer is not entitled to the deductions reported from them issue two a section 482-generally sec_482 was designed to prevent the artificial shifting milking or distorting of the true net incomes of commonly controlled enterprises 405_us_394 194_f3d_782 7th cir 372_f2d_415 4th cir cert_denied 389_us_841 42_tc_114 aff’d 358_f2d_342 6th cir cert_denied 385_us_899 cf h_r rep no 70th cong 1st sess sec_482 provides in relevant part 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 to clearly reflect the income of any of such organizations trades_or_businesses emphasis added for the reallocation rule_of sec_482 to apply to a transaction the transaction must involve at least two entities owned or controlled by the same interests sec_482 imposes two requirements ownership or control must exist in some manner among the participants and the same interests must possess the control none of the participants in the corporation lease_stripping transaction are directly or indirectly related to each other while common ownership may often be indicative of the existence of a control group for sec_482 purposes sec_482 is applicable where a party is found to have actually exercised control_over the participants in the transaction at issue legal standard for determining control under sec_482 definition of control when control does not exist through majority ownership of voting_stock or a legally enforceable agreement delegating the power to direct an entity’s actions the regulations provide alternatively that control results from the action of two or more taxpayers acting in concert or with a common goal or purpose sec_1 i control includes any kind of control regardless of whether such control is direct or indirect or legally enforceable id case law is in accord with the regulation’s definition of control indicating that it is actual and practical control which counts in the application of sec_482 rather than record ownership or legally enforceable control ach t c pincite 17_tc_231 aff’d 202_f2d_873 5th cir cert_denied 346_us_819 acq in part and nonacq in part 1952_2_cb_2 1972_2_cb_2 see also appeal of isse koch co inc postf-150654-01 b t a acq 1925_1_cb_2 control not arising or flowing from means legally enforceable may be just as effective in evading taxation as if founded on the most formal and readily enforceable legal instrument dhl corp v commissioner t c memo holding that foreign investors did not have sec_482 control_over a corporation despite their ability to appoint a majority of its board_of directors because domestic shareholders retained the ability to control day-to-day operations and major events charles town f 2d pincite holding that two shareholders were in control of a corporation in which they only owned two percent of the outstanding_stock because of their possession of effective and practical control_over the corporation in addition final regulations provide that a presumption of control arises if income and deductions have been arbitrarily shifted sec_1_482-1 case law is in accord with the regulation’s presumption of control through the arbitrary shifting_of_income or deductions dhl corp t c memo pincite when the interests controlling one entity and those controlling another have a common interest in shifting income from the former to the latter entities may be considered commonly controlled see also 598_f2d_1382 5th cir holding that the government correctly argued that proof of a shifting_of_income between two corporations establishes a presumption of common_control under sec_1_482-1 -predecessor to current sec_482 regulations 294_f2d_82 5th cir finding presumption of control under sec_29 of regulation 111-predecessor to current sec_482 regulations according to both the sec_482 regulations and the applicable case law it is not required that a taxpayer possess a majority stock ownership_interest in a participant to establish control as defined under sec_482 both the regulations and case law provide the service with the authority to determine the existence of control by considering the reality of the participant’s relationships and examining whether the same interests effectively control the participants to the transaction involved rather than basing the control determination solely on the taxpayer’s percentage of ownership of voting_stock or legal right to direct the participant’s actions thus proof of the actual exercise of control by a party or parties will establish the existence of control for sec_482 purposes once sec_482 control is established the section applies to determine the clear_reflection_of_income among the members of the controlled_group under the section legal standard for determining the same interests under sec_482 the regulations provide no guidance as to what the term the same interests means under sec_482 case law has indicated that in using the term the same interests congress intended to include more than the same persons or the same individuals see 453_f2d_1144 2d postf-150654-01 cir cert_denied 407_us_934 rejecting tax court’s view that two independently owned corporations acting in concert together to make interest-free loans to a jointly owned corporation did not constitute the same interests within the meaning of sec_482 366_f2d_890 5th cir cert_denied 386_us_1016 cf 2_bta_229 cf 598_f2d_1375 5th cir but see the 5_tc_558 acq c b acq withdrawn 1965_1_cb_5 case law indicates that the legal standard for determining whether the same interests control an entity is identical to the standard applied to determine whether control of an entity exists therefore if different entities are found to have a common goal to shift income or deductions among each other not only will control of the entities exist but the entities will also constitute the same interests for the purpose of sec_482 as previously discussed there appears to exist a common plan among the lease_strip participants to shift deductions to taxpayer while shifting income away from taxpayer consequently taxpayer constitutes the same interests with respect to the participants in this transaction under sec_482 meaning that the service may reallocate the rental income as well as the rental and loss deductions claimed by taxpayer to prevent the evasion of taxes or to clearly reflect income existence of control among taxpayer partnership corporation corporation partnership and corporation -acting in concert and the control presumption under sec_1_482-1 and the relevant case law taxpayer is not required to own an interest in any of the participants majority or otherwise for the requisite control to exist under sec_482 instead the service may consider whether taxpayer actually exercised control_over the participants despite taxpayer’s having no apparent legal or contractual right to direct their actions additionally in making this determination the service may also apply the presumption of control provided for in sec_1_482-1 and in the applicable case law from the facts provided to us it appears as though the participants acted in concert pursuant to a common plan to arbitrarily shift substantial rental deductions and losses from partnership to taxpayer while shifting the associated rental income to tax exempt entities the leases which were used for the second lease_strip originated with partnership which owned the equipment at the initiation of the second lease_strip partnership sold the equipment to corporation to generate long-term note through which substantial losses were ultimately claimed by taxpayer partnership immediately leased back the equipment under postf-150654-01 the over leases since the equipment was already subject_to preexisting leases to corporation over the same terms as the over leases and for the same rent partnership was able to retain ownership of the equipment for the term of the over leases without having to make any actual payments to corporation partnership 1’s retained ownership of the equipment for the over lease terms allowed it to strip the rental income to be received from corporation from the associated rental expenses through the use of corporation entity a tax exempt entity was the recipient of all the stripped rental income partnership 1’s and corporation 11’s participation in the lease_strip enabled corporation to receive a leasehold interest in the purported sec_351 transaction stripped of its associated income but not of its associated rental deductions corporation 10’s issuance of long-term note served to ultimately provide taxpayer the means to claim large loss deductions due to partnership 1’s immediate leasing back of the equipment under the over leases corporation could offset the amounts due under long-term note by the amounts partnership owed under the over leases when partnership transferred long-term note as part of the purported sec_351 transaction this provided taxpayer with a large carryover_basis in long-term note of dollar_figureu which taxpayer could then use and did in fact use to generate substantial loss deductions upon a subsequent disposition of long-term note corporation was able to issue long-term note at no substantive cost to itself because according to the facts its obligation under long- term note was exactly offset by the payments partnership owed corporation under the lease back of the equipment partnership 4’s and corporation12’s participation in lease_strip allowed taxpayer to realize the loss deductions inherent in the transferred long-term note taxpayer sold to partnership and corporation for minimal consideration partial_interests in the long-term note which were offset by taxpayer’s obligations under the over leases transferred by partnership thus partnership and corporation received nothing of substance in return for their purchases of interests in the long-term note it was these sales which resulted in losses on long-term note dispositions of dollar_figurev dollar_figureu cost_basis minus dollar_figuret sales_price and dollar_figureaa dollar_figurez cost_basis minus dollar_figurey sales_price partnership and corporation effectively acted as accommodation parties to allow taxpayer to recognize the losses inherent in the transferred long-term note these facts considered in conjunction with the short time frame in which the transaction occurred are supportive of a finding that taxpayer and the other participants acted in concert within the meaning of the regulations the parties had the common goal to separate rental income from the leases with the corresponding rental expenses and arbitrarily shift only the rental expenses to taxpayer without any associated income inclusions and shift to taxpayer losses which we recommend should be argued were not economically sustained postf-150654-01 due to the offsetting nature of all the obligations partnership and corporation acted together to strip the lease income from the equipment into the hands of entity a tax neutral entity corporation received dollar_figurem from partnership which can be viewed as income analogous to fee income for its participation in the common plan it is unclear what partnership received from its participation in the plan other than dollar_figurebb from corporation for corporation 1’s redemption of the stock more facts should be developed to determine if partnership claimed a substantial loss on corporation 1's stock_redemption by reporting an inflated basis for the stock more facts should also be developed to determine what form of compensation or other benefit corporation partnership and corporation may have received for their roles in the common plan taxpayer partnership corporation partnership corporation and corporation acted in conjunction with one another to effectuate the lease_stripping transaction because each of the participants in the lease_stripping transaction acted in concert and pursuant to a common plan to arbitrarily shift rental income away from taxpayer to a tax neutral entity arbitrarily shift rental deductions away from partnership corporation and partnership and arbitrarily shift loss deductions away from partnership control is presumed to exist among the parties for the purposes of sec_482 pursuant to sec_1_482-1 and the applicable case law we fail to see any significant evidence that would rebut this presumption ii application of sec_482 to this transaction there are two alternative bases to apply sec_482 to this transaction to prevent the evasion of tax and to clearly reflect income a economic_substance tax_evasion standards of sec_482 the application of sec_482 has been upheld where the challenged transaction was arranged without a valid business_purpose and solely in order to avoid taxes see 88_tc_252 when analyzing potential tax_avoidance aspects of a transaction the commissioner will respect the transaction’s contractual terms if consistent with the true economic_substance of the transaction sec_1_482-1 the economic_substance standard of the regulations overlaps with the economic_substance and sham_transaction doctrines developed in case law which allow the service to disregard transactions lacking a business_purpose and a potential for economic profit however the see 293_us_465 364_us_361 interest deductions disallowed where nothing of substance could be realized from the transaction other than a tax deduction 435_us_561 postf-150654-01 sec_482 regulations expand upon case law guidance by providing additional guidance specifically the regulations provide the following the contractual terms including the consequent allocation of risks that are agreed to in writing before the transactions are entered into will be respected if such terms are consistent with the economic_substance of the underlying transactions in evaluating economic_substance great weight will be given to the actual conduct of the parties and the respective legal rights of the parties if the contractual terms are inconsistent with the economic_substance of the underlying transaction the district_director may disregard such terms and impute terms that are consistent with the economic_substance of the transaction sec_1_482-1 in making allocations under sec_482 the district_director is not restricted to the case of improper accounting to the case of a fraudulent colorable or sham_transaction or to the case of a device designed to reduce or avoid tax by shifting or distorting income deductions credits or allowances sec_1_482-1 thus sec_482 provides an alternative approach to challenging a transaction for lack of economic_substance by providing additional criteria under which to apply the economic_substance and sham inquiries to the parties’ conduct and not restricting the service’s allocation authority to instances of sham transactions see 88_tc_252 under sec_482 the economic_substance of a transaction is analyzed by focusing on the parties’ actual conduct the economic risks purportedly transferred and whether from a business perspective the transaction makes objective business sense see sec_1_482-1 and sec_1_482-1 where the economic_substance of a transaction is inconsistent with the parties’ purported characterization the service may disregard the contractual terms underlying the transaction and treat the transaction consistent with its economic_substance this treatment may result in a denial of deductions arising from the transaction at issue see eg b forman f 2d pincite the simple expedient of drawing up papers is not controlling for tax purposes when the objective economic realities of a situation are to the contrary 752_f2d_89 4th cir transaction is a sham where taxpayer is motivated by no business_purpose other than obtaining tax benefits in entering a transaction and where transaction has no economic_substance because no reasonable possibility of profitability exists 157_f3d_231 3d cir cert_denied 526_us_1017 transaction devoid of economic_substance cannot be the basis for a deductible loss postf-150654-01 the contractual terms of this transaction are inconsistent with its economic_substance this transaction was set up to resemble a series of leases financed with notes however the terms of this transaction are inconsistent with its true substance partnership 1’s transfer of the equipment to corporation was structured to resemble a sale and corporation 10’s transfer of long-term note was intended to represent corporation 10’s payment obligation under the purported sale the transaction was also structured to include partnership 1’s leasing back of the equipment in reality structuring the transaction as a sale leaseback with offsetting rental and note payment obligations on both sides of the transaction made possible the establishment of long-term note as a vehicle for generating loss deductions once transferred to taxpayer creation of long-term note as a loss recognition vehicle occurred without corporation acquiring the burden of having to make payments under long-term note or taxpayer acquiring the burden to make rental payments the stripping off of all of the rental income associated with the equipment leases prior to taxpayer’s receipt of its interest in the equipment helped further tax_avoidance objectives by ensuring taxpayer could obtain the deductions and losses that the transaction was intended to achieve without having any corresponding income inclusion since the over leases and the note do not actually invoke payment obligations on behalf of either partnership or corporation sec_482 permits the recasting of this transaction consistent with its economic_substance recasting the transaction consistent with its economic_substance would result in disregarding the over leases between partnership and corporation so that taxpayer never acquires the obligation to pay rent to corporation as a result of the purported sec_351 transfer and corporation never acquires the purchase obligation upon which the long-term note was based treating the transaction consistently with its economic_substance would prevent the avoidance of tax because taxpayer would be prohibited from taking rental deductions for rent purportedly paid to corporation under the transferred over leases for which it bore no true economic burden taxpayer would also be prevented from claiming loss deductions upon the disposition of the long-term note the transaction lacks any apparent business_purpose taxpayer claims that it had a valid business_purpose for this transaction taxpayer’s asserted business_purpose was to earn a profit from the re-leasing and or sale of the equipment taxpayer claimed that it expected to earn dollar_figuree at the cost of a dollar_figurecc investment from re-leasing the equipment subject_to the corporation end user leases at their expiration however it does not appear that taxpayer had the right to engage in the future actions necessary to establish a business_purpose for this transaction according to the facts partnership only leased the postf-150654-01 equipment from corporation for the terms of the over leases which was equivalent to the terms of the master lease and it is this partial interest that was transferred to corporation in the purported sec_351 transaction corporation retained the rights to the equipment subsequent to the expiration of the over leases master lease we question whether taxpayer could have reasonably expected to receive any renewal rents from the equipment as it had no rights to the equipment subsequent to the expiration of the end user leases it is not clear to what extent if any that taxpayer assumed any risk with respect to this transaction we are not aware of any facts which would support a finding that taxpayer had any substantive risk with respect to the transaction8 b clear_reflection_of_income standard of section allocation to prevent the artificial separation of income from expenses even in the absence of tax_avoidance motives the commissioner may make a sec_482 allocation if necessary to clearly reflect income the clear_reflection_of_income prong of sec_482 has been applied to transactions where the expenses attributable to property have been artificially separated from the income earned from the property for instance in 305_f2d_681 9th cir the taxpayers transferred planted crops to another corporation in exchange for the corporation’s stock the profit from the harvested crop was included in the income of the transferee corporation while the transferors deducted the expenses attributable to raising the crop prior to the transfer applying sec_482 the commissioner allocated the expenses of raising the crop from the transferors to the transferee corporation the court upheld the allocation finding it necessary to clearly reflect income by matching the income with the expenses associated with producing it id pincite see also 198_f2d_214 2d cir cert_denied 344_us_874 applying the clear_reflection_of_income standards of sec_482 either the stripped rental income received by corporation from corporation under the master lease should be allocated back to taxpayer or taxpayer’s rental deductions for rent purportedly paid to corporation should be allocated to partnership and corporation making one of these alternative allocations would prevent the artificial separation of the rental income and the deductions attributable to the payments due under the leases the income from the leases would then be properly matched with the expenses_incurred in producing the income -- the but see ies industries inc v u s 253_f3d_350 8th cir compaq computer corp v commissioner u s app lexis 5th cir ups of america v commissioner 254_f3d_1014 11th cir postf-150654-01 corresponding obligation to pay rent under either the master lease or the over leases allocations involving nonrecognition transactions when a sec_351 transfer is involved the commissioner may disregard the nonrecognition provisions of sec_351 to make a sec_482 allocation if necessary to clearly reflect income among controlled taxpayers sec_1 f iii a to clearly reflect income or prevent the avoidance of taxes the commissioner may make an allocation under sec_482 with respect to transactions that would otherwise qualify for nonrecognition_of_gain_or_loss under sec_351 additional authority exists through case law in support of the service’s position allowing the disregarding of nonrecognition provisions if necessary to clearly reflect income one such case in accord with the service’s position is 137_f2d_600 3d cir cert_denied 320_us_794 in which a parent_corporation transferred stock with a substantial_built-in_loss to a wholly-owned subsidiary in a transaction which qualified as a nonrecognition_transaction under the predecessor to sec_351 the subsidiary sold the stock and claimed a loss deduction id pincite the commissioner disregarded the nonrecognition_transaction and treated the amount of the pre-contribution loss as sustained by the parent instead of the subsidiary under sec_45 of the revenue act of the predecessor to sec_482 id the taxpayer claimed that the subsidiary was entitled under the nonrecognition and basis provisions of the code to claim a loss deduction by virtue of the carryover_basis it received in the stock transfer id pincite the court rejected the taxpayer’s argument stating that in every case in which sec_45 was applied its application would result in a conflict with the literal provisions of some other act id according to the court the section could still be applied to clearly reflect income despite a conflict with the literal provisions of another section of the code id other cases are in accord with national securities corp that sec_482 may be applied to clearly reflect income despite apparent conflict with the provisions of another section of the code see rooney v united_states f 2d pincite sec_482 will control when it conflicts with sec_351 central cuba sugar co f 2d pincite commissioner properly applied sec_482 to reallocate deductions associated with property acquired in a reorganization to transferee to clearly reflect income 811_f2d_543 10th cir commissioner has broad discretion under sec_482 to correct distortion_of_income occurring through the strict application of other provisions of the code and may invoke sec_482 to reallocate income derived from the disposition of property previously acquired in a nonrecognition_transaction 281_f2d_7 4th cir 756_f2d_1430 9th cir cert_denied 474_us_1055 commissioner may invoke sec_482 to reallocate income derived from the disposition of property previously acquired in a nonrecognition_transaction see also 88_tc_252 but see 643_f2d_747 ct_cl aff’d without opinion 732_f2d_168 fed cir in the absence of tax_avoidance motives the commissioner may not disregard sec_351 transactions to apply sec_482 even if doing so would be necessary to clearly reflect income in the instant case partnership 1’s transfer of the long-term note and its interest in the over leases resulted in a distortion_of_income partnership 1’s sec_351 transfer enabled taxpayer to acquire in a tax-free transaction both the right to claim rental deductions on the equipment as a sublessee without the corresponding burden of having to make an actual cash outlay for rental payments as well as a high carryover_basis in long-term note as a result of the sec_351 transfer taxpayer was able to claim deductions collectively amounting to dollar_figuredd from year - year for which taxpayer paid only dollar_figureee a significant distortion_of_income resulted from the sec_351 transfer because taxpayer acquired the right to deductions which it did not economically incur no rental deductions were economically incurred by taxpayer because taxpayer never had any real substantive obligation with respect to the rental payments owed to corporation under the over leases in that the payments due from corporation under long- term note appear to have been designed to offset any economic obligation similarly this offset prevented corporation from having an economic obligation under the note therefore the note taxpayer received did not justify the dollar_figureo carryover_basis that taxpayer was able to report as a result of the sec_351 transfer applying the analysis adopted in the national securities corp line of cases the service may therefore disregard the sec_351 transfer and allocate taxpayer’s rental deductions and loss deductions on the long-term note back to partnership to clearly reflect income a sec_482 allocation may be made despite the fact that its application would result in a conflict with the provisions of sec_351 which would treat the transferee corporation corporation as the true owner of the leasehold interests and allow taxpayer to claim the rental deductions and losses issue three gain_or_loss to corporation on exchange of stock whether or not the transaction between partnership and corporation is respected as a sec_351 exchange corporation would not recognize gain_or_loss on its transaction with partnership sec_1032 provides that no gain_or_loss shall be recognized to a corporation on the receipt of money or other_property postf-150654-01 in exchange for stock including treasury_stock of such corporation sec_1_1032-1 emphasizes that the no gain_or_loss rule applies regardless of the nature of the transaction and the facts and circumstances involved the disposition by a corporation of shares of its own stock including treasury_stock for money or other_property does not give rise to taxable gain or deductible loss to the corporation regardless of the nature of the transaction or the facts and circumstances involved corporation 1’s loss on sale of long-term note corporation will have the same basis in the long-term note it receives from partnership whether or not the transaction between corporation and partnership qualifies as a sec_351 exchange therefore a determination that the transaction between partnership and corporation fails to qualify under sec_351 does not provide an independent alternate grounds for adjustments to the deductions for the loss on the sale of the portions of long-term note reported by the taxpayer in a transaction that qualifies under sec_351 the transferee’s basis in the property it receives from transferor is computed under sec_362 sec_362 gives the transferee a carryover_basis -- that is a basis equal to the basis of such property in the transferor’s hands -- increased in the amount of any gain recognized to the transferor on such transfer here the property received by corporation from partnership in the purported sec_351 transaction consisted of long-term note partnership had acquired long-term note along with short-term note in a sec_1001 taxable_exchange less than one-month earlier under sec_1001 partnership presumably recognized gain_or_loss on this taxable_exchange in an amount measured by the difference between the aggregate amount partnership realized ie the face value of long-term note and short-term note 2--dollar_figurej and its adjusted_basis in the equipment because partnership took the face value of long-term note and short-term note into its amount_realized partnership 1's tax_cost_basis in each such note is its respective face value 126_fsupp_184 ct_cl therefore if the partnership - corporation exchange qualifies under sec_351 corporation 1’s basis in long-term note would appear to be that note’s face value dollar_figurek in in fact however corporation reported a dollar_figureo carryover_basis in long-term note consisting of the face_amount of dollar_figurek plus interest of dollar_figureq for month of year ordinarily a taxpayer reports interest_income paid_or_accrued in gross_income under sec_61 but does not include that interest in long-term note 1’s basis it is unclear on the facts before us what partnership 1’s rationale was for increasing its basis in long-term note we suggest you consider exploring this matter further given that the effects of increasing basis in an asset include increasing the amount of loss or decreasing the postf-150654-01 addition there is no apparent gain recognized by partnership from this transactiondollar_figure if the transaction between partnership and corporation fails to qualify under sec_351 corporation 1’s basis in the property it received from partnership long-term note would be computed under sec_1012 sec_1 d sec_1012 provides in general that the basis_of_property shall be the cost of such property sec_1_1012-1 of the income_tax regulations provides that the cost of property is the amount_paid for property in cash or other_property part of the cost of property and thus an amount also included in the basis of such property is any liability incurred to make the acquisition or any liability of the seller assumed by the taxpayer as consideration for the property 331_us_1 441_f2d_465 5th cir 103_tc_501 strictly speaking in the recognition and nonrecognition transactions involved here corporation as a transferee of long-term note derives its basis from different sources in a taxable transaction corporation 1’s basis would be its own sec_1012 cost via its assumption of partnership 1’s overlease payment obligation whereas the sec_351 transaction involved here would give corporation a carryover_basis that derives from partnership 1’s tax cost resulting from partnership taking the face_amount of long-term note into partnership 1’s amount_realized as noted above as a practical matter however this difference is without significance the note payment obligation on long-term note and the overlease payment obligation exactly offset each other moreover corporation obtained long-term note less than month after corporation issued it and there has been no evidence offered to suggest that the equivalency in value between the two payment obligations has been altered accordingly corporation 1’s basis in long-term note should be the same whether it acquired long-term note in a taxable or a sec_351 transaction therefore a determination that the transaction between partnership and corporation does not qualify under sec_351 does not provide an independent alternate grounds for adjustments to the deductions for the loss on the sale of the portions of long-term note reported by taxpayer amount of gain realized on the subsequent disposition of that asset partnership 1’s only potential for gain in this transaction lies in the application of sec_357 partnership 1’s basis in the property transferred ie long-term note was its face value however the face value of long-term note was equal to partnership 1’s liability under the over lease accordingly partnership will recognize no gain under sec_357 postf-150654-01 corporation 1’s rental expense deductions we believe there is no theory under which failure of the transaction between partnership and corporation to qualify under sec_351 will provide an alternate ground for adjustments to the rental expense deductions reported by taxpayer from the leasehold interest introductory discussion concerning issues four through eight the following discussion and analysis is meant to facilitate the analysis of issues four through eight this material analyzes certain aspects and parts of the overall transaction in detail and is intended to provide a basis for understanding the analysis of the aforementioned issues date sale_and_leaseback on date partnership sold the equipment subject_to the master lease to corporation in exchange for two notes totaling dollar_figurej a dollar_figurek long-term nonrecourse secured installment note long-term note and a dollar_figurel short-term secured promissory note short-term note dollar_figure long-term note was payable in semi-annual installments beginning on date and ending on date under sec_1001 partnership presumably recognized gain_or_loss on this transaction in an amount measured by the difference between the aggregate amount partnership realized dollar_figurej and its adjusted_basis in the equipmentdollar_figure corporation did not actually execute a dollar_figurel note in favor of partnership it simply assumed dollar_figurel of partnership 1’s dollar_figurei obligation to corporation under note because we do not know partnership 1’s basis in the equipment it sold we also do not know the exact amount of partnership 1’s gain_or_loss the statutory formula for determining such gain_or_loss however is found in sec_1001 which provides that a taxpayer’s gain from the sale of property shall be the excess of the taxpayer’s amount_realized over the adjusted_basis provided in sec_1011 for determining gain and that a taxpayer’s loss shall be the excess of the taxpayer’s adjusted_basis provided in sec_1011 over the amount_realized sec_1001 provides that a seller’s amount_realized from the sale of property is the sum of any money received plus the fair_market_value of the property other than money received sec_1011 provides for purposes of this analysis that the adjusted_basis for determining the gain_or_loss from the sale_or_other_disposition of property shall be the basis of such property as determined under sec_1012 cid cid postf-150654-01 because partnership took the face values of long-term note and short-term note into its amount_realized partnership 1’s tax_cost_basis in each is its respective face value 126_fsupp_184 ct_cl if partnership used the installment_method under sec_453 to report recognized gain over the term of long-term note and short-term note it would use the gross_profit formula found in sec_453 to determine the percentage of each payment that represented respectively the taxable gain and non-taxable return of basis on the equipment sale accrued interest on long-term note and short- term note would be includible in partnership 1’s gross_income under sec_61 alternatively if partnership elected out of the installment_method and all gain was recognized in the year_of_sale its subsequent-year collections on long-term note and short-term note would be tax-free but would reduce the basis in long-term note and short-term note with accrued interest on long-term note and short-term note being includible in partnership 1’s income under sec_61 on the same day as the sale partnership leased the equipment back from corporation the rental payments that partnership agreed to make to corporation under the over lease exactly offset the payments that corporation owed partnership under long-term note these over lease payments generally are deductible by partnership ratably over the period of the lease_term regardless of whether partnership makes prepayments see sec_461 economic_performance for_the_use_of property occurs as the taxpayer uses such property date income strip to corporation on date partnership sold the right to master lease income to corporation however because partnership disposed merely of the master lease income stream partnership continues as the lessor on the master lease receiving current income from the payment by corporation because corporation and partnership continue to be in a lessor lessee relationship under the over lease partnership continues both to be liable to corporation for lease payments under that over lease and to be entitled to ratable rental deductions postf-150654-01 date 9’s purported sec_351 transfer between partnership and corporation on date less than a month after partnership 1’s acquisition of long-term note in a taxable transaction the following purported sec_351 nonrecognition_transaction occurred partnership transferred long-term note to corporation in exchange for corporation 1’s assumption of partnership 1’s obligation to make rental payments to corporation under the over lease and for z shares of corporation stock of nominal valuedollar_figure the effect of this transaction was that corporation became the owner of an asset - long-term note -- and thus became the party to which corporation 10’s note payment obligation ran but also became the party liable on the over lease payment obligation to corporation conversely partnership as a transferor in the sec_351 exchange with corporation no longer owned long-term note and was no longer liable on the over lease payment obligation to corporation dollar_figure partnership 1’s realized gain_or_loss on the exchange computed under sec_1001 would be the difference between partnership 1’s amount_realized on its disposition to corporation of long-term note and its adjusted_basis in long- term note dollar_figure the fact that the lease payments due initially from partnership the record before us suggests that the corporation stock was valued at dollar_figureii a share this valuation derives from taxpayer which also participated in the purported sec_351 transaction and which received xx shares of corporation stock in exchange for its contribution to corporation of dollar_figuren the facts presented in the request for assistance do not indicate that partnership transferred the over lease to corporation but rather corporation merely assumed the liability to make lease payments to corporation because partnership remains the lessee under the over lease it may not claim a lump-sum lease deduction related to corporation 1’s assumption of this liability see 111_tc_231 lump-sum payment to satisfy remaining lease obligation does not give rise to a current deduction if the lessee lessor relationship continues partnership 1’s deductions for lease expenses under the over lease continue to be allowable only ratably over the period of the lease an amount_realized under sec_1001 is the sum of any money received and the fair_market_value of property other than money received relief from liabilities are treated as part of the amount_realized under 331_us_1 the amount included in amount_realized may however be affected by the type of liability involved a common type of liability relief is the taking over of a debt obligation in such circumstances the face_amount of the note is ordinarily the measure of what is included in an amount_realized assuming that the note carries adequate_stated_interest thus if what corporation had taken over was a debt obligation of partnership 1’s partnership 1’s amount_realized would include long-term note 1's face value however corporation relieved partnership not of a debt liability but of a liability to make a future stream of rental payments although we did not find authority directly on point we believe that partnership would include in its amount_realized the fair_market_value rather than the face value of corporation 1’s promise to assume partnership 1’s rental payment obligation to corporation under postf-150654-01 and subsequently from corporation exactly equaled the note payments due from corporation under long-term note suggests that the parties viewed the fair_market_value of the over lease payment obligation relief from which constituted partnership 1’s amount_realized and the face value of long-term note in which partnership had basis as being equal accordingly partnership would appear to have only a nominal realized gain on the exchange reflecting the fact that partnership 1’s amount_realized also included the fair_market_value of the z shares of corporation stock partnership received under sec_1001 gain_or_loss on a sale_or_other_disposition of property is recognized unless a nonrecognition_provision applies thus partnership 1’s realized gain on the exchange with corporation would escape recognition if the purported sec_351 exchange is given tax effect but would be recognized if the transfer does not qualify under sec_351 issue four in 483_f2d_209 9th cir the court citing macgruder v supplee 316_us_394 stated that the payment of a liability by a subsequent purchaser is not the discharge of a burden but is actually as well as theoretically a payment of the purchase_price similarly in 77_tc_1134 aff’d 708_f2d_1254 7th cir the court held it is well settled that the payment of an obligation of a preceding owner of property by the person acquiring such property is not an ordinary and necessary business_expense rather when paid such payment is a capital_expenditure which becomes part of the cost_basis of the acquired property such is the result irrespective of what would have been the tax character of the payment to the prior owner see also 153_f2d_323 8th cir dollar_figure the over lease if the sum of the fair_market_value of corporation 1’s assumption of the over lease payment obligation and the fair_market_value of the corporation stock was less than partnership 1’s basis in long-term note the partnership corporation transfer would result in a realized loss to partnership although such loss would not be recognized if the sec_351 transaction is given effect in issue of revrul_95_74 1995_2_cb_36 we indicated that the holdcroft decision would not be followed where a transferor transfers substantially_all of the assets and liabilities associated with a trade_or_business here partnership has retained the leasehold and corporation merely assumed partnership 1’s obligation to make payments to corporation under the over lease accordingly the postf-150654-01 corporation 1’s assumption of the over lease payment obligation is along with a nominal amount of stock the consideration paid for long-term note accordingly any subsequent payment corporation makes pursuant to this assumption represents the purchase_price issue five as mentioned above corporation 1’s transfer to satisfy the over lease payment obligation represents the purchase_price of long-term note long-term note is a capital_asset and the satisfaction of the liability is reflected in corporation 1’s basis in long-term note issue six corporation claimed two types of deductions regarding these transfers it claimed lease expense deductions with respect to the partnership transfer and payments to corporation and it claimed a loss on the transfer of the remaining portion to corporation based on the foregoing it is clear that no deduction for lease expenses is allowable not only were payments of the over lease obligation merely the purchase_price of long-term note but partnership rather than corporation was the lessee with respect to the over lease see 316_us_394 purchaser of property who paid outstanding property taxes of previous owner was not entitled to a deduction for tax_payments corporation would not therefore be entitled to a current deduction for extinguishing the lease obligation compare revrul_69_511 c b it is also clear that corporation 1's claimed loss deductions on its transfers to corporation are not allowable because those transfers created neither a tax nor an economic loss sec_165 generally allows a deduction sustained during the taxable_year and not_compensated_for_by_insurance_or_otherwise sec_1001 provides that the amount of loss on a sale_or_exchange is the excess of the adjusted_basis over the amount_realized corporation obtained the long-term note from partnership in a purported sec_351 transaction if the sec_351 transaction is given effect partnership 1's dollar_figurep tax_cost_basis in long-term note carried over to corporation if instead the partnership - corporation exchange was a recognition transaction corporation took a sec_1012 cost_basis in long-term note given the exactly offsetting nature of the note payment and over lease payment obligations holdcroft decision may be followed postf-150654-01 that cost_basis must also be assumed to be dollar_figurep regardless of the precise source of corporation 1’s long-term note basis as an economic matter that basis reflects the equivalency in value between long-term note and the over lease payment obligation corporation transferred its remaining partial_interests in long-term note to corporation in exchange for an unsecured promissory note with a face value of dollar_figuret and for corporation 12’s assumption of corporation 1’s remaining over lease payment obligation corporation then claimed a loss of dollar_figurev -- the difference between the face value of the unsecured promissory note and corporation 1’s remaining dollar_figureu basis in long-term note in other words corporation included only one of the two types of consideration it received in its amount_realized we cannot discern on the facts before us any justification for corporation 1’s failure to include the fair_market_value of the assumed over lease payment obligation in its amount_realized in the absence of any indication that the value of this assumption is any lower than corporation 1’s basis in the allocable portion of long-term note corporation should be denied any loss deduction under sec_165 economically corporation is in essentially the same position following the claimed deductions in year that it was in prior to the date sale and over lease issue seven generally sec_461 allows a deduction for a business_expense in the proper taxable_year under the taxpayer’s method_of_accounting - generally in the year in which all events establishing the fact and amount of the liability have occurred and under sec_461 economic_performance has occurred if a court were to accept that corporation was entitled to a lease termination expense deduction it is clear that the economic_performance prerequisite for current deduction under sec_461 would be satisfied the payment would fully satisfy the liability issue eight sec_467 applies to sec_467 rental property defined in sec_467 as any rental agreement for_the_use_of tangible_property under which a there is at least one amount allocable to the use of property during a calendar_year that is to be paid after the close of the calendar_year following the calendar_year in which such use occurs or b there are increases in the amount to be paid as rent under the agreement the over lease provides for xxx semi-annual lease payments of dollar_figuregg and yyy semi-annual payments of dollar_figurehh payable on date and date the first payment postf-150654-01 was scheduled to be paid on date but the transfer to partnership occurred on date the first transfer to corporation occurred on date and the second occurred on date as stated above the lease expense deductions are properly allocable to partnership as the lessee rather than to corporation if a court found that corporation is the lessee however it would appear that the equipment subject_to the over lease is sec_467 rental property although neither partnership nor corporation have physical possession of the equipment the agreement is for_the_use_of tangible_property and the property is still used in the sense that the over lease lessee subleases the property under the master lease however sec_467 does not appear to apply to lease termination_payments issue nine a partnership paid corporation to assume partnership 1’s rental obligation we understand the analysis in the incoming but believe as explained below that it is appropriate to characterize the rental expenses as still belonging to partnership even though they were paid_by corporation therefore partnership rather than taxpayer may claim rental deductions for year year and year partnership transferred the long-term note to corporation in exchange for corporation assuming the rental obligations of partnership where property is transferred in exchange for the transferee’s assumption of the transferor’s rental obligations but the transferor continues to be the lessee the rental expenses are still deductible by the transferor moreover deductions of rental expenses for which the transferor already derived a benefit will continue to belong to the transferor and not to the transferee who is compensated for making those payments see 308_us_488 expenses of a corporation paid_by a shareholder are not deductible by the shareholder but instead by the corporation therefore because partnership paid corporation for assuming its rental obligations the deductions generated from these obligations continue to be deductible by partnership the transferor and not by corporation the transferee see notice_2001_17 2001_09_irb_730 b treatment of corporation as an agent of partnership to determine whether a corporation is a true agent of an owner-principal the supreme court in 336_us_422 looked to the following four indicia of an agency relationship postf-150654-01 whether the corporation operates in the name and for the account of the principal whether the corporation binds the principal by its actions whether the corporation transmits money received to the principal whether the receipt of income is attributable to the services of the principal’s employees and to the assets of the principal id pincite the court in national carbide also required that the corporation’s business_purpose must be the carrying on of the normal duties of an agent in order for an agency relationship to be recognized for tax purposes between a corporation and its owners id the supreme court also held in 485_us_340 that the genuineness of the agency relationship is adequately assured when the agency relationship is set forth in a written_agreement the corporation functions as an agent and the corporation is held out as an agent in all dealings with third parties related to the transaction none of the foregoing factors are present in this case no written agency agreement exists between partnership and corporation corporation did not a operate in the name and for the account of partnership b bind partnership by its actions c transmit any money to partnership and d receive money attributable to the services of employees of partnership and to assets belonging to partnership furthermore corporation was not owned by partnership thus its relations with partnership were not dependent upon the fact that it was owned by partnership and its business_purpose does not appear to have been the carrying on of the normal duties of an agent accordingly the facts do not support the position that corporation served as partnership 1’s agent issue ten the facts do not indicate that either partnership or corporation served as corporation 1’s agent no written agency agreement exists between any of these parties neither partnership nor corporation a operated in the name and for the account of corporation b bound corporation by its actions c transmitted money to corporation and d received money attributable to the services of employees of corporation and to assets belonging to corporation finally partnership is not owned by corporation and the fact that corporation and corporation share an address alone is not indicative that corporation acted as corporation 1’s agent therefore the facts do not support the contention that either partnership or corporation carried on the normal duties of an agent postf-150654-01 issue eleven sec_6662 imposes an accuracy-related_penalty in an amount equal to percent of the portion of an underpayment attributable to among other things negligence or disregard of rules or regulations any substantial_understatement_of_income_tax and any substantial_valuation_misstatement there can however be no stacking of those components of the accuracy-related_penalty sec_1_6662-2 thus the maximum accuracy-related_penalty imposed on any portion of an underpayment is percent percent in the case of a gross_valuation_misstatement sec_6662 even if that portion of the underpayment is attributable to more than one type of misconduct eg negligence and substantial_valuation_misstatement see dhl corp v commissioner tcmemo_1998_461 the service alternatively determined that either the 40-percent gross_valuation_misstatement penalty under sec_6662 or the 20-percent negligence_penalty under sec_6662 was applicable negligence - negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal_revenue_code or to exercise ordinary and reasonable care in preparing a tax_return see sec_6662 sec_1_6662-3 negligence also includes the failure to do what a reasonable and ordinarily prudent person would do under the same circumstances see marcello v commissioner 380_f2d_499 5th cir aff'g on this issue 43_tc_168 negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction credit or exclusion on a return that would seem to a reasonable and prudent person to be too good to be true under the circumstances sec_1_6662-3 in this case taxpayer's subsidiary issued ten shares of its common_stock to partnership which were redeemed less than three years later for dollar_figurebb in exchange for a leasehold interest with built-in rent deductions that exceeded dollar_figureff million those numbers produce an astronomical writeoff cost ratio in excess of big_number to although taxpayer claims to have had a profit_motive for the transaction as was discussed herein in connection with issue sec_1 and there is no apparent way taxpayer could have earned a pre-tax profit from the transaction as a result this was a deal too good to be true substantial_understatement - a substantial_understatement_of_income_tax exists for a taxable_year if the amount of understatement exceeds the greater of percent of the tax required to be shown on the return or dollar_figure in the case of corporations other than s_corporations or personal_holding_companies sec_6662 the assigned revenue_agent has indicated that the adjustments based on the disallowances of the losses and rental expenses in question meet these technical thresholds postf-150654-01 if a corporate taxpayer has a substantial_understatement that is attributable to a tax_shelter_item see sec_6662 the accuracy-related_penalty applies to the understatement unless the reasonable_cause exception applies see sec_1_6664-4 the determination of whether a corporation acted with reasonable_cause and good_faith is based on all pertinent facts and circumstances sec_1_6664-4 a corporation’s legal justification may be taken into account as appropriate in establishing that the corporation acted with reasonable_cause and in good_faith in its treatment of a tax_shelter_item but only if there is substantial_authority within the meaning of sec_1_6662-4 for the treatment of the item and the corporation reasonably believed when the return was filed that such treatment was more_likely_than_not the proper treatmentdollar_figure sec_1_6664-4 based on all the above-described facts we find the existence of neither substantial_authority nor reasonable belief in the more_likely_than_not standard in the unlikely event that the taxpayer meets the substantial_authority and reasonable belief requirements that is still not dispositive of whether the taxpayer acted with reasonable_cause if the taxpayer’s participation in the tax_shelter lacked significant business_purpose or if the taxpayer claimed benefits that were unreasonable in comparison to the initial investment in the tax_shelter sec_1_6664-4 as noted above the taxpayer's participation lacks business_purpose and it is a deal too good to be true substantial_valuation_misstatement - for the accuracy-related_penalty attributable to a substantial_valuation_misstatement to apply the portion of the underpayment attributable to a substantial_valuation_misstatement must exceed dollar_figure in the case of a corporation other than an s_corporation or a personal_holding_company a substantial_valuation_misstatement exists if the value or adjusted_basis of any property claimed on a return is percent or more of the amount determined to be the correct amount of such value or adjusted_basis sec_6662 if the value or adjusted_basis of any property claimed on a return is percent or more of the amount determined to be the correct amount of such value or adjusted_basis the valuation misstatement constitutes a gross_valuation_misstatement sec_6662 if there is a gross_valuation_misstatement the percent penalty under sec_6662 is increased to percent sec_6662 one the regulations provide that in meeting the requirement of reasonably believing that the treatment of the tax_shelter_item was more_likely_than_not the proper treatment the corporation may reasonably rely in good_faith on the opinion of a professional tax advisor if the opinion is based on the tax advisor’s analysis of the pertinent facts and authorities in the manner described in sec_1_6662-4 and the opinion unambiguously states that the tax advisor concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged by the service sec_1_6664-4 we are not aware that taxpayer relied on the opinion of a professional tax advisor in reporting the deductions at issue postf-150654-01 of the circumstances in which a valuation misstatement may exist is when a taxpayer’s claimed basis is disallowed for lack of economic_substance 933_f2d_143 2d cir cert_denied 502_us_1031 if the facts establish that the adjusted_basis of an asset with a basis traceable to a lease-stripping transaction is percent or more of the correct amount then either a substantial_valuation_misstatement or a gross_valuation_misstatement may exist here if the service prevails in its challenge to the economic_substance of the series of transactions involved in the lease_stripping transaction in which partnership corporation corporation and corporation participated we believe the basis in the long-term note would be disallowed as that basis was the source of the deductions at issue the penalty provided by code sec_6662 would apply to deficiencies resulting from the disallowance of the deductions on the grounds that a substantial_valuation_misstatement would exist in summary as to the accuracy-related_penalty the service’s primary position should be that it applies to the portion of the underpayment that results from the disallowance of the deductions at the percent rate for gross_valuation_misstatements the service’s secondary position should be that it applies at the percent rate please call if you have any further questions by carolyn h gray acting assistant to the branch chief branch office of the associate chief_counsel passthroughs and special industries


internal_revenue_service number release date index number ------------------------- -------------------------------------- ------------------------------------------- -------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact ---------------------- id no ------------- telephone number --------------------- refer reply to cc psi b03 plr-112111-08 date september legend x a b c ------------------------- ---------------------------------------------- ----------------------- ------------------------- ------------------------------ --------------------- country ---------- d1 d2 --------------------- --------------------- dear ------------ this letter responds to a letter dated date and subsequent correspondence written on behalf of x requesting a ruling under sec_301_9100-3 of the procedure and administration regulations facts x was formed under the laws of country x represents that it is a foreign_entity eligible to elect to be classified as a disregarded_entity for federal tax purposes x was a wholly-owned subsidiary of a a country corporation b a country corporation acquired a through a subsidiary entity c on d1 upon b’s acquisition of a it was plr-112111-08 intended that x would be treated as a disregarded_entity effective d2 however due to inadvertence a form_8832 entity classification election to treat x as a disregarded_entity effective d2 was not timely filed law and analysis sec_301_7701-3 provides in part that a business_entity that is not classified as a corporation under sec_301_7701-2 or an eligible_entity can elect its classification for federal tax purposes as provided in sec_301_7701-3 an eligible_entity with at least two members can elect to be classified as either an association and thus a corporation under sec_301_7701-2 or a partnership and an eligible_entity with a single owner can elect to be classified as an entity separate from its owner sec_301_7701-3 provides in part that except as provided in sec_301_7701-3 unless the entity elects otherwise a foreign eligible_entity is a a partnership if it has two or more members and at least one member does not have limited_liability b an association if all members have limited_liability or c disregarded as an entity separate from its owner if it has a single owner that does not have limited_liability sec_301_7701-3 provides in part that an eligible_entity may elect to be classified other than as provided under sec_301_7701-3 or to change its classification by filing form_8832 entity classification election with the service_center designated on form_8832 sec_301_7701-3 provides that an election under sec_301_7701-3 will be effective on the date specified by the entity on form_8832 or on the date filed if no such date is specified on the election form the effective date specified on form_8832 can not be more than days prior to the date on which the election is filed and can not be more than months after the date on which the election is filed if an election specifies an effective date more than days prior to the date on which the election is filed it will be effective days prior to the date it was filed sec_301_9100-1 provides that the commissioner may grant a reasonable extension of time under the rules set forth in sec_301_9100-2 and sec_301_9100-3 to make a regulatory election or a statutory election but not more than months except in the case of a taxpayer who is abroad under all subtitles of the internal_revenue_code except subtitles e g h and i sec_301_9100-2 provides the standards the commissioner will use to determine whether to grant an automatic_extension of time for making certain elections plr-112111-08 sec_301_9100-3 provides the guidelines for granting extensions of time for making elections that do not meet the requirements of sec_301_9100-2 sec_301 a provides that requests for relief subject_to sec_301_9100-3 will be granted when the taxpayer provides evidence including affidavits described in sec_301_9100-3 to establish to the satisfaction of the commissioner that the taxpayer acted reasonably and in good_faith and the grant of relief will not prejudice the interests of the government conclusion based solely on the facts submitted and the representations made we conclude that x has satisfied the requirements of sec_301 and sec_301_9100-3 as a result x is granted an extension of sixty days from the date of this letter to file a properly executed form_8832 with the appropriate service_center to elect to be classified as a disregarded_entity effective d2 a copy of this letter should be attached to the form_8832 except as specifically set forth above we express no opinion concerning the federal tax consequences of the above described facts under any other provision of the internal_revenue_code in accordance with a power_of_attorney on file with this office a copy of this letter is being sent to your authorized representative this ruling is directed only to the taxpayer who requested it sec_6110 provides that it may not be used or cited as precedent sincerely s william p o’shea associate chief_counsel passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes cc