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 postf-150636-01 uilc internal_revenue_service national_office field_service_advice memorandum for associate area_counsel lmsb har from associate chief_counsel passthroughs and special industries cc psi subject lease_strip inflated basis transactions this chief_counsel_advice responds to your undated memorandum in accordance with sec_6110 this chief_counsel_advice should not be cited as precedent legend a b taxpayer subsidiary1 subsidiary2 x y promoter entity a postf-150636-01 entity b corporation a corporation b corporation c_corporation d corporation e corporation f corporation g corporation j corporation k corporation l individual a individual b individual c individual d individual e individual f individual g individual h individual i individual j individual k postf-150636-01 individual l financial_institution a financial_institution b financial_institution c appraiser year year year year year year d1 d2 d3 d4 d5 d6 d7 d8 d9 d10 d11 postf-150636-01 d12 d13 d14 d15 d16 d17 d18 d19 d20 d21 d22 p1 p2 p3 p4 dollar_figurea dollar_figureb dollar_figurec dollar_figured dollar_figuree dollar_figuref dollar_figureg postf-150636-01 dollar_figureh dollar_figurei dollar_figurej dollar_figurek dollar_figurel dollar_figurem dollar_figuren dollar_figureo dollar_figurep dollar_figureq dollar_figurer dollar_figures dollar_figuret dollar_figureu dollar_figurev dollar_figurew dollar_figurex dollar_figurey dollar_figurez dollar_figureaa dollar_figurebb dollar_figurecc postf-150636-01 dollar_figuredd dollar_figureee dollar_figureff dollar_figuregg dollar_figurehh dollar_figureii dollar_figurejj dollar_figurekk dollar_figurell dollar_figuremm dollar_figurenn a b c d e f g h i j k postf-150636-01 l a b c d e f g h i j k issues whether the basis of the preferred_stock may be challenged because the underlying lease_stripping transactions lacked economic_substance whether the series of transactions in which the taxpayer obtained and sold the preferred_stock lacked economic_substance whether sec_351 applies to the exchanges described below what is the transferor’s basis in the stock acquired in the exchanges whether the taxpayer failed to substantiate its entitlement to the capital_loss whether sec_482 applies to the transaction whether the accuracy-related_penalty provided by sec_6662 applies to deficiencies that resulted from adjustments to the losses reported by taxpayer from its disposition of the stock received in the purported sec_351 transaction postf-150636-01 conclusion sec_1 the basis of the preferred_stock may be challenged because the underlying lease_stripping transactions lacked economic_substance the series of transactions in which the taxpayer obtained and sold the preferred_stock lacked economic_substance sec_351 does not apply to the exchanges described below for numerous reasons as discussed below the basis in the stock is limited to its fair_market_value for several reasons set out in this advice it appears that taxpayer failed to substantiate its entitlement to the capital_loss sec_482 applies to the transaction the accuracy-related_penalty provided by sec_6662 applies to deficiencies that resulted from adjustments to the losses reported by taxpayer from its disposition of the stock received in the purported sec_351 transaction facts lease_stripping transactions this case involves a series of prearranged transactions whereby taxpayer recognized a purported capital_loss of dollar_figurehh resulting from its wholly-owned subsidiary’s sale of inflated basis preferred_stock acquired in a lease_stripping transaction between d2 and d3 x a publically traded corporation purchased a from an unrelated corporation for dollar_figureee between d1 and d4 x purchased b from another unrelated corporation for dollar_figurekk x paid a total of dollar_figurenn for the a and b hereinafter the equipment on d5 x sold the equipment to p1 a limited_partnership for dollar_figurenn the same amount_paid by x for the equipment the partners of p1 are p2 the c general_partner and p3 the k limited_partner the partners of p3 are p2 the c general_partner and p4 the k limited_partner the partners of p4 p3's general_partner are entity a the k limited_partner a tax neutral entity and individual a a corporation a a and corporation b b as general partners the sole general_partner of p2 was corporation c a corporation that was affiliated with promoter the promoter of the leasing transactions under this tiered arrangement postf-150636-01 a substantial portion of p1’s items of income were ultimately allocated to the tax neutral entity p1 issued to x a g-day promissory note the partnership note in the principal_amount of dollar_figurenn which bore interest at d per annum for its purchase of the equipment the partnership note was due on d9 provided for full recourse against p1 and was secured_by a perfected first priority security_interest in the equipment and any proceeds therefrom including basic rent under the user lease described below p1 leased-back the equipment to x under a user lease the user lease was for a term of e months in the case of the a and for a term of f months in the case of the b under the user lease x was obligated to pay rent to p1 in the amount of dollar_figureq per month for the a and dollar_figurer per month for the b collectively the user lease rent x did not have the right to acquire any equipment at the end of the lease terms on the same day p1 purchased the equipment it sold the equipment encumbered by the user lease to corporation k for dollar_figurenn corporation k paid the purchase_price with four notes two short-term recourse promissory notes in the aggregate amount of dollar_figurew due d9 collectively the transferee st notes one nonrecourse promissory note in the amount of dollar_figurebb and one nonrecourse promissory note in the amount of dollar_figurejj collectively the transferee lt notes the four notes together are the transferee notes immediately after it purchased the equipment from p1 corporation k leased-back the equipment to p1 for an approximately a year term commencing d5 and ending d20 with respect to the a and for a b year term commencing d5 and ending d22 with respect to the b under a triple net_lease the master lease under the master lease p1 was obligated to pay rent to corporation k in the same amounts and at the same times as the installments were due on the transferee lt notes p1 had no right under the master lease to either acquire the equipment or to renew the master lease with respect to any equipment as lessee under the master lease p1 was the sublessor under the user lease and would be the sublessor under any user leases during the portion of the term of the master lease that extended beyond the expiration of the user lease consequently p1 was entitled to receive all of the revenues from such leases from d19 through d20 for the a and from d21 through d22 for the b postf-150636-01 on d6 p1 sold to financial_institution a its right to receive all of the user lease rent due from x payable after d6 for dollar_figurell under the tiered arrangement a substantial portion of rental income related to the underlying leases was stripped from the equipment and allocated to the tax neutral entity on the same day financial_institution a transferred the funds directly to x the funds were credited as a prepayment of p1's obligation on the partnership note on d7 in a purported sec_351 transaction p1 transferred to y a subsidiary of x all of its position assets which were x’s interests in the transferee notes in the amounts of dollar_figurew dollar_figurebb and dollar_figurejj the agreement under the user lease whose rent stream had been stripped off to financial_institution a and the master lease agreement corporation k’s lease back to p1 under which p1 was obligated to pay rent to corporation k in the same amounts and at the same times as the installments due under the transferree lt notes in exchange for i shares of preferred_stock of y y agreed to assume the position obligations which were all of p1's obligations as sublessor under the user lease all of p1's obligations as lessee under the master lease including the obligations to pay the master lease rent all of the remaining obligations under the partnership note of which dollar_figurell had already been credited towards the dollar_figurenn due p1's obligation to pay the fixed consulting fee to promoter dollar_figuret and e up to dollar_figured of p1's obligation to pay the documentation fee as part of the same transaction x simultaneously contributed dollar_figureu to y in exchange for j shares of y’s voting common_stock as a result of the contributions and stock issuance p1 and x owned respectively l of the total issued and outstanding preferred_stock of y and l of the total issued and outstanding common_stock of y no other classes of stock were outstanding on d7 thus at the end of the day on d7 y had notes equaling approximately dollar_figuremm with an offsetting liability to pay rents due at the same time as the installment payments due under the transferee lt notes although it still had the transferee st notes worth approximately dollar_figurev y also accepted the remaining liability on the original dollar_figurenn partnership note which had only been pre-paid to the extent of the dollar_figurell million received from financial_institution a moreover y’s obligation to pay the dollar_figuret fee was essentially fulfilled by the transfer from x of dollar_figureu contributed to y by x in the purported sec_351 transaction on d6 p1 and promoter entered into a consulting agreement whereby p1 agreed to pay promoter a consulting fee of dollar_figuret the fixed consulting fee in return for certain unknown investment banking and consulting services performed by promoter regarding the sale of the equipment to corporation k it is our understanding that the fixed consulting fee constituted promoter’s fee for this lease_stripping promotion postf-150636-01 taxpayer’s own documentation concludes that the net aggregate value of the assets and obligations was approximately dollar_figurep and that the fair_market_value of the i shares of the preferred_stock was also allegedly approximately dollar_figurep and that the fair_market_value of the j shares of common_stock issued to x was approximately dollar_figureu on d5 appraiser conducted an appraisal of the equipment in which it projected rental income from the equipment for the c-month periods beginning at the end of the user lease and ending at the end of the master lease we note that on the basis of the appraisal data summarized in the field memorandum the expected total undiscounted value of this rental income from a and b during these periods was dollar_figurecc appraiser also concluded that the residual_value of the a and b was projected to be dollar_figurex and dollar_figureff respectively taxpayer’s documentation asserts that p1's contribution of the assets to y in exchange for the preferred_stock and y’s assumption of obligations and x’s contribution of dollar_figureu to y in exchange for j shares of y’s common_stock qualified as a nonrecognition_transaction under sec_351 y’s basis in the position assets was equal to the basis of the asset in p1's hands before the contribution p1's basis in the transferee st notes and the transferee lt notes immediately before the contribution was in each case equal to the original face_amount of the transferee notes reduced by any principal payments on such notes by p1 prior to the contribution dollar_figurenn p1's basis in the user lease agreement immediately before the contribution was dollar_figurea p1's basis in the master lease agreement immediately before the contribution was equal to the amount of the dollar_figuret consulting fee reduced by the amount of allowable amortization deductions beginning on the closing date of the sale of the equipment to corporation k and ending on the date of the contribution y was not required to include in income any amounts received as principal payments on the transferee st notes or the transferee lt notes but must include in gross_income as interest the amount of interest that accrues under the transferee notes during any taxable_year in accordance with their terms y was required to include in gross_income the amount of rental income received or accrued in respect of a sublease renewal rents payable to it y was entitled to claim rental deductions for rents paid_or_incurred under the master lease y was entitled to deduct amortization allowances on a straight_line basis over the remaining term of the master lease in respect of the unamortized balance of the dollar_figuret fee as of the date of the contribution y was not required to include in income any amounts in respect of the user lease rent and x would be entitled to claim a rental deduction for rents paid_or_incurred under the user lease on d8 corporation k sold the equipment and its rights under the master lease to financial_institution b subject_to corporation k’s obligations under the master lease for dollar_figurenn in cash corporation k used the cash received to prepay the transferee notes in full financial_institution b and y proceeded to make amendments to the master lease which among other things provided y with an option to purchase the postf-150636-01 equipment at the expiration of the master lease after financial_institution b acquired the equipment and the master lease the master lease was amended to grant y the right to purchase the equipment from financial_institution b at fair_market_value y’s rights to acquire the equipment was described in the clause if y declined to exercise its purchase option financial_institution b was to sell the equipment to the highest third-party bidder the amendment provided that at the expiration of the master lease_term an adjustment to the master lease rent was payable according to a formula that ensured that financial_institution b would retain exactly dollar_figurez3 from the sale of the equipment regardless of whether that sale was to y pursuant to its purchase option or to a third-party bidder any difference between the actual sales_price and dollar_figurez was to be treated as a positive or negative adjustment to the master lease rent thus for example if y exercised its purchase option or if the equipment were sold to a third-party bidder at a fair_market_value of dollar_figurey y would make a dollar_figurec payment to financial_institution b which payment would be characterized as additional master lease rent conversely if the equipment were sold for dollar_figureaa financial_institution b would make a payment of dollar_figurek to y which payment would be characterized as a refund of master lease rent sec_351 exchange subsidiary was a wholly-owned subsidiary of taxpayer taxpayer also acquired subsidiary which was allegedly involved in the leasing business on or about d8 p1 borrowed dollar_figurep from financial_institution c the loan was evidenced by a one-year e promissory note payable quarterly as collateral for the loan p1 pledged the i shares of preferred_stock to financial_institution c on d8 p1 instructed financial_institution c to remit the loan proceeds directly to promoter that same day p1 also instructed x to remit all preferred_stock dividends to financial_institution c if y and financial_institution b could not agree on a fair_market_value an appraisal was to be conducted this amount is exactly g of dollar_figurenn ie the original purchase_price of the equipment the sales_price under both sale-leaseback transactions described above and the aggregate amount of the transferee notes if the fair_market_value of the equipment at the termination of the master lease were equal to its appraised expected value on that date as set forth in the original appraisal dated d5 financial_institution b would be obligated to pay dollar_figuredd to y as a rent refund this is based on an estimated fair_market_value for the a of dollar_figurex on d20 and for the b of dollar_figureff on d22 the accuracy of these numbers should be verified because if correct they would indicate that y possessed considerable future profit potential postf-150636-01 notwithstanding the stock pledge on d11 p1 transferred h shares of the preferred_stock with a fair_market_value of dollar_figurei and an adjusted_basis of dollar_figureii to subsidiary2 in exchange for d shares of subsidiary2 common_stock in a purported sec_351 transaction there is no evidence that financial_institution c or x were notified of the transfer of preferred_stock at the time of the purported sec_351 exchange with subsidiary2 p1 agreed to be responsible for any then-existing liens on the stock in the same purported sec_351 transaction taxpayer transferred a note with a face_amount and alleged fmv of dollar_figurem and with an adjusted_basis of dollar_figurea to subsidiary2 for no consideration the remaining h shares of y preferred_stock previously had been transferred by p1 to entity b to complete the prearranged transfer of the entire i shares of preferred_stock to subsidiary2 on d12 subsidiary2 purchased the remaining h shares from entity b for dollar_figureg subsidiary2 paid for the shares with a promissory note which remains outstanding on d14 x advised subsidiary2 that it had been informed by p1 of the transfer and assignment of p1's right title and interest in the preferred_stock x further indicated in its letter that it wished to redeem the i shares for dollar_figureb per share on d15 subsidiary2 accepted x’s redemption offer and advised that the preferred_stock was in the possession of financial_institution c as collateral for certain loans subsidiary2 further directed x to remit all redemption proceeds directly to financial_institution c because the proceeds were used to satisfy p1's obligation to the bank p1 and p1's managing partner became indebted to subsidiary2 in the amount of the liabilities subsidiary2 claimed a capital_loss of dollar_figurehh as a result of its acceptance of the redemption offer taxpayer was able to utilize dollar_figuregg of the loss in year year year and year taxpayer explained that it entered into the transactions because it believed that it would facilitate future investment banking fees with y relationships among the parties as with most if not all of the lease_stripping transactions examined to date many of the parties to the transaction in this case are either owned related to or controlled by other participants these relationships are as follows the partners of p1 are p2 the c general_partner and p3 the k limited_partner the partners of p3 are p2 the c general_partner and p4 the k limited_partner the partners of p4 p3's general_partner are entity a the k limited_partner and individual a a corporation a a and corporation b b as general partners postf-150636-01 corporation a is a subsidiary of corporation l which is owned k by individual a corporation b is owned by corporation d another promoter of lease_stripping transactions corporation d is a wholly-owned subsidiary of corporation e which also owns l of the common_stock of corporation f and corporation g corporation e is owned by individual b h and individual c j who is married to individual d individual b admitted during an interview relating to the examination of another lease_stripping transaction that she acts only on individual d’s instructions according to corporation e’ year return individual e individual f and individual g were compensated officers of taxpayer of which individual e was the l shareholder p2’s sole general_partner is corporation c it’s executive vice president is individual l who is a i stockholder of promoter the remaining stock of promoter is owned by individual h corporation k which purchased the equipment from p1 has the same corporate address as taxpayer whose subsidiary subsidiary2 acquired the inflated basis preferred_stock in y from p1 taxpayer is owned l by individual e the officers of taxpayer are individual e individual f and individual g all former employees of corporation d taxpayer’s chairman of the board is individual i who is also the l common stockholder of corporation j corporation j is a preferred stockholder of taxpayer corporation j’s year return is signed by individual j an employee of individual d as noted above individual d’s wife is the majority shareholder of corporation e which controls corporation b the officers of corporation f another subsidiary of corporation e are individual d individual k and individual j the preferred_stock of taxpayer is owned by corporation b corporation f and corporation g the officers of corporation b are individual d and individual k the officers of corporation f are individual d and individual k individual b is a director the officers of corporation g are individual d and individual k with individual b as a director the name corporation g appears on the door to the offices of entity b entity b which sold h shares of y preferred_stock to subsidiary2 on d12 is represented by individual k subsidiary1 a subsidiary of taxpayer reported the following fee income from entity b in year dollar_figurej on d10 dollar_figureh on d17 and dollar_figuref on d17 subsidiary1 also reported fee income of dollar_figures in year from corporation a for a different transaction and the following fee income from corporation g during that year dollar_figurel on d13 dollar_figuree on d16 and dollar_figuren on d18 in year subsidiary1 also deducted referral fees of dollar_figureo paid to individual d postf-150636-01 law and analysis issue the lease_stripping transactions lacked economic_substance a transaction that is entered into primarily to reduce taxes and that has no economic or commercial objective to support it is a sham and is without effect for federal_income_tax purposes nicole rose v commissioner 117_tc_27 64_tc_752 752_f2d_89 4th cir 435_us_561 when a transaction is treated as a sham the form of the transaction is disregarded and the proper tax treatment of the parties to the transaction is determined 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 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 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 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 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 81_tc_184 aff'd in part and rev'd in part 752_f2d_89 4th 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 postf-150636-01 consequences to be respected for tax purposes acm partnership f 3d pincite casebeer f 2d pincite see also notice_95_53 1995_2_cb_334 all of the facts and circumstances surrounding the transactions must be considered no single factor will be determinative courts will respect the taxpayer’s characterization of the transactions if there is a bona_fide transaction with economic_substance compelled or encouraged by business or regulatory realities imbued with tax-independent considerations and not shaped primarily by tax_avoidance features that have meaningless labels attached see 435_us_561 909_f2d_1360 9th cir in acm partnership the service was successful in showing that a series of prearranged transactions involving the purchase and sale of debt instruments in an attempt to shift accelerated installment_sale gain to a tax-neutral partner and manufacture a loss for another partner lacked economic_substance acm partnership v commissioner tcmemo_1997_115 aff’d in relevant part rev’d in part remanded 157_f3d_231 3d cir cert_denied 526_us_1017 in acm partnership the commissioner argued that the purchase and sale of debt instruments were prearranged and predetermined devoid of economic_substance and lacking in economic reality the court found that the taxpayer desired to take advantage of a loss that was not economically inherent in the object of the sale but which the taxpayer created artificially through the manipulation and abuse of the tax laws the court stated that the tax law requires that the intended transactions have economic_substance separate and distinct from economic benefit achieved solely by tax reduction it held that the transaction lacked economic_substance and therefore that the taxpayer was not entitled to the claimed deductions the opinion demonstrates that the court will disregard a series of otherwise legitimate transactions where the commissioner is able to show that the facts when viewed as a whole have no economic_substance see also revrul_99_14 1999_1_cb_835 because lease-in lease-out transactions have no economic_substance a u s taxpayer could not take deductions for rent or interest_paid or incurred in connection with the transaction see also 113_tc_254 the eleventh circuit recently affirmed the tax court’s determination that the transaction entered into by the taxpayer was a substantive sham 254_f3d_1313 11th cir but see united parcel service of america inc v commissioner tcmemo_1999_2685 5in united parcel service of america inc the eleventh circuit recently reversed the tax_court on the issue of economic_substance finding that ups’s restructuring of its excess-value business had both real economic effects and a business_purpose the court reasoned that setting up a transaction with tax planning in mind is permissible as long as there is a bona_fide profit seeking business_purpose united parcel service of postf-150636-01 while the profit potential or economic risk relative to the expected tax_benefit necessary to meet the objective economic_substance test has not been quantified a reasonable prospect or possibility for profit is required see horn f 2d pincite- n rice’s toyota world inc t c pincite nominal profit potential does not imbue a transaction with economic_substance 364_us_361 912_f2d_736 4th cir rev’g u s t c cch e d n c 103_tc_29 94_tc_738 84_tc_412 recently 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 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 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 in this case because the inflated basis stock was traceable to a lease_stripping transaction the economic_substance inquiry focuses first on whether the initial lease_stripping transactions lacked economic_substance and secondly whether the taxpayer’s subsequent transfer of the inflated basis stock lacked economic_substance we believe that this series of prearranged lease_stripping transactions taken as a whole lacks business_purpose and was entered into primarily to reduce taxes a transaction involving a sale and lease-back transaction would reasonably be expected to be tax-neutral over its normal life expectancy typically the lessee would report rental deductions with respect to its payments for use of a particular property and the lessor would realize corresponding income with respect to its grant america inc v commissioner 254_f3d_1014 11th cir postf-150636-01 of a lease of the property here the parties according to a prearranged plan artificially divided the transaction into an income leg and a loss leg the allocation of the income through the tiered_partnership structure to a tax neutral entity created a division of the transaction into an income and a loss leg and does not appear to be rationally related to a useful nontax purpose that is plausible in light of the economic situation rather the structure of the transactions appears to be shaped principally by tax_avoidance the offsetting legal obligations and circular cash flows among the parties reinforces the conclusion that the lease_stripping transactions lacked economic_substance x purchased the equipment for dollar_figurenn sold the equipment to p1 for dollar_figurenn and leased back the equipment from p1 for rental payments equaling the payments on the note it received for its original sale to p1 simultaneously p1 sold the equipment to corporation k for dollar_figurenn in notes and leased back the equipment from corporation k for rental payments equaling the payments on the transferee lt notes these offsetting legal obligations and circular flows of cash left the parties in the same economic positions that they were in prior to the transactions both subjectively and objectively the parties could not have anticipated a profit from these transactions however the structure of the transactions allowed the parties to strip the income from the transactions to the tax neutral entity the prearranged nature of the transaction is revealed by the subsequent participation of x’s subsidiary y x entered into a transaction with p1 in which it sold the equipment and simultaneously leased it back for a period of e months and f months for lease payments which offset the payments due x on the partnership note this wash transaction theoretically deprived x of the residual_value of the property even though x had paid an identical amount for its original full ownership of the equipment the circle of both money and equipment is completed however when x’s subsidiary ultimately acquires a purchase option on the equipment further evidence of prearrangement is evidenced by the fact that many of the parties to these transactions are either owned related to or controlled by other participants and have a history of involvement in lease_stripping transactions the relationships among the parties and their participation in a pre-determined plan in carrying out the above-described steps establishes that they had no regard for the economic implications of the steps but rather intended to pursue the steps primarily to receive the resulting tax benefits based upon these facts there is no economic_substance to the lease_stripping transactions because the lease_stripping transactions in which p1 acquired the preferred_stock lacked economic_substance p1's basis in the preferred_stock is limited to the value of the property p1 contributed in exchange for that stock postf-150636-01 issue lack of economic_substance to the inflated basis transactions after the purported sec_351 transaction on d7 y had notes equaling approximately dollar_figuremm with an offsetting liability to pay rents due at the same time as the installment payments due under the transferee lt notes although it still had the transferee st notes worth approximately dollar_figurev y also accepted the remaining liability on the original dollar_figurenn partnership note which had only been pre-paid to the extent of the dollar_figurell received from financial_institution a moreover y’s obligation to pay the dollar_figuret fee was essentially fulfilled by the transfer from x of dollar_figureu contributed to y by x in the purported sec_351 transaction there is no credible subjective or objective business_purpose for acquiring these offsetting assets and liabilities moreover at this juncture x had not acquired a purchase option for the equipment and could not claim a theoretical profit in the future on the equipment accordingly there was no credible business_purpose either subjectively or objectively for y to acquire these assets in a purported sec_351 transaction in return for i share of its preferred_stock any claim by p1 to value in the y shares lacks validity in the face of p1's subsequent transfer of h shares in a purported sec_351 transaction on d11 to subsidiary2 only a few months later subsidiary2 purchased the remaining shares for dollar_figureg shortly thereafter x redeemed the shares at dollar_figureb per share taxpayer’s subsidiary had no business_purpose for acquiring and selling the preferred_stock and those transactions lacked economic_substance consequently subsidiary2 would have a cost_basis in the preferred_stock as a result taxpayer through the consolidated_group is not entitled to the loss generated from this transaction issue the exchange of the leasehold positions for stock is not a sec_351 exchange a control requirement sec_351 provides nonrecognition treatment for transfers by one or more persons of property to a corporation solely in exchange for stock_or_securities in such corporation if immediately_after_the_exchange such person or persons are in control of the corporation to which the property was transferred sec_1_351-1 control requires ownership of stock possessing at least percent of the combined voting power of all classes of stock entitled to vote and at least percent of the total number of shares of all other classes of stock of the transferee corporation sec_351 and sec_368 the transaction in which the transferee stock is received here the transfer by p1 to y must be carefully analyzed to determine that it does in fact satisfy the technical requirements of sec_351 transferors who contribute property to a corporation at different times may be considered part of a single control group if their rights have been previously defined and the execution of the agreement proceeds with an postf-150636-01 expedition consistent with orderly procedure sec_1_351-1 for example under the facts presented a pre-existing shareholder or shareholders must join with the transferor p1 in transferring property to the transferee corporation y in order for the exchange in the first purported sec_351 transaction to satisfy the control requirement of sec_351 an existing shareholder will not be considered part of a transferor group if the property it transfers is of relatively small value in comparison to the value of the stock and securities already owned by the transferor and if the primary purpose of the transfer is to qualify under sec_351 the exchanges of property by other persons transferring property sec_1_351-1 the property transferred will not be considered to be of relatively small value within the meaning of sec_1 a ii if the fair_market_value of the property transferred is equal to or in excess of percent of the fair_market_value of the stock and securities already owned by such person revproc_77_37 sec_3 1977_2_cb_568 in the instant case both the first purported sec_351 transaction and the second purported sec_351 transaction appear to have included transfers of property by pre- existing shareholders intended to qualify the exchanges under sec_351 in order to meet the control requirement in the first purported sec_351 transaction between p1 and y x simultaneously transferred dollar_figureu in cash to y in exchange for j shares of y’s voting common_stock an argument can be made that the primary purpose of the transfer by x was to qualify p1 for sec_351 treatment however because the value of the j shares of voting common_stock issued by y to x in the first purported sec_351 transaction does not appear to be relatively small compared to the value of the old stock owned by x shares it appears that an argument can not be made that the first purported sec_351 transaction did not meet the control requirement of sec_351 in the second purported sec_351 transaction taxpayer transferred a note in the face_amount of dollar_figurem to subsidiary2 for no consideration on the same day that p1 transferred h shares of the y preferred_stock to subsidiary2 in exchange for d shares of subsidiary2 common_stock the taxpayer will argue that the control requirement of sec_351 has been met because the ownership_interest of all transferors participating in a single transaction are aggregated a careful factual determination of the value of the dollar_figurem note is required the value of the note must be compared to the value of the subsidiary2 common_stock previously owned by taxpayer to determine if sec_1_351-1 will apply to negate the transfer of the note by taxpayer and thus prevent sec_351 from applying to the second purported sec_351 transaction b business_purpose requirement in addition to satisfying the technical requirements of sec_351 a transfer must have a bona_fide business_purpose in order to qualify as a sec_351 exchange see revrul_55_36 1955_1_cb_340 688_fsupp_1129 n d tex aff'd on other issues 865_f2d_644 5th cir 714_f2d_977 9th cir kluener v commissioner tcmemo_1996_519 aff’d 154_f3d_630 6th cir determining whether a bona_fide non-tax business_purpose motivated at least in part a sec_351 transaction requires intensive factual development of the motives and intent of the parties as gleaned through their written communications contracts and agreements their expertise on tax matters in general as well as their conduct throughout the transaction the service and the various courts have distilled several factors that aid in determining whether a valid non-tax business_purpose is present in a purported sec_351 transaction these factors include whether the transfer achieved its stated business_purpose whether the transfer primarily benefitted the transferor or the transferee the amount of potential non-tax benefit to be realized by the parties whether the transferee corporation is a meaningless shell whether the transferee's existence is transitory whether the transferee corporation has any other assets of the type transferred the number of times the property was transferred both prior to and after the sec_351 transaction the amount of time each party held the property both prior to and after the sec_351 transaction whether there were any pre-arranged plans concerning future dispositions of the property and whether there were independent parties such as creditors that requested a specific structure for the transaction taxpayer's explanation that it entered into this transaction because it believed that it would facilitate future investment banking fees with y does not appear to be a valid business_purpose the facts as currently developed do not suggest a plausible business_purpose for the transactions it appears there was no real purpose for the transactions apart from the creation of an asset the y preferred_stock with a basis far in excess of its value in order to generate a substantial tax loss that is not a bona_fide business_purpose postf-150636-01 other considerations re the sec_351 business_purpose requirement it is important to note that our discussion of the hazards is not intended to dissuade you of the merits of the government's case to the contrary based on our legal and factual arguments and the clear abuse we believe that disallowance of the claimed loss will be sustained in court disqualifying the transaction under sec_351 for lack of business_purpose presents significant factual and legal hazards factually it could be difficult to establish that the exchange is devoid of any business_purpose while courts have consistently acknowledged the doctrine it has proven extremely easy for taxpayers to satisfy the requirement in fact we are unaware of a case in which an exchange otherwise meeting the requirements of sec_351 was disqualified and rendered a taxable_exchange solely for lack of sufficient business_purpose nevertheless the service position is that there is a business_purpose requirement in sec_351 since these cases present a particularly compelling case for a business_purpose argument we encourage the argument be made c summary the transfers by p1 and x to y in the first purported sec_351 transaction do not qualify under sec_351 therefore the transactions are taxable exchanges under sec_1001 and under sec_1012 p1 takes a cost_basis in the y preferred_stock ie a basis equal to the fair_market_value of the leasehold position transferred which might reasonably be argued to equal the fair_market_value of the y preferred_stock received in the transaction note that this argument applies equally to the transfer of y preferred_stock to subsidiary2 in exchange for subsidiary2 common_stock in the second purported sec_351 transaction although the present transaction presents a very strong case for disqualification for lack of a business_purpose courts have not required a strong showing in order to satisfy the sec_351 business_purpose requirement therefore the following arguments must also be developed 6according to taxpayers documentation the fair_market_value of the i shares of y preferred_stock issued to p1 was approximately dollar_figurep postf-150636-01 issue even if the transfers qualify under sec_351 the basis in the stock is reduced by the amount of the obligations to make rental payments application of sec_358 reduces basis by the amount of the liability assumption sec_357 provides in relevant part that except as provided in sec_357 and c if the taxpayer ie the transferor receives property that would be permitted to be received under sec_351 without the recognition of gain if it were the sole consideration ie the stock of the transferee corporation and as part of the consideration another party to the exchange assumes a liability of the taxpayer then such assumption or acquisition shall not be treated as money or other_property and shall not prevent the exchange from being within the provisions of sec_351 sec_357 provides that if taking into consideration the nature of the liability and the circumstances in the light of which the arrangement for the assumption was made it appears that the principal purpose of the taxpayer with respect to the assumption described in sec_357 was a purpose to avoid federal_income_tax on the exchange or if not such a purpose was not a bona_fide business_purpose then such assumption shall for purposes of sec_351 be considered as money received by the taxpayer on the exchange sec_357 provides that the burden is on the taxpayer to prove by the clear preponderance_of_the_evidence that such assumption is not to be treated as money received by the taxpayer sec_357 provides in relevant part that in the case of an exchange to which sec_351 applies if the sum of the amount of the liabilities assumed exceeds the total of the adjusted_basis of the property transferred pursuant to such exchange then such excess shall be considered as a gain from the sale_or_exchange of a capital_asset or of property which is not a capital_asset as the case may be sec_357 provides that sec_357 shall not apply to any exchange to which sec_357 applies sec_357 provides that if a taxpayer transfers in an exchange to which sec_351 applies a liability the payment of which either would give rise to a deduction or would be described in sec_736 then for purposes of sec_357 the amount of such liability shall be excluded in determining the amount of liabilities assumed sec_357 provides that sec_357 shall not apply to any liability to the extent that the incurrence of the liability resulted in the creation of or increase in the basis of any property sec_358 provides in relevant part that in the case of an exchange to which sec_351 applies the basis_of_property permitted to be received under such section postf-150636-01 without the recognition of gain_or_loss ie the stock of the transferee corporation shall be the same as that of the property exchanged decreased by the fair_market_value of any other_property received by the taxpayer the amount of money received by the taxpayer and the amount of loss to the taxpayer that was recognized on the exchange and increased by the amount that was treated as a dividend and the amount of gain to the taxpayer which was recognized on such exchange other than the dividend amount sec_358 provides that where as part of the consideration to the taxpayer another party to the exchange assumed a liability of the taxpayer such assumption shall for purposes of sec_358 be treated as money received by the taxpayer on the exchange sec_358 provides that sec_358 shall not apply to the amount of any liability excluded under sec_357 the assumption of the transferor's p1’s obligation to pay rent on its leasehold position is an assumption that would if made by a purchaser of the leasehold position in a taxable_exchange be included in the seller's amount_realized thus the assumption of this liability is within the scope of sec_357 and under sec_357 sec_358 and sec_358 the basis of the stock received must be reduced by the amount of the liability assumed the taxpayer may take the position that the obligation to pay rent as part of the leasehold position is a liability described in sec_357 and that therefore the assumption of the liability does not reduce the stock basis by reason of sec_358 we disagree with this position congress enacted sec_357 to prevent inappropriate gain recognition resulting from the application of sec_357 to certain liabilities in general the assumption of a deductible_liability in a sec_351 exchange should be a nonrealizable event because it is improper to treat the assumed liability as income to the transferor and deny him the tax_benefit for its satisfaction 68_tc_223 otherwise the transferor is taxed on an amount which never was and never would be received by him as an economic gain id to prevent such inappropriate gain recognition under sec_357 congress enacted sec_357 see sec_103 of 7it is noted that for transactions on or after date the basis of the y stock irrespective of any other provisions of the code or regulations would be reduced by the amount of the liability but not below fair_market_value under sec_358 the transactions in the instant case occurred before date and therefore sec_358 does not apply postf-150636-01 the technical corrections act of p l 1980_1_cb_499 s rep no 1980_1_cb_517 in the case under consideration to the extent the user lease_term and the master lease_term are identical the transfer of the leasehold position in the first purported sec_351 transaction includes no corresponding right to use property subject_to the lease or to receive income from the property transferred under these circumstances ie where the user lease_term and the master lease_term are identical the transferor cannot be considered to have transferred a trade_or_business accordingly revrul_95_74 1995_2_cb_36 does not apply to the transfers and under 153_f2d_323 8th cir the payment of the rent obligation will be a capital_expenditure not a deductible expense with respect to the transferee corporation because the payment of the rent obligations will not be a deductible expense of the transferee corporation y the deduction for the rental payments when made may accrue to the transferor p1 in such a case the purpose of sec_357 is not served by the exclusion of a liability because the transferor will not be denied the tax_benefit for the satisfaction of the liability therefore it is our position that to the extent the terms of the user lease and the master lease overlap the associated rental obligations are not within the intended scope of sec_357 because the deduction remains with the transferor accordingly sec_358 has no application to such liabilities and the transferor's basis in the transferee stock must be reduced by the amount of the liabilities assumed in the first purported sec_351 transaction however the transferee corporation y received both a right and an obligation to use the equipment including the right to lease out the equipment and to pay rent respectively for the term beginning with the expiration of the user lease and ending with the expiration of the master lease the residual lease_term as a result we believe the transferee may be entitled to a rent deduction for the equipment during the residual lease_term generally when this assumes the rental payments during the term of the user lease are an ordinary_and_necessary_expense paid_or_incurred by the transferor in carrying_on_a_trade_or_business a threshold question in determining whether an activity is in a trade_or_business is whether there is a bona_fide objective of making a profit the submission from the field suggests that the transferor had a substantial profit_motive and thus may have been entitled to a rental deduction for the user lease_term because as stated in the appraisal the transferor expected to recover its original investment plus receive a substantial return on its investment because of the participation of this appraiser in a majority of lease_stripping cases we have reason to doubt the appraisal’s conclusions this should be substantiated through further factual development postf-150636-01 a taxpayer has the right to use property and the obligation to pay rent such taxpayer would be allowed to claim a rental deduction provided the taxpayer’s activity has been undertaken in good_faith with the dominant hope and intent of realizing a profit to the extent the taxpayer establishes that it had a valid non-tax profit_motive a corresponding portion of the liability may be within the scope of sec_357 and sec_358 even if the assumption of the lease obligations would otherwise be within the scope of sec_357 and sec_358 the assumption is treated as a distribution of money under sec_357 and therefore reduces stock basis under sec_358 as stated above sec_357 provides that if taking into consideration the nature of the liability and the circumstances under which the arrangement for the assumption was made it appears that the principal purpose of the taxpayer with respect to an assumption described in sec_357 was not a bona_fide business_purpose then such assumption shall for purposes of sec_351 be considered as money received by the taxpayer on the exchange based on the facts presented and as discussed above it appears the principal purpose of the transferor p1 with respect to the assumption was simply to create an asset with a basis far in excess of its value viz the y preferred_stock that could be sold to generate a substantial loss for tax purposes with no real economic cost to the parties this is not a bona_fide business_purpose accordingly the liability assumption in this case is squarely within the scope of sec_357 and is to be treated as a distribution of money to the transferor on the exchange consequently under sec_358 the basis in the transferee stock ie the y preferred_stock is reduced by the amount of the assumed obligations note that sec_357 takes precedence over both sec_357 and sec_357 sec_357 provides for application of the general_rule of sec_357 e xcept as provided in subsection b and c sec_357 expressly provides that sec_357 shall not apply to any exchange to which sec_357 applies this necessarily extends to sec_357 which simply excludes certain liabilities for purposes of applying sec_357 thus in an exchange to which sec_357 applies sec_357 does not apply and therefore sec_357 is rendered moot accordingly neither the this argument assumes that the transfer of the positions assets including the master lease to y the transferee in the first purported sec_351 transaction resulted in a transfer of the right to either use or re-lease the equipment during the residual lease_term postf-150636-01 general_rule of sec_357 nor sec_357 and apply to an exchange to which sec_357 applies other considerations re treating the leasehold obligations as within the scope of sec_357 in terms of our analysis of the sec_351 exchange the taxpayer may argue that the leasehold obligations are contingent liabilities and therefore not liabilities within the scope of sec_357 and sec_358 the argument is based on the principle that the net effect of a taxable sale of assets in exchange in whole or in part for the buyer's assumption of a contingent_liability of the seller that has not produced a financial or tax_benefit to the seller before the asset sale is that the seller's net_income or loss with respect to the sale is not increased or reduced as a consequence of the buyer's assumption of such a contingent_liability of the seller jerred g blanchard jr and kenneth l hooker fixing the assumption of liability rules the wrong way and the right way tax note sec_933 sec_937 date consequently the argument goes in a tax-free sec_351 exchange such a contingent_liability should not be taken into account or is not a liability for purposes of sec_357 and sec_358 it also finds some support in the case law cited below and the legislative_history of sec_357 nevertheless we disagree with this position furthermore the argument that the very liabilities described by sec_357 are not liabilities or are not to be taken into account for purposes of sec_357 and sec_358 is circular they necessarily are to be taken into account for purposes of sec_357 and sec_358 otherwise sec_357 and sec_358 are superfluous congress enacted sec_357 in response to several court cases that had developed different approaches to prevent the application of sec_357 to an assumption of a liability that had not produced a financial_institution b or tax_benefit for the transferor see 533_f2d_1114 9th cir rev'g in part and aff'g in part 61_tc_28 470_f2d_921 2d cir rev'g tcmemo_1971_262 reasoning that the term liability under sec_357 was meant to be limited to what might be called tax_liabilities ie liens in excess of tax costs 68_tc_223 reasoning that the term liability under sec_357 should be limited to those obligations which if transferred cause gain recognition under 331_us_1 and an obligation should not be treated as a liability to the extent that its payment would have been deductible if made by the transferor in contrast to the approaches developed by the courts however congress did not define or redefine the term liabilities for purposes of sec_357 or sec_357 in general rather under sec_357 congress excluded certain liabilities from the postf-150636-01 sec_357 determination specifically liabilities the payment of which would give rise to a deduction unless the liability had generated a tax_benefit for the transferor further the senate_finance_committee report accompanying the revenue act of which enacted sec_357 states that the provision is not intended to affect the definition of the term liabilities for any other provision of the code including sec_357 and sec_357 s rep no 95th cong 2d sess vol c b the taxpayer may also make an argument under sec_358 enacted as of the community renewal tax relief act of p l while taking the position that sec_358 does not apply to their particular transaction taxpayers may nevertheless argue that the legislative_history of sec_358 indicates congress did not view contingent liabilities as within the scope of sec_357 and sec_358 ie prior to the enactment of sec_358 although there is an indication in the legislative_history that the present congress was concerned whether contingent liabilities are within the scope of sec_357 we do not believe that sec_358 or its legislative_history precludes the arguments described above it is well settled that the views of one congress as to the construction of a statute adopted many years before by another congress have ‘very little if any significance ' 392_us_157 see also 356_us_590 we recommend the national_office be consulted with respect to the merits of any argument raised by the taxpayer under sec_358 and its legislative_history if and when that occurs the transaction does not represent a bona_fide loss the facts presented do not indicate that in reality any of the parties have suffered a genuine economic loss sec_165 provides that a taxpayer may deduct any loss sustained during the taxable_year for which the taxpayer is not indemnified by insurance or otherwise the loss must be a bona_fide loss representing a real change_of position in a true economic sense substance rather than form governs in determining a deductible loss sec_1 b a deduction for a loss must be based on an actual economic loss see eg 840_f2d_478 7th cir immediately after the second purported sec_351 exchange in which p1 transferred to subsidiary2 h shares of y preferred_stock in exchange for d shares of subsidiary2 common_stock and after subsidiary2 purchased the other h shares of y preferred_stock for dollar_figureg subsidiary2 possessed i shares of y preferred_stock worth approximately dollar_figurep immediately thereafter x redeemed subsidiary2's i shares of y preferred_stock for dollar_figurep subsidiary2’s economic position never declined accordingly subsidiary2 has had no loss and so it is not entitled to a sec_165 postf-150636-01 deduction in fact arguably subsidiary2 recognized a gain of dollar_figured on the redemption of the h shares of y preferred_stock that it purchased for dollar_figureg and sold to x for dollar_figurei note that this argument is consistent with other arguments such as sham_transaction and lack of economic_substance that are addressed in other sections of this advice issue it appears that taxpayer failed to substantiate its entitlement to the capital_loss based upon the facts as currently developed we believe that taxpayer’s claimed loss should not be allowed without taxpayer providing evidence of its basis however for purposes of tax_administration we believe substantiation and evidentiary issues are better suited for field determination and therefore we defer to the field’s determination on this issue issue sec_482 applies to the transaction i discussion of the requirements of sec_482 section 482-generally sec_482 was designed to prevent the artificial shifting milking or distorting of the true net incomes of commonly controlled enterprises taxpayers who act in concert or pursuant to a common design or plan may be treated as controlled by the same interests with respect to the transactions that they collectively control 453_f2d_1144 2nd cir cert_denied 407_us_934 reh’g denied 409_us_899 nonacq 1975_2_cb_3 372_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 postf-150636-01 legal standard for determining control under sec_482 definition of control a court decisions the regulations under sec_482 define control to include any kind of control regardless of whether such control is direct or indirect or legally enforceable sec_1_482-1 case law supports the regulation’s definition of control indicating that it is the reality of control that is actual and practical control which is determinative in the application of sec_482 rather than record ownership or legally enforceable control 42_tc_114 aff’d 358_f2d_342 6th cir cert_denied 385_us_899 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 1_bta_624 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 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 372_f2d_415 4th cir cert_denied 389_us_841 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 consequently according to both the sec_482 regulations and the applicable case law none of the participants in this transaction is required to have legal control of another participant through majority ownership of that other participant’s voting_stock for control to exist as defined under sec_482 the service has the authority to determine whether control exists by considering the reality of the control situation and examining whether the same interests effectively control the participants to the transaction rather than basing the determination of control solely on the taxpayer’s percentage of ownership of voting_stock or legal right to direct the participant’s actions see b forman pincite1 b sec_1_482-1 acting in concert or with a common goal or purpose and the presumption of control for the tax_year covering the d11 transfer by p1 of h shares of y to subsidiary2 in a sec_351 exchange for common shares the control standard is governed by temp_reg sec_1_482-1 postf-150636-01 the regulations governing the years covered by this case provide that when control does not exist through a taxpayer’s majority ownership of a participant’s voting_stock or a legally enforceable agreement delegating the power to direct an entity’s actions control may result from the actions of two or more taxpayers acting in concert or with a common goal or purpose sec_1_482-1dollar_figure see also dhl corp t c memo pincite by its terms the regulation does not require taxpayers to be related to each other by overlapping ownership to effect sec_482 control by acting in concert or pursuant to a common goal or purpose in addition a presumption of control arises under the regulations if income and deductions have been arbitrarily shifted id case law is in accord with the regulation’s presumption of control through the arbitrary shifting_of_income or deductions see 294_f2d_82 5th cir finding presumption of control under sec_29 of regulation predecessor to current sec_482 regulations however by its terms the existence of control by acting in concert or with a common goal or purpose may be found separately under the final regulations whether or not a presumption of control is found through an arbitrary shifting from the facts a loss deduction has been artificially created by the lease-stripping transaction in which p1 participated and the subsequent contribution of the transferee notes to y in a tax-free sec_351 transaction the only apparent purpose for contributing the transferee notes to y was for the purpose of inflating the basis on its stock so that a built-in_loss could be facilitated through another sec_351 transaction this basis inflation occurred in four steps first immediately after purchasing the equipment from x p1 sold the equipment to corporation k holding for dollar_figurenn second p1 sold the user lease rent to financial_institution a for dollar_figurell the sale of the user lease rent resulted in a dollar_figurell taxable gain to p1 almost all of which was allocated to a tax-exempt partner third when p1 made its capital_contribution to y the earlier sale of the user lease rent had the effect of stripping a significant portion of the value from the contributed assets while leaving the basis of those assets unchanged at dollar_figurenn finally under sec_351 p1 claimed a transferred_basis in the y preferred_stock once the loss deduction had been built into the y stock the parties acted in concert to shift it to a party who could make use of the loss the h shares of y preferred_stock contributed by p1 to subsidiary2 in the purported sec_351 transaction of d11 the final_regulation applies during the year year in which the built-in_loss was realized by subsidiary2’s redemption of it shares in y postf-150636-01 had a built-in_loss representing the difference between a claimed basis of dollar_figureii and a claimed fair_market_value of dollar_figurei shortly thereafter on d15 subsidiary2 accepted an offer for the redemption of these h shares of y preferred_stock together with an additional h shares it allegedly purchased from entity b the resulting capital_loss recognized by subsidiary2 offset a total of dollar_figuregg in gains during the taxable years year through year this loss did not correspond to any economic loss by subsidiary2 and may be viewed as arbitrarydollar_figure significantly p1 had little use for a capital_loss deduction because its k limited_partner was a partnership p3 whose k limited_partner was yet another partnership p4 whose k limited_partner was not subject_to u s income_taxation to preserve the tax_benefit from the built-in_loss that was the counterpart to the rent strip the parties to this transaction sought to shift the built-in_loss to the taxpayer’s consolidated_group a taxable party c the presumption of control among the parties in making the sec_482 control determination the service may apply the presumption of control provided for in sec_1_482-1 and in the applicable case law the regulations do not require the service to also establish that the parties acted in concert or with a common goal or purpose for the presumption to be applicable the service must only establish that income or deductions have been arbitrarily shifted between the parties for the presumption of control to arise from the facts provided to us and in addition to the acting in concert control theory discussed above it appears as though a loss deduction has been arbitrarily shifted from p1 to subsidiary2 in particular no plausible business_purpose has been offered as to why subsidiary2 would accept stock with so little apparent worth in exchange for its own stock the only apparent reason for the transfer was to facilitate subsidiary2’s use of the built-in capital_loss which p1’s ultimate indirect k owner could not use similarly no plausible reason has been offered as to why p1 would prefer to own common_stock representing a small minority interest in subsidiary2 a closely-held corporation instead of preferred_stock which paid cumulative dividends of f in y one might expect that the possibility of receiving dividends on all of a company’s preferred_stock would offer a greater potential for profit than holding a small minority percentage of a shell company’s common_stock the absence of credible non-tax reasons as to why subsidiary2 would want y preferred_stock and as to why p1 would want subsidiary2 common_stock makes the shifting of the loss built into the stock appear to have occurred in an arbitrary manner indeed this loss did not correspond to any economic loss by any party including to any party to the lease-stripping transaction that resulted in the manufacture of the high-basis low-value y preferred_stock postf-150636-01 d legal standard for determining the same interests under sec_482 the regulations do not define what the term the same interests means under sec_482 case law indicates that in using the term the same interests congress intended to include more than the same persons or the same individuals under this approach 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 see 372_f2d_415 4th cir cert_denied 389_us_841 453_f2d_1144 2d cir cert_denied 407_us_934 366_f2d_890 5th cir cert_denied 386_us_1016 cf 598_f2d_1375 5th cir stating that different persons with a common goal or purpose for arbitrarily shifting income can constitute the same interests for purposes of sec_482 2_bta_229 but see the 5_tc_558 acq c b acq withdrawn 1965_2_cb_7 as previously discussed the facts show the apparent existence of a common plan between p1 and subsidiary2 to shift a substantial capital_loss to subsidiary2 on the basis of these facts we conclude that p1 and subsidiary2 constitute the same interests under sec_482 assuming the transfer of y preferred_stock by p1 to subsidiary2 is respected as a valid nonrecognition transfer under sec_351 we conclude that adequate grounds exist under sec_482 to reallocate the loss deduction claimed by subsidiary2 to prevent the evasion of taxes or to clearly reflect income ii application of sec_482 to subsidiary2’s redemption transaction the sec_351 transaction immediately follows a lease_stripping transaction of the type described in notice_95_53 1995_2_cb_334 the notice indicates that lease_stripping transactions effected through a transferred_basis transaction will result in the exercise of the service’s authority to reallocate gross_income deductions credits or allowances between the participants in the transaction at this stage of development the facts indicate that the contribution and sale of the stock were part of a prearranged transaction to avoid taxation through the creation and transfer of a capital_loss when a sec_351 transfer is involved the commissioner may disregard the nonrecognition provisions of sec_351 to make a sec_482 allocation to clearly reflect income among the controlled taxpayers sec_1_482-1 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 postf-150636-01 through case law in support of the service’s position allowing the disregard of nonrecognition provisions if necessary to clearly reflect income sec_1_482-1 adopts the same rule reflected in the third circuit’s holding in 137_f2d_600 3rd 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 in form 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 instead by the parent 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 provision id the court held 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 198_f2d_214 2nd cir cert_denied 344_us_874 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 305_f2d_681 9th cir sec_482 will control when it conflicts with sec_351 84_tc_996 aff’d in part and rev’d in part 856_f2d_855 7th cir sec_482 may be applied in circumstances involving sec_351 transactions if necessary to clearly reflect income or prevent the avoidance of tax 88_tc_252 but see 643_f2d_747 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 postf-150636-01 on the facts provided we conclude that subsidiary2’s redemption of its y stock is subject_to allocation under sec_482 in accordance with sec_1_482-1 national securities and its progeny we also conclude that the facts show that subsidiary2 and p1 engaged in the sec_351 transaction primarily to further tax_avoidance motives and that the subsequent disposition of the y preferred_stock acquired by subsidiary2 in the sec_351 transfer resulted in a distortion_of_income by disposing of the inflated basis low value y preferred_stock at a substantial loss subsidiary2 was able to shelter significant capital_gains income for the cost of twenty shares of its stock given that subsidiary2 held the stock for only a short time before accepting the redemption offer13 and the loss generated upon the redemption of the stock offset gains of dollar_figuregg during the taxable years year through year it is apparent that the pre-contribution loss attributable to the stock properly belongs to p1 accordingly under the analysis adopted in national securities corp and its progeny the service may disregard the sec_351 transfer and allocate the losses subsidiary2 claimed on the sale of the y preferred_stock back to the transferor entity p1 to clearly reflect income of the parties who acted in concert and pursuant to the common plan to shift income and deductions we also recommend that the facts may appropriately demonstrate a lack of business_purpose with respect to the sec_351 transfer by p1 and the redemption of y shares within k months after subsidiary2 received the stock accordingly we believe that sufficient evidence of tax_avoidance is present and conclude that the result in ruddick would not apply to this transaction if the case were to be appealable to the federal_circuit issue the accuracy-related_penalty provided by sec_6662 applies to deficiencies that resulted from adjustments to the losses reported by taxpayer from its disposition of the stock received in the purported sec_351 transaction 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 under chapter sec_1_6662-2 provides that there is no stacking of the accuracy-related_penalty components thus the maximum accuracy-related_penalty imposed on any portion of an underpayment is percent in the case of a gross_valuation_misstatement 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 where the service alternatively determined that either the 40-percent accuracy-related_penalty attributable to a gross_valuation_misstatement penalty under sec_6662 or the percent accuracy-related_penalty attributable to negligence was applicable the the y stock was held for a shorter period than the stock was held by the transferee in national securities postf-150636-01 accuracy-related_penalty provided by sec_6662 does not apply to any portion of an underpayment on which a penalty is imposed for fraud under sec_6663 sec_6662 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 the preparation of a tax_return sec_6662 and 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 43_tc_168 sec_1_6662-3 provides that 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 if the facts establish that a taxpayer reported losses from a transaction that lacked economic_substance or reported losses or deductions from assets with bases traceable to lease_stripping transactions that would have seemed to a reasonable and prudent person to be too good to be true then the accuracy- related penalty attributable to negligence may be applicable if the taxpayer failed to make a reasonable attempt to ascertain the correctness of the claimed losses or deductions the facts as currently developed support the view that the accuracy-related_penalty attributable to negligence applies to the deficiency that results from the disallowance of the built-in losses from the inflated basis assets because taxpayer appears to have disregarded the economic_substance of the transactions from which the losses were claimed and has failed to offer evidence that there was reasonable_cause for its return position for the losses or that it acted in good_faith in claiming them there is no evidence that they thoroughly investigated the bona_fide economic aspects of the lease_stripping transactions or reasonably relied on professional advice that the losses are allowable see 904_f2d_1011 5th cir sec_1_6664-4 we accordingly conclude that the facts as developed support the conclusion that taxpayer was negligent and that the penalty provided by sec_6662 should therefore be imposed substantial_understatement_of_income_tax 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 dollar_figured in the case of corporations other than s_corporations or personal_holding_companies sec_6662 understatements are generally reduced by the portion of the understatement attributable to the tax treatment of items for which there was substantial_authority for such treatment and any item postf-150636-01 if the relevant facts affecting the item’s tax treatment were adequately disclosed in the return or an attached statement and there is a reasonable basis for the taxpayer’s tax treatment of the item sec_6662 in the case of items of taxpayers other than corporations attributable to tax_shelters exception above does not apply and exception applies only if the taxpayer also reasonably believed that the tax treatment of the item was more_likely_than_not the proper treatment sec_6662 in the case of items of corporate taxpayers attributable to tax_shelters neither exception nor above applies sec_6662 therefore if a corporate taxpayer has a substantial_understatement that is attributable to a tax_shelter_item the accuracy-related_penalty applies to the understatement unless the reasonable_cause exception applies see sec_1_6664-4 for special rules relating to the definition of reasonable_cause in the case of a tax_shelter_item of a corporation the definition of tax_shelter includes among other things any plan or arrangement a significant purpose of which is the avoidance or evasion of federal_income_tax sec_6662 for transactions entered into before date the relevant standard was whether tax_avoidance_or_evasion was the principal purpose of the entity plan or arrangement sec_1_6662-4 if the facts establish that an understatement attributable to the disallowance of losses or deductions from assets with bases traceable to lease_stripping transactions exceeds the greater of percent of the tax required to be shown on the return or dollar_figure dollar_figured in the case of corporations other than s_corporations or personal_holding_companies a substantial_understatement_penalty may be applicable we believe that the facts as currently developed support the position that the series of transactions in which subsidiary2 acquired and sold the inflated basis stock to recognize the built-in losses was a tax_shelter consequently any understatement that resulted from the disallowance of the loss claimed from the preferred_stock would if substantial be subject_to the penalty provided by sec_6662 if the series of prearranged transactions in which taxpayer acquired and sold the preferred_stock to recognize the built-in losses was not a tax_shelter we believe that any understatement that resulted from the disallowance of the loss claimed from the inflated basis assets would if substantial be subject_to the penalty provided by sec_6662 because neither of the exceptions contained in sec_6662 seem to apply in this case as discussed below the facts as developed do not support the conclusion that taxpayer had a reasonable basis for claiming the inflated basis in addition it does not appear that the relevant facts affecting the items’ tax treatment were disclosed in the return of taxpayer or in attached statements 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 dollar_figured in the case of a corporation other than an s postf-150636-01 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 then the penalty under sec_6662 is increased to sec_6662 this penalty does not apply to the extent that the reasonable_cause and good_faith exception to this penalty set forth in sec_1_6664-4 sec_1_6662-5 one 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 we believe that the facts as currently developed support the position that the accuracy-related_penalty attributable to a substantial_valuation_misstatement applies to these transactions if the facts establish that the adjusted_basis of the preferred_stock an asset with a basis traceable to a lease_stripping transaction is percent or more of the correct amount then a substantial_valuation_misstatement exists if the facts establish that the adjusted_basis of the preferred_stock is percent or more of the correct amount then a gross_valuation_misstatement exists as discussed below the facts developed do not support the conclusion that the taxpayer had a reasonable basis for claiming the inflated basis the reasonable_cause exception the accuracy-related_penalty and fraud_penalty do not apply with respect to any portion of an underpayment with respect to which it is shown that there was reasonable_cause and that the taxpayer acted in good_faith sec_6664 the determination of whether a taxpayer acted with reasonable_cause and in good_faith is made on a case-by-case basis taking into account all pertinent facts and circumstances sec_1_6664-4 generally the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax_liability id reliance on the advice of a professional tax advisor does not necessarily demonstrate reasonable_cause and good_faith reliance on professional advice however constitutes reasonable_cause and good_faith if under all the circumstances such reliance was reasonable and the taxpayer acted in good_faith id see also 469_us_241 reasonable_cause is established when a taxpayer shows that he reasonably relied on the advice of an accountant or attorney in determining whether a taxpayer has reasonably relied on professional tax_advice as to the tax treatment of an item all facts and circumstances must be taken into account sec_1_6664-4 postf-150636-01 the advice must be based upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances for example the advice must take into account the taxpayer’s purpose and the relative weight of such purposes for entering into a transaction and for structuring a transaction in a particular manner a taxpayer will not be considered to have reasonably relied in good_faith on professional tax_advice if the taxpayer fails to disclose a fact it knows or should know to be relevant to the proper tax treatment of an item sec_1_6664-4 the advice must not be based on unreasonable factual or legal assumptions including assumptions as to future events and must not unreasonably rely on the representations statements findings or agreements of the taxpayer or any other person for example the advice must not be based upon a representation or assumption that the taxpayer knows or has reason to know is unlikely to be true such as an inaccurate representation or assumption as to the taxpayer’s purposes for entering into a transaction or for structuring a transaction in a particular manner sec_1_6664-4 further where a tax_benefit depends on nontax factors the taxpayer also has a duty to investigate such underlying factors the taxpayer cannot simply rely on statements by another person such as a promoter see novinger v commissioner tcmemo_1991_289 taxpayer could not avoid the negligence_penalty merely because his professional advisor had read the prospectus and had advised the taxpayer that the underlying investment was feasible from a tax perspective assuming the facts presented were true moreover if the tax advisor is not versed in these nontax factors mere reliance on the tax advisor does not suffice see 205_f3d_54 2d cir taxpayer’s reliance on tax advisor was not reasonable given the cautionary language in offering memoranda and the tax advisor’s lack of adequate knowledge to evaluate essential aspects of underlying investment 89_tc_849 aff’d 904_f2d_1011 5th cir reliance on tax_advice not reasonable where taxpayer did not consult experts with respect to the bona fides of the financial aspects of the investment 39_f3d_402 2d cir taxpayer’s reliance on accountant’s advice to invest in a partnership engaged in oil_and_gas was not reasonable where accountant lacked industry knowledge 857_f2d_1383 9th cir penalties upheld where advisor knew nothing firsthand about the venture reliance on tax_advice may not be reasonable or in good_faith if the taxpayer knew or should have known that the advisor lacked knowledge in the relevant aspects of the federal tax law sec_1_6664-4 for a taxpayer’s reliance on advice to be sufficiently reasonable so as possibly to negate a sec_6662 accuracy- related penalty the tax_court in neonatalogy associates p a v commissioner 115_tc_46 stated that the taxpayer has to satisfy the following three-prong test the adviser was a competent professional who had sufficient expertise to justify reliance the taxpayer gave to the advisor the necessary and accurate postf-150636-01 information and the taxpayer actually relied in good_faith on the adviser’s judgment with respect to reasonable_cause for the substantial_understatement_penalty attributable to tax_shelter items of a corporation special rules apply see sec_6662 for the definition of a tax_shelter 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 treatment sec_1_6664-4 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 percent likelihood that the tax treatment of the item will be upheld if challenged by the service sec_1_6664-4 therefore if possible the tax advisor's opinion should be obtained to determine whether these requirements are met although satisfaction of the substantial_authority and belief requirements is necessary to a reasonable_cause finding this may not be sufficient for example reasonable_cause may still not exist if the taxpayer's participation in the tax_shelter lacked significant business_purpose if the taxpayer claimed benefits that were unreasonable in comparison to the initial investment in the tax_shelter or if the taxpayer agreed with the shelter promoter that the taxpayer would protect the confidentiality of the tax aspects of the structure of the tax_shelter sec_1 e the facts as developed do not support the conclusion that the taxpayer had reasonable_cause or acted in good_faith with respect to any portion of its underpayment there is no indication that taxpayer thoroughly investigated the bona_fide economic aspects of the transactions or reasonably relied on professional advice that the losses were allowable as previously discussed we believe that the transactions in which subsidiary2 acquired and sold the inflated basis stock to recognize the losses was a tax_shelter we believe that the facts as developed do not support the conclusion that the taxpayer acted with reasonable_cause under the special rule for the substantial_understatement_penalty attributable to tax_shelter items of a corporation taxpayer has not attempted to satisfy the authority postf-150636-01 requirement of sec_1_6664-4 or show that it reasonably believed at the time the return was filed that the tax treatment of the item was more_likely_than_not the proper treatment case development and other considerations postf-150636-01 postf-150636-01 postf-150636-01 in the course of working a particular case additional arguments or counter arguments may be raised by individual taxpayers and the facts may suggest additional arguments to be made by the service in that event please contact our office for additional information or advice 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 please call if you have any further questions associate chief_counsel passthroughs and special industries by carolyn h gray acting assistant to the branch chief office of the associate chief_counsel passthroughs and special industries