Blogging Employee Benefits

February 3, 2006

Characterization of Alleged Sham Transaction Remains In Dispute

Filed under: IRS, Litigation — Fuguerre @ 12:00 am

Fun, pure rollicking fun. An amazing little package of tax law tied up in a tight little bundle of only 18 pages. To some extent ancient history, as the fight largely concerns a transaction that has since been shut down by the IRS. But even in sorting out whether that transaction had any prior validity, the court addresses general concepts that might well govern decisions on any new creative tax schemes. Or at the very least, this case perhaps illuminates some of the terrain now being wallpapered with Circular 230 disclaimers. Hmm, how best to memorialize this appellate court moment without simply reciting each and every delicious word of it . . .

The 4th Circuit Court of Appeals agreed with the district court in denying summary judgment for the IRS, concluding that IRC 357 and 358 do not require reduction in basis in a stock sale by the amount of transferred liabilities. However, the district court erred in granting summary judgment in favor of the taxpayer in a dispute with the IRS over the tax implications of a certain transaction, according to the appellate court, since the district court incorrectly looked to the bona fide economic basis of the entity involved in the transaction, rather than correctly focusing on the nature of the transaction itself. Accordingly, the case is remanded to the district court for further proceedings as to the alleged sham nature of the transaction itself. [Black & Decker v. U.S., CA4, No. 05-1015, 2/2/06]

At issue was a 1998 transaction subsequently addressed by the IRS in Notice 2001-17: transfer of a high basis asset to a corporation in exchange for stock of the transferee, in connection with the transferee’s assumption of a liability, in Black & Decker’s case a contingent liability for future health benefits claims via outsourcing of its healthcare management function. Under tax law as amended in 2000, Black & Decker would have been required to reduce its basis by the amount of the transferred liabilities, hence would not have suffered been able to claim the capital loss it sought to claim. There ensued in the court’s decision a detailed analysis of the tax law that governed the 1998 transaction, ultimately concluding that the contingent liability fell within the 357(c)(3) exception as it stood at the time, thereby denying the IRS motion for summary judgment. Perhaps of distant technical value for any remaining cases being fought over what led to Notice 2001-17.

But in confirming denial of the IRS motion, the appellate court did not leave Black & Decker in any comfortable position, since the district court’s approval of Black & Decker’s own motion was reversed. The IRS advanced two arguments against Black & Decker’s motion: one argument based on the tax code itself, the second argument based on sham transaction doctrine. Again digging deep into analysis of specific tax code provisions, the appeallate court turned the IRS down yet again on its first argument. But in its final discussions coming to sham transaction doctrine, the appellate court focused on the objective criteria that a transaction must have economic substance with a reasonable possibility of profit, apart from any claimed tax benefits. Here, the district court had focused on the economic substance of the entity, rather than on the transaction itself. Since material facts regarding the transaction itself remained in dispute, the case was remanded for further proceedings.

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