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Coordinated Issue Paper Addresses Use of S Corp.
and Straddles to Generate Loss Deductions
The
IRS
has issued a Coordinated Issue Paper (CIP) on
transactions described in Notice
2002-65, 2002-2 CB 690. In Notice
2002-65, the
IRS
indicated that it will challenge transactions that
use a straddle, one or more transitory shareholders
and the rules of subchapter S to generate deductions
that purportedly allow taxpayers to claim an
immediate loss while deferring an offsetting gain in
the taxpayer's investment. Such a transaction could
also involve a partnership rather than an S
corporation. The CIP is intended to help
IRS
examiners in identifying and developing issues in
these types of transactions on a consistent basis.
The transaction described in Notice
2002-65 involved a series of preplanned
steps. First, an investor and one or more persons,
such as employees of a promoter, form an S
corporation. The investor initially has a minority
stock interest in the S corporation. The S
corporation then enters into long and short
positions, or straddles, on foreign currencies and
may acquire other assets. The positions are
substantially offsetting positions, so that as one
position increases in value, the other position
decreases in value.
The S corporation terminates the gain leg of the straddle and
allocates the gain to the shareholders pro rata
according to their stock ownership. The gain
increases each shareholder's basis in the stock of
the S corporation. The S corporation redeems the
stock of the shareholders other than the investor,
and the other shareholders claim a loss as a result
of the redemption. The S corporation then elects to
treat the S corporation's tax year as though it
consists of two separate tax years, with the first
year ending on the date of the redemption.
After the redemption, but in the same calendar year, the S
corporation terminates the loss leg of the straddle.
In order to maximize the allowable loss, the
investor may make an additional contribution or a
loan to the S corporation in order to increase the
investor's basis in the S corporation. The entire
loss from the loss leg of the straddle then passes
through to the investor, who is the sole remaining
shareholder in the S corporation. The loss reduces
the investor's basis in the S corporation's stock
and debt.
In the CIP, the
IRS
has identified eight issues that should be
considered by
IRS
examiners working on a "Notice
2002-65" transaction and states its
conclusion for each issue. First, the S corporation
and the investor should be disallowed losses under Code
Sec. 165(c)(2) because the transaction
was not entered into for profit. Any reasonable
expectation of earning a profit on the straddle
transaction is greatly outweighed by the fees paid
for the transaction to the promoter.
Second, the losses should be disallowed under Code
Sec. 269 because the principal purpose of
the transaction was the avoidance of income taxes.
In order for Code
Sec. 269 to apply, the investor must have
acquired control of the S corporation. In a "Notice
2002-65" transaction, the investor
does not become the sole shareholder until after the
redemption; therefore, determination of whether the
investor has control is measured after the
redemption because the redemption is pre-arranged.
The redemption always occurs after the gain leg is
closed and before the loss leg is closed so that the
investor gets all of the straddle loss but only part
of the straddle gain.
Third, under the Code
Sec. 988 anti-abuse regulations, the
transaction should be recharacterized and the loss
accelerated to a time prior to the promoter
shareholders' redemption. Under these regulations,
if the substance of a foreign currency gain or loss
differs from its form, the
IRS
may recharacterize the timing, source and character
of gains or losses with respect to the transaction
in accordance with its substance. Thus, the tax
consequences to the investor and the other
shareholders may be realigned with the economic
substance of the transaction by marking the loss leg
of the straddle to market before the redemption and
allocating the resulting tax loss to the other
shareholders and away from the investor.
Fourth, the corporation's S election is ineffective because the
promoter, rather than the promoter's employees,
should be treated as the shareholder, and the
promoter is an ineligible shareholder. The facts may
indicate that the promoter shareholders are agents
of the promoter based on the promotional materials,
whether they are compensated for participating in
the transaction, how much control the promoter
exerts over them and other factors. If the promoter
shareholders are agents of the promoter, then the
promoter is treated as the shareholder in the
corporation. If the promoter is an entity such as an
limited liability company (LLC), then the promoter
is an ineligible shareholder and the S corporation
election is ineffective. If the S corporation
election is ineffective, then the gains and losses
from the termination of the legs of the straddle are
reported as if the corporation was a C corporation
and the gains and losses will not flow through to
the shareholders.
Fifth, under judicial doctrines such as the step-transaction,
economic substance, and substance-over-form
doctrines, the benefit of the deduction claimed upon
the termination of the loss leg of the straddle
should be disallowed. The primary purpose of the
transaction is not for the parties to trade and
invest in foreign currency straddles. Instead, the
transaction is a substantially meaningless series of
steps that manipulate tax rules to artificially
create tax losses for the investor.
IRS
examiners should assert arguments using various
judicial doctrines with discretion in appropriate
cases and only after detailed development. Such
doctrines should be asserted only as a secondary
argument following any appropriate technical
arguments.
Sixth, the transaction costs incurred in connection with a "Notice
2002-65" transaction, including
promoter's fees, accounting fees, legal fees, and
consulting fees, are not deductible under Code
Sec. 162 or 212.
The fees incurred are not deductible under Code
Sec. 162 because they are payments to
purchase tax benefits for the participants. Such
costs are also not deductible under Code
Sec. 212 because they are incurred in
obtaining tax advice in furtherance of a sham
transaction.
Seventh, the accuracy-related penalty under Code
Sec. 6662 may apply to "Notice
2002-65" transactions. Finally, the
accuracy-related penalty provisions under Code
Sec. 6662A for any reportable transaction
understatement may also apply to "Notice
2002-65" transactions for tax years
ending after October 22, 2004.
All Industries --"Notice 2002-65" Tax
Shelter, Coordinated Issue Paper (Effective date:
May 9, 2005).
All industries: Notice 2002-65 Tax Shelter:
Coordinated Issue Paper: Industry Specialization
Program.
Effective Date:
May 9, 2005
Coordinated
Issue Paper All Industries
"Notice
2002-65" Tax Shelter
UIL
9300.22-00
Introduction
On October 15, 2002, the Service issued Notice
2002-65, 2002-2 C.B. 690, announcing that
the Service will challenge transactions that use a
straddle, one or more transitory shareholders, and
the rules of subchapter S, to generate deductions
that purportedly allow taxpayers to claim an
immediate loss while deferring an offsetting gain in
the taxpayer's investment in the S corporation.
Issues
1. Whether the S corporation and the Investor should
be denied the loss under §
165(c)(2)?
2. Whether the Investor should be denied the loss
under §
269 because the principal purpose of
acquiring control of the S corporation was the
avoidance of income taxes?
3. Whether the transaction should be recharacterized
under the §
988 anti-abuse regulations?
4. Whether the Promoter, an ineligible shareholder,
should be treated as the shareholder, thus making
the S corporation's S election ineffective?
5. Whether under judicial doctrines (i.e., step
transaction, economic substance, and substance over
form), the loss deduction should be allowed?
6. Whether the legal, promoter fees, and "out
of pocket expenses" should be allowed?
7. Whether the §
6662 accuracy-related penalty applies to Notice
2002-65 transactions?
8. Whether the §
6662A accuracy-related penalty provisions
apply to Notice
2002-65 transactions?
Conclusions
1. The S corporation and the Investor should be
disallowed the losses under §
165(c)(2).
2. The losses should be disallowed under §
269, because the principal purpose of
this transaction was the avoidance of income taxes.
3. The transaction should be recharacterized, and
the loss accelerated to a time prior to the Promoter
Shareholders' redemption, under the §
988 anti-abuse regulations.
4. The corporation's S election was ineffective
because the Promoter, an ineligible shareholder,
should be treated as the shareholder.
5. Under judicial doctrines (i.e., step transaction,
economic substance, and substance over form), the
benefit of the deduction claimed upon the
termination of the loss leg of the straddle should
be disallowed. These arguments should be utilized
with discretion in appropriate cases and only after
detailed development.
6. The transaction costs incurred in connection with
this transaction, including promoter's fees,
accounting fees, legal fees and consulting fees, are
not deductible under §§
162 or 212.
7. The §
6662 accuracy-related penalty applies to Notice
2002-65 transactions.
8. The §
6662A accuracy-related penalty provisions
apply to Notice
2002-65 transactions.
Facts
The facts below describe a typical Notice
2002-65 transaction. Accordingly, some of
the facts may vary depending on the transaction
being examined. A typical Notice
2002-65 transaction involves a number of
precisely arranged steps which are intended to
ultimately result in a deductible noneconomic loss
for the Investor. The key components of a Notice
2002-65 transaction are (1) the use of a
straddle that is not subject to the mark to market
rules of §
1256, (2) an S corporation1 , (3) and one or more transitory shareholders.
First, the Investor and and one or more employees of
the Promoter form a corporation (Promoter
Shareholders)2
. The shareholders of the corporation elect to be
treated as an S corporation under §
1362(a).
The Promoter loans $800 to the Promoter
Shareholders.3
Investor contributes $200 in exchange for 200 shares
of S corporation voting stock (a 20% equity
interest). Investor's basis in the S corporation
stock is $200. The Promoter Shareholders contribute
$800 (obtained from the Promoter) in exchange for
800 shares of S corporation non-voting stock (an 80%
equity interest). The Promoter Shareholders' total
basis in the S corporation stock is $800. The price
per share of the voting stock and non-voting stock
is identical. In addition, the Investor loans $4,000
to the S corporation. The loan increases the
Investor's basis in the S corporation to $4,200. The
S corporation uses the contributed cash to establish
an account with Bank. Bank is the custodian of the
account and is authorized to buy or sell foreign
currencies upon instruction from either the S
corporation or the Promoter.
Second, in taxable Year 1, S corporation acquires
long and short positions (straddles) in forward
interest rate swaps and minor foreign currency
trading. The straddles acquired by the S corporation
could also be comprised of financial instruments
other than interest rate swaps or foreign currency
forward contracts. Such positions are substantially
offsetting so that as one position increases in
value, the other position will decrease in value to
substantially the same degree.
Third, the S corporation terminates the gain leg of
the straddles for a gain of $10,000. The $10,000
gain is allocated to the shareholders pro rata
according to their stock ownership. Accordingly, the
gain is allocated $2,000 to the Investor and $8,000
to the Promoter Shareholders. Under §
1367(a)(1),
Investor's basis in the S corporation stock is
increased by $2,000 to $6,200, and the Promoter
Shareholders' total basis is increased by $8,000 to
$8,800. Immediately after the gain leg is
terminated, the loss position is "locked
in" by putting on a "switch
position,"4
and the S corporation is left with a net unrealized
loss of $10,000.
The proceeds from the terminated gain leg are
invested either in quarterly bonds or OTC Deposit
Annexes (Synthetic CDs). The quarterly bonds or
Synthetic CDs provide collateral for the $10,000
unrealized loss position. Accordingly, when the loss
leg is terminated (Step 5) the quarterly bonds or
Synthetic CDs will be used to cover the loss (i.e.,
neutralize the loss).
Fourth, the S corporation forms a single member
limited liability company (Trading LLC), which is
treated as a disregarded entity and thus a division
of the S corporation. As discussed below, an
affiliate of the Promoter (the Promoter Affiliate)
manages the assets of Trading LLC.
Fifth, the S corporation redeems the stock of the
Promoter Shareholders for $825, an amount that is
slightly higher than the Promoter Shareholders'
initial investment. The Promoter Shareholders claim
a loss of $7,975 on the redemption.5
The S corporation files an election under §1377(a)(2)
to treat the S corporation's taxable year as though
it consists of two separate taxable years, with the
first year ending on the date of the redemption.6
Sixth, following the redemption but within the same
calendar year, the S corporation terminates the loss
leg. This generates a $10,000 loss which is
allocated to the Investor. Because the Investor has
inadequate stock and debt basis to claim the entire
$10,000 loss and in order to claim that the overall
transaction has a profit objective, the Investor
makes an additional contribution to the S
corporation.7
This post-redemption capital contribution can take
any form including cash, a stock investment account,
or an operating business.
Generally, Notice
2002-65
transactions are marketed with an overall fee
structure of 5% of the capital tax losses and 6% of
the ordinary tax losses. Initially, some fees are
paid directly to the Promoter, accountants, and
attorneys. S corporation also enters into a
management agreement with the Promoter. As part of
the agreement, S corporation agrees to pay a fee
equal to a percentage (e.g., 1/4 of 1%) of the net
fair market value of S corporation's account on
deposit with the Bank. However, after Promoter
Shareholders' stock is redeemed, the fee is waived.8
The S corporation enters into a management
arrangement with the Promoter Affiliate. The fee
agreement is a two part agreement consisting of a
Currency Consulting and U.S. Government and Agency
Securities Trading Agreement (the Consulting
Advisory Fee) and fees for investment advisory and
management services. The majority of the fees are
paid pursuant to the Consulting Advisory Fee.
The only assets subject to Currency Advisory Fee are
the assets held by Trading LLC. Trading LLC's only
asset is the balance in the trading account after
the redemption of the Promoter-Shareholders. The
balance is equal to the initial capital contribution
less the redemption amount, the loan from
shareholder, and interest on the initial cash
deposits plus or minus any actual trading gains or
losses.
The Consulting Advisory Fee approximately equals the
amount of funds the Promoter Affiliate is to manage
(i.e., the assets held by Trading LLC) over a two
year period. The Consulting Advisory Fee is either
paid by the Investor or by the S corporation from
assets contributed to the S corporation by the
Investor after the redemption of the Promoter
Shareholders. If the Consulting Advisory Fee was
paid by Trading LLC, there would be no assets left
in the Trading LLC for the Promoter Affiliate to
manage.
After paying the Consulting Advisory Fee in an
amount approximately equal to the assets initially
held in the Trading LLC (an amount slightly greater
than Investors initial equity and loan contribution
($ 4,200)), the Promoter Affiliate invests most of
the Trading LLC's assets in US Treasury securities
or other cash equivalents.
LEGAL THEORIES
1. The S corporation and the Investor should
be disallowed the loss under § 165(c)(2).
Section
165(a)
allows as a deduction any loss sustained during the
year and not compensated by insurance or otherwise.
Losses claimed by individuals, other than casualty
losses, are limited by §
165(c)
to (1) losses incurred in a trade or business and
(2) losses incurred in any transaction entered into
for profit, though not connected with a trade or
business. The requirements of §
165(c)(2)
were applied to certain straddle transactions in Fox
v. Commissioner, 82 T.C. 1001 (1984). The Tax
Court found that §
165(c)(2)
requires that the taxpayer enter into the
transaction "primarily for profit." 82 T.C.
at 1019-21. See also Dewees v. Commissioner,
870 F.2d 21, 33 (1st Cir. 1989), and the cases cited
therein. This "primary profit motive" test
(which also applies to other deductions requiring a
business or profit motive, such as §
162),
has its origins in the Supreme Court decision, Helvering
v. National Grocery Co., 304 U.S. 282 (1938),
which interpreted a predecessor of §
165(c).
See also United States v. Generes, 405
U.S.
93, 105 (1972) ("dominant motive"
required).
The application of §
165(c)
does not require a finding that the transaction
lacks economic substance. For example, the Tax Court
in Fox found that because the taxpayer did
not meet the requirements of §
165(c)(2),
it did not have to find that the transaction was a
sham. See also Smith v. Commissioner, 78 T.C.
350 (1982), aff'd without published opinion,
820 F.2d 1220 (4th Cir. 1987), where the Tax Court
found certain straddles not to be shams, but at the
same time disallowed the resulting losses because
the taxpayers lacked the requisite economic profit
objective under §
165(c)(2).
In
Ewing
, 91 TC at 418, the Tax Court derived the following
guidelines from Fox:
(1) The ultimate issue is profit motive and not
profit potential. However, profit potential is a
relevant factor to be considered in determining
profit motive.
(2) Profit motive refers to economic profit
independent of tax savings.
(3) It is the overall scheme which determines the
deductibility or nondeductibility of the loss.
(4) If there are two or more motives, it must be
determined which is primary, or of first importance.
The determination is essentially factual, and
greater weight is to be given to objective facts
than to self-serving statements characterizing
intent.
(5) Because the statute speaks of motive in
"entering" a transaction, the main focus
must be at the time the transactions were initiated.
However, all circumstances surrounding the
transactions are material to the question of intent.
In applying the profit motive test to the Notice
2002-65
transactions, the Investor initiates the transaction
by communicating a targeted tax loss to the
accountant as a "solution" to offset
federal income tax liabilities. The Promoter then
creates a trading portfolio to reach the targeted
tax loss. The Investor's fees for the transaction
are generally 5% or 6% of the targeted tax loss. Any
reasonable expectation of earning a profit on the
straddle transaction is greatly outweighed by the
fees paid. After the targeted tax loss is achieved
in Year 1 (when the loss leg of the straddle is
terminated), the Investor attempts to establish
profitability through unrelated activities in
subsequent years.
2. The losses should be disallowed under §
269, because the principal purpose of this
transaction was the avoidance of income taxes.
Section
269
provides that any person or corporation who acquires
control of a corporation and the principal purpose
of such acquisition was evasion or avoidance of
federal income tax by securing the benefit of a
deduction, credit or other allowance which such
person or corporation would not otherwise enjoy, the
Secretary may disallow such credit, deduction or
other allowance. For purposes of this section,
control means the ownership of stock possessing at
least 50 percent of the total combined voting power
of all classes of stock entitled to vote or at least
50 percent of the total value of shares of all
classes of stock of the corporation.
Tax avoidance constitutes the principal purpose of
an acquisition when it outranks or exceeds any other
purpose. The determination of the purpose for which
an acquisition was made requires a scrutiny of the
entire circumstances in which the transaction or
course of conduct occurred, in connection with the
tax result claimed to arise therefrom. Section
1.269-3(a).
The principal purpose determination is made at the
time of the acquisition. Hawaiian Trust Co., Ltd.
v.
U.S.
, 291 F.2d 761 (9th Cir. 1961).
Subsequent events may demonstrate that the
acquirer's original purpose was tax avoidance
because the acquisition of control was merely the
first step in a multi-step transaction. Swiss
Colony Inc. v. Commissioner, 52 T.C. 25 (1969), aff'd,
428 F.2d 49 (7th Cir. 1970). However,
later developments, such as the acquirer's
postacquisition discovery of a tax advantage or the
later unrelated acquisition of a profitable
business, will not negate a business-related
principal purpose which was established as of the
time of the acquisition. Hawaiian Trust, supra.
In a Notice
2002-65
transaction, the Investor acquires control of all of
the voting stock of the S corporation at or near
inception, but the Investor does not become the sole
shareholder (and thus allowing the economically
accrued losses to flow through solely to the
Investor) until the pre-arranged redemption of the
Promoter Shareholders' stock. Prior to such
redemption the Investor is entitled to only 20% of
the gains and losses. After the redemption the
Investor is entitled to 100%. By pre-arrangement,
the redemption always occurs after the gain leg is
closed but before the loss leg is closed so that the
Investor is allocated 100% of the straddle loss
while recognizing only 20% of the straddle gain. At
the time of the redemption, the loss has already
economically accrued and it has been locked-in and
neutralized. See Inductotherm Industries v.
Commissioner, T.C. Memo 1984-281
(Post-acquisition deductions and allowances subject
to disallowance under §
269
where they had economically accrued prior to the
acquisition).
In this situation, the Investor arguably meets the
50% control requirement of §
269(a)
when the Investor purchases the 20% interest in the
S corporation (which gives the Investor 100% of the
voting control of that corporation). However, the
Investor cannot achieve the Investor's purpose (to
have 100% of the economically accrued losses flow
through to the Investor) without also causing the
corporation to redeem the Promoter Shareholders'
stock. Thus, it is necessary to measure the §
269(a)
control requirement after taking such redemption
into account. Swiss Colony, supra
(control requirement of §
269(a)
tested after series of integrated steps completed,
even though requirement nominally satisfied
earlier). Further, a redemption of the stock of
another shareholder constitutes a mechanism by which
the remaining shareholder can acquire control of the
corporation for purposes of §
269(a).
Younker Brothers, Inc. v.
U.S.
, 318 F. Supp. 202 (S.D.
Iowa
1970).
Pursuant to section
269(c),
only 80% of the loss would be disallowed. That is,
the Investor should be allowed to offset the gain
completely and not recognize only the portion of the
loss that was truly secured by the taxpayer's
acquisition.
3. The transaction should be recharacterized,
and the loss accelerated to a time prior to the
Promoter Shareholder's redemption, under the § 988
anti-abuse regulations.
Sections
985
through 989 of the Internal Revenue Code, enacted as
part of the Tax Reform Act of 1986, set forth a
comprehensive set of rules for the treatment of
foreign currency transactions. Section
988(a)(1)(A)
provides that foreign currency gain or loss
attributable to a "Section
988
transaction" is computed separately and treated
as ordinary income or loss. The legislative history
of §§
985
through 989 suggests a consistent concern about tax
motivated transactions. The Senate Finance Committee
Report accompanying the Tax Reform Act of 1986
stated that one reason for the enactment of these
provisions was to address opportunities existing
under prior law for taxpayers to engage in
tax-motivated transactions. S. Rep. No. 313., 99th
Cong., 2d Sess. 450 (1986). Accordingly, in enacting
§§
985
through 989, Congress granted broad authority for
the Service to promulgate regulations "as may
be necessary or appropriate to carry out the
purposes of [§§
985-989]
...." Section
989(c).
The legislative history to the Technical and
Miscellaneous Revenue Act of 1988 ("TAMRA"),
in discussing the law prior to the enactment of
TAMRA, stated that "[t]he Secretary has general
authority to provide the regulations necessary or
appropriate to carry out the purposes of [§§
985-989].
For example, the Secretary may prescribe regulations
appropriately recharacterizing transactions to
harmonize the general realization and recognition
provisions of the Code with the policies of §
988."
H.R. Rep. No. 795, 100th Cong., 2d Sess.
296 (1988); S. Rep. No. 445, 100th Cong.,
2d Sess. 311 (1988) (containing identical language).
Under the authority of §
989(c),
the Service has issued §1.988-2(f),
which provides in part as follows:
If
the substance of a transaction described in §1.988-(1)(a)(1)
[i.e., a §
988
transaction] differs from its form, the timing,
source, and character of gains or losses with
respect to such transaction may be recharacterized
by the Commissioner in accordance with their
substance ....
If it is determined that the Investor did not own
all or substantially all of the stock of the S
corporation holding the foreign currency positions
from the outset of the transaction, and that the
participation of the Promoter Shareholders must
therefore be taken into account, §
1.988-2(f)
can be used to accelerate recognition of the loss
leg of a foreign currency straddle prior to the
redemption of the Promoter Shareholders and the
corresponding increase of the Investor's interest in
the S corporation. Because the loss leg of the
straddle is "locked in" shortly after the
gain leg is closed, the Investor is not exposed
(beyond its initial 20% interest) to economic
fluctuations in the value of the foreign currency
positions held by the S corporation. Only narrow
differences in timing account for the fact that
losses, 80% of which were economically incurred by
the Promoter S hareholders, are instead allocated to
the Investor. The closure of the loss leg of the
straddle is delayed just long enough for the
Investor to increase its interest in the S
corporation holding the loss position from 20% to
100% and thereby claim an allocation of 100% of the
loss. Eighty percent of the loss thus allocated to
the Investor derives from economic events that
occurred when the Promoter Shareholders owned most
of the S corporation. Accordingly, the tax
consequences to the Investor and to the Promoter S
hareholders may be realigned with the economic
substance of the transaction by marking the loss leg
of the straddle to market under §
1.988-2(f)
before the Promoter Shareholders' interests are
redeemed (and the Investor's interest in the S
corporation is increased) and allocating the
resulting tax loss to the Promoter Shareholders and
away from the Investor.
4. The corporation's S election was
ineffective because the Promoter, an ineligible
shareholder, should be treated as the shareholder.
Section
1361(b)(1)(B)
provides that a "small business
corporation" cannot have as a shareholder a
person (other than an estate and other than a trust
described in §
1361(c)(2)
or an organization described in §
1361(c)(6))
who is not an individual.
Section
1.1361-1(e)(1)
provides that the person for whom stock of a
corporation is held by a nominee, guardian,
custodian, or an agent is considered to be the
shareholder of the corporation. For example, a
partnership may be a nominee of S corporation stock
for a person who qualifies as a shareholder of an S
corporation. However, if the partnership is the
beneficial owner of the stock, then the partnership
is the shareholder, and the corporation does not
qualify as a small business corporation. Further, §
1.1361-1(f)
provides that a corporation in which any shareholder
is a corporation, partnership, or certain trust does
not qualify as a small business corporation.
Generally, courts limit the circumstances in which
the agency principle is applied. See Northern
Indiana Public Service Co. v. Commissioner, 105
T.C. 341 (1995), aff'd 115 F.3d 506 (7th
Cir. 1997); Commissioner v. Bollinger, 485
U.S. 340 (1988); National Carbide v. Commissioner,
336 U.S. 422(1949).
The following facts are helpful in establishing that
the Promoter Shareholders are agents of the
Promoter: the promotional materials, transactional
documents, and (or) the parties involved treat the
Promoter as the shareholder, the Promoter directs
all of the transactions, the Promoter loans to the
Promoter Shareholders the funds which are
contributed to the S corporation, the Promoter
compensates the Promoter Shareholders for
participating in the transaction, and the Promoter
manages the Shareholder LLCs with sole discretion
and control over such LLCs, including the LLCs' bank
accounts and records.
If it is determined that the Promoter Shareholders
are agents of the Promoter and thus under §
1.1361-1(e)(1)
the Promoter, an ineligible shareholder (e.g. an
LLC) is the beneficial owner of the S corporation
stock, the S corporation election is ineffective.
Accordingly, all gains and losses from the
termination of the legs of the straddle should be
reported as if the corporation is a C corporation.
The effect of treating the corporation as a C
corporation is that gains and losses should be
netted for a minimal gain or loss and those gains or
losses will not flow through to the shareholders.
5. Under judicial doctrines (i.e., step
transaction, economic substance, and substance over
form), the benefit of the deduction claimed upon the
termination of the loss leg of the straddle should
be disallowed.
The primary purpose of the transaction is not for
the parties to trade and invest in foreign currency
straddles, but rather, the transaction is a
substantially meaningless series of steps that
manipulate tax rules to artificially create tax
losses for the Investor. Various judicial doctrines
may be applicable to Notice
2002-65
transactions. The arguments have been classified
under the general doctrines of step transaction,
economic substance and substance over form.9
However, even in those cases when it is appropriate
to raise the argument, judicial doctrines should
only be asserted as a secondary or tertiary
argument, following any appropriate technical
arguments.
A. Step Transaction Doctrine
In tax avoidance situations such as the Notice
2002-65
transaction described above, the substance of a
transaction, rather than its form, governs the
federal income tax treatment of the transaction. Commissioner
v. Court Holding Co., 324
U.S.
331 (1945); Gregory v. Helvering, 293
U.S.
465 (1935). The question of the applicability of the
substance over form doctrine and related judicial
doctrines requires "a searching analysis of the
facts to see whether the true substance of the
transaction is different from its form or whether
the form reflects what actually happened." Harris
v. Commissioner, 61 T.C. 770, 783 (1974). See
also, Gordon v. Commissioner, 85 T.C.
309, 327 (1985); Gaw v. Commissioner, T.C.
Memo. 1995-531, aff'd without published opinion,
111 F.3d 962 (D.C. Cir. 1997). One such judicially
created doctrine is the step transaction doctrine.
Under the step transaction doctrine, a series of
formally separate steps may be collapsed and treated
as a single transaction if the steps are in
substance integrated and focused toward a particular
result.
The
step transaction doctrine generally applies in cases
where a taxpayer seeks to get from point A to point
D and does so stopping in between at points B and C.
The whole purpose of the unnecessary stops is to
achieve tax consequences differing from those which
a direct path from A to D would have produced. In
such a situation, courts are not bound by the
twisted path taken by the taxpayer, and the
intervening stops may be disregarded or rearranged.
[Citation omitted.]
Smith v. Commissioner, 78 T.C. 350, 389
(1982). See also Andantech v. Commissioner,
T.C. Memo. 2002-97, aff'd in part and remanded in
part, 331 F.3d 972 (D.C. Cir. 2003); Long-Term
Capital Holdings, et al. v.
United States
, 330 F. Supp. 2d 122 (D. Conn. 2004). Courts
have applied three alternative tests in deciding
whether the step transaction doctrine should be
invoked in a particular situation: the binding
commitment test, the end result test, and the
interdependence test.
The binding commitment test is the most limited of
the three tests. It looks to whether, at the time
the first step was entered into, there was a binding
commitment to undertake the later transactions. This
is the most rigorous test of the step transaction
doctrine. Commissioner v. Gordon, 13 F.3d
577, 583 (2d Cir. 1994). If there were a moment in
the series of the transactions during which the
parties were not under a binding obligation, the
steps cannot be collapsed under this test. As a
practical matter, the binding commitment test is
seldom used. See, e.g., Andantech
v. Commissioner, supra; Long-Term Capital,
supra.
The end result test analyzes whether the formally
separate steps merely constitute prearranged parts
of a single transaction intended from the outset to
reach a specific end result. This test relies on the
parties' intent at the time the transaction is
structured. The intent the courts focus on is not
whether the taxpayers intended to avoid taxes, but
whether the parties intended from the outset to
"to reach a particular result by structuring a
series of transactions in a certain way."
Additionally, they focus on whether the intended
result was actually achieved. True v.
United States
, 190 F.3d 1165, 1175 (10th Cir. 1999).
Finally, the interdependence test looks to whether
the steps are so interdependent that the legal
relations created by one step would have been
fruitless without a completion of the later series
of steps. See Penrod v. Commissioner, 88 T.C.
1415, 1428-1430 (1987). Steps are generally accorded
independent significance if, standing alone, they
were undertaken for valid and independent economic
or business reasons. Green v.
United States
, 13 F.3d 577, 584 (2d Cir. 1994); Sec.
Insurance Company v.
United States
, 702 F.2d 1234, 1246 - 7 (5th Cir.
1983).
The existence of economic substance or a valid
nontax business purpose in a given transaction does
not preclude the application of the step transaction
doctrine.
"Events
such as the actual payment of money, legal transfer
of property, adjustment of company books, and
execution of a contract all produce economic effects
and accompany almost any business dealing. Thus, we
do not rely on the occurrence of these events alone
to determine whether the step transaction doctrine
applies. Likewise, a taxpayer may proffer some
nontax business purpose for engaging in a series of
transactional steps to accomplish a result he could
have achieved by more direct means, but that
business purpose by itself does not preclude
application of the step transaction doctrine.".
True v.
United States
, supra, at 1177. See also Associated
Wholesale Grocers v. United States, 927 F.2d
1517 (1991); Long-Term Capital Holdings, supra,
at 193.
The three tests are not mutually exclusive and the
requirements of more than one test may be met in one
transaction. Further, the circumstances of a
transaction need only satisfy one of the tests for
the step transaction to operate. Associated
Wholesale Grocers, Inc. v. United States, 927
F.2d 1517, 1527-1528 (10th Cir. 1991)
(finding the end result test inappropriate but
applying the step transaction doctrine using the
interdependence test). And finally, even if the step
transaction doctrine does not apply to an entire
transaction, it may allow the Government to collapse
a portion of a transaction, which may be sufficient
to prevent the intended tax avoidance result. For a
recent detailed discussion of the application of the
three alternative tests in lease stripping
transactions, see Andantech L.L.C. v.
Commissioner, supra, and Long-Term
Capital, supra.
The step transaction doctrine is particularly
tailored to the examination of transactions
involving a series of potentially interrelated steps
for which the taxpayer seeks independent tax
treatment. True v.
United States
, 190 F.3d at 1177. As a general rule, courts
have held that in order to collapse a transaction,
the Government must have a logically plausible
alternative explanation that accounts for all the
results of the transaction. Del Commercial Props.
Inc. v. Commissioner, 251 F.3d 210, 213-214
(D.C. Cir. 2001), aff'g T.C. Memo. 1999-411; Penrod
v. Commissioner, supra, at 1428-1430; Tracinda
Corp. v. Commissioner, 111 T.C. 315, 327 (1998).
The explanation may combine steps; however, some
courts have declined to apply the doctrine where the
Government's alternative explanation would invent
new steps or simply reorder the actual steps taken
by the parties. "'Useful as the step
transaction doctrine may be ... it cannot generate
events which never took place just so an additional
tax liability might be asserted.'" See Grove
v. Commissioner, 490 F.2d 241, 247-248 (2d Cir.
1973), aff'g T.C. Memo. 1972-98 (quoting Sheppard
v. United States, 176 Ct. Cl. 244; 361 F.2d 972,
978 (1966))); see also Esmark, Inc. &
Affiliated Cos. v. Commissioner, 90 T.C. 171,
196 (1988), aff'd without published opinion,
886 F.2d 1318 (7th Cir. 1989); But cf. Long-Term
Capital, supra, at 196 (footnote
94)(indicating that Esmark may be of limited
applicability and distinguishable where all of the
parties necessary to achieve the ultimate result are
privy to the mutual understanding between the
parties.)
The step transaction doctrine may be applicable to a
transaction substantially similar to the one under
discussion here, depending of course, on how the
actual transaction is structured. For example, the
end result test and/or the interdependence test of
the step transaction doctrine could be used to
disregard the Promoter Shareholders' transitory
ownership of the S corporation, thereby allocating
all the gains from the closing of the gain leg to
the Investor. If it can be shown that Promoter
Shareholders' transitory ownership of the S
corporation stock added nothing of substance to the
transaction (other than a transitory party to which
the gain could be allocated), then the Promoter
Shareholders' transitory ownership of the S
corporation stock may arguably be disregarded.
Collapsing the transaction and allocating both gains
and losses to the Investor would match up the gains
and losses from the straddle and, therefore, prevent
the Investor from being allocated the loss without
the gain.
Examiners should look at the facts on a case-by-case
basis to determine if the step transaction doctrine
would be applicable in their specific case.
B. Economic Substance
Discretion must be exercised in determining whether
to utilize an economic substance argument10
in all cases. The doctrine of economic substance
should be considered, but only in cases where the
facts show that the transaction at issue was
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