Federal Taxation Developments Blog : Federal Taxation Lawyer & Attorney : Fox Rothschild Law Firm : Federal Income Taxation & Tax Litigation

In a decision deserving of Supreme Court review, the en banc decision of the First Circuit Court of Appeal in Textron, 104 AFTR 2d 2009-5719, 08/13/2009 , has vacated the district court's determination that a public corporation's tax accrual workpapers were protected from IRS summons by the work-product doctrine. Instead, the First Circuit held that the work-product privilege was not implicated with regard to the taxpayer's tax accrual workpapers, because it found that the workpapers were not prepared "for" litigation and were required to be produced pursuant to an IRS administrative summons. The First Circuit noted that the IRS's right to compel the production of these types of records was important in detecting and disallowing the benefits sought by taxpayers investing in potentially abusive tax shelters. The taxpayer had indeed invested in nine sale-in, lease-out (SILO) transactions which were "listed transactions." After experiencing recent judicial defeats, the Textron case reflects the determination of the IRS Commissioner to have the judicial system reflect the proper goals and aims involved in administering the tax laws. Effective administration requires the production of non-privileged information used in preparing returns, including underlying tax analysis that supports positions and details the anticipated risk that a deficiency in tax, penalties, and interest may follow. The need to obtain tax accrual workpapers is heightened where the returns reflect tax items attributable to tax-motivated transactions. The First Circuit essentially agrees with the IRS's efforts to obtain tax accrual workpapers during discovery in appropriate cases, such as Textron. It places corporate tax payers on notice that some courts will find that tax accrual workpapers or FIN 48 workpapers are not "work product" per se, as was the position taken by the First Circuit, while other courts may use the Fifth Circuit's standard and determine that workpapers are not primarily prepared in anticipation of litigation.

Textron recently filed a writ for certioari before the Supreme Court which the government needs to respond by on or before March 29, 2010. A number of amicus curiae filings have been submitted on behalf of Textron.

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 ^{Wells Fargo & Company and Subsidiaries v. United States ,105 AFTR 2d 2010 (Ct. Fed. Cl. 01/08/2010).}

Tax refund suit filed by WF claiming over $115M in depreciation, interest and expenses for 2002 in connection with participating in 26 leveraged lease transactions, 17 with domestic transit agencies and 9 pertaining to qualified technological equipment ("QTE") Five of the 26 were selected for trial by agreement of the parties who agreed to allow the principles from these transactions to govern the balance. Of the five trial transactions, four involved public transit agencies, and one a QTE lease involving cellular telecommunications equipment. The lessees were public authorities or governmental agencies. A sale in/lease out or SILO tax shelter is where a tax-exempt entity transfers tax benefits for a fee to a United States taxpayer, e.g., WF. The transactions involving depreciable property ranging from buses to trains to telecommunications equipment. The object for each transaction is for the purchaser-lessor to obtain substantial tax deductions from an otherwise tax-exempt entity (seller-leaseback lessee).

The government’s attacks on such arrangements generally involve: (i) applying the substance over form doctrine to determine whether WF really acquired ownership with respect to the purchased assets or whether in substance, the seller really retained ownership and all that is involved is an artificial shifting of tax benefits; (ii) does the financing aspects associated with such sale and lease back, which involves a loan to the original owner to finance the transaction should be respected and allow interest deductions on the loan repayments; and (iii) whether there is any economic substance to these transactions, other than the transfer of tax benefits, that would warrant depreciation and transaction cost deductions.

The Claims Court conducted a 20 day trial in Spring 2009 at which time 33 witnesses, including 13 experts testified. The evidentiary record was voluminous consisting of over 5,000 pages of trial transcript and over 1,100 exhibits. The Court conducted a 20-day trial in Washington, D.C. during April 6 through May 1, 2009.

Other courts have been asked to rule on SILOs or "lease in/lease out" or "LILO" transaction. With one exception, the courts have ruled against the taxpayers claiming the desired tax benefits. See AWG Leasing Trust v. United States, 592 F.Supp.2d 953 (N.D. Ohio 2008); BB&T Corp. v. United States, 2007 WL 37798 [99 AFTR 2d 2007-376], at 1 (M.D.N.C., Jan. 4, 2007), aff'd, 523 F.3d 461 (4th Cir. 2008); Altria Group, Inc. v. United States, 2009 WL 874207, at 1 (S.D.N.Y. July 9, 2009). The taxpayer was successful in Consolidated Edison Company of New York, Inc. v. United States, 2009 WL 3418533 (Fed. Cl. Oct. 21, 2009) (Horn, J.), also a Claims Court case which found that the particular LILO transaction involved had legitimate business purposes and allowed the claimed dedutions.

In Hoosier Energy Rural Electric Cooperative, Inc. v. John Hancock Life Ins. Co., 588 F. Supp. 2d 919 (S.D. Ind. 2008), aff’d 582 F.3d 721 (7^{th Cir. 2009), involved an insurance company which had its credit rating reduced as part of the economic downturn. The lessor of the property, John Hancock, exercised its right to demand that Hoosier Energy find a replacement for the tenant even though it had not missed any payments. The case involves Hoosier Energy's request for injunctive relief to maintain the status quo while Hoosier Energy seeks a replacement for the tenant. In granting injunctive relief, the district court described the SILO transaction as a "blatantly abusive tax shelter" that is "rotten to the core." The Court of Appeals affirmed the district court's grant of injunctive relief, but clarified that the agreements comprising the SILO transaction were legally enforceable under New York law, even if not an approved tax shelter under the Internal Revenue Code. The Court of Appeals gave Hoosier Energy until the end of 2009, approximately 3-1/2 months, to find a replacement user. 582 F.3d at 730.}

After reviewing the record, the Claims Court found that WF is not entitled to the claimed tax deductions on the 5 trial transactions. WF never acquired the burdens and benefits of ownership. Moreover, the transactions lack economic substance, and were intended only to reduce WF’s federal taxes by millions of dollars. Although well disguised in "a sea of paper and complexity", the SILO transactions essentially amount to WF’s purchase of tax benefits for a fee from a tax-exempt entity that cannot use the deductions. The transactions are designed to minimize risk and assure a desired outcome to WF, regardless of how the value of the property may fluctuate during the term of the transactions. Indeed, nothing of any substance changes in the tax-exempt entity's operation and ownership of the assets. The only money that changes hands is Wells Fargo's up-front fee to the tax-exempt entity, and Wells Fargo's payments to those who have participated in or created the intricate agreements. If the Court were to approve of these SILO schemes, the big losers would be the IRS through the loss of millions of taxes.

On the issue of economic substance, the Court examined if there was any likelihood of profit aside from the tax benefits. After going through the detailed paperwork the Court concluded that the end result is that the trial transactions produce an overall loss without the tax benefits, and no rational person would engage in these transactions absent the tax benefits. The Court announced that it will set a conference with counsel during the next 45 days to determine whether any further proceedings are necessary to address the remaining 21 transactions at issue in this case.

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In Menard, Inc., 560 F3d 620 (7th Cir., 2009), rev'g TC Memo 2004-207 , the Seventh Circuit Court of Appeals reversed the Tax Court and found in favor of the taxpayer that a large 5% bonus arrangement payment was in fact paid for services rendered and was deductible in computing the corporation's taxable income for 1998, the year in issue. It reversed the lower court’s (Tax Court's memorandum decision) holding that the 5% bonus compensation was a disguised dividend.

Menard, Inc, was a closely held hardware and building supply company which maintained retails stores in the Midwest. It was founded by the Taxpayer, John Menard, in 1962. The year in issue was 1998, at which time the Company had grown to 138 stores and was the third largest chain store of its type. Menard owed 100% of the voting stock and 56% of the nonvoting stock. The balance of the shares were held by family members, several of whom worked in the business. The record reflected that under his stewardship, Menard caused the Company’s reveunes to grow from $788M (1991) to $3.4B (1998) and that its taxable income grew from $59M to $315M resulting in a 18.8% return which was higher than its competitors, Home Depot or Lowes. Menard’s salary in 1998 was modest, i.e., $157,000 and he received a profit-sharing bonus under a plan of slightly over $3M. He also received a 5% bonus under a program that yielded him more than $20.6M. The 5% bonus plan, which went into effect approximately 25 years earlier, was suggested by the Company’s accounting firm. It called for a bonus in the amount of 5% of net income before taxes subject to a reimbursement agreement if part of the 5% bonus were held to be unreasonable. As a result of his salary, profit-sharing bonus, and the 5% bonus, John's total compensation for the 1998 tax year exceeded $20 million. The 5% bonus also was subject to the following reimbursement agreement: In the event that the IRS disallowed as a deduction any portion of John's compensation, he had to repay to the corporation the entire amount disallowed.

Claiming the salary, profit-split and 5% bonus as deductible compensation, the IRS challenged the corporation's deduction for the entire 5% bonus to Menard as unreasonable and excessive. In response to the taxpayer’s Petitition, the Tax Court ruled that the 5% bonus was excessive and was intended to be and "looked" more like a dividend that a salary. It started its analysis by applying the independent investor test announced by the 7th Circuit in Exacto Spring Corp., 196 F.3d 833 (7th Cir. 1999). The Tax Court and the IRS agreed that John's compensation satisfied the independent investor test, but the Tax Court found the compensation paid to Menard substantially exceeded that level of compensation paid to CEOs of comparable publicly traded corporations. The Tax Court looked at what the CEO of Home Depot was paid in 1998 and that was only $2.8 million that year, even though Home Depot was a much larger company than Menards. In addition, the CEO of Lowe's, also a larger company than Menard, was paid $6.1 million. Accordingly, the Tax Court viewed: (i) Menard’s compensation substantially succeeded that paid to CEO of comparable public companies; and (ii) such evidence was sufficient to rebut the presumption of reasonableness created by the Company’s rate of return under the "independent investor" test. Looking at financial ratios among the three companies, the Tax Court concluded that only an amount slightly in excess of $7M was reasonable and that the excess portion was not intended as compensation but instead as a dividend.

The Seventh Circuit, on appeal, reversed and registered its strong disagreement with the Tax Court. It took special note of the fact that unlike a public company, owners of a closely held business there is tax incentive to treat payments from profits to some extent as compensation and not as a non-dedeductible dividend. The Court, in general, distinguished the application of the various factors when looking at a closely held corporation. It did not view the 5% of net profits bonus looked like a concealed dividend inasmuch as dividends are generally stated as specific dollar amounts rather than a percentage of earnings. Here the 5% bonus was a clear incentive for Menard to work hard and increase profits, and had no application to a passive shareholder’s waiting to realize a satisfactory rate of return.

While the Tax Court was also critical of the "one-man" determination of compensation that Menard made, since he was the sole voting shareholder, the 7th Circuit noted that such fact could not change and rejected such idea. Still, the 7th Circuit thought it would have been a slightly better argument to say that the board of directors should have sought outside advice on appropriate compensation. The record reflected however that Menard had a strong view on what the value of his services were worth.

The Seventh Circuit also discounted the argument that since the corporation had paid no formal dividend, that some portion of the compensation was a disguised dividend.

Menard sounds a major victory for paying high levels of deductible compensation employee-shareholders of closely held corporations. Still, things are no so simple and the prudent tax advisor must address the factual and legal terrain in setting forth compensation awards and programs on a go forward basis as well as in assessing  potential IRS challenges under section 162 and related sections, including section 531 pertaining to the accumulated earnings tax.  

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In Klamath Strategic Investment Fund, 103 AFTR 2d 2009-2220 (5th Cir. 2009), the Fifth Circuit adopted the same approach used by a majority of the other circuits by concluding that a taxpayer must, in order to avoid a lack of economic substance challenge, satisfy what is referred to as both a subjective test and an objective test that the transaction was entered into for profit. Meeting both parts or standards is challenging for the typical tax shelter in which the costs of entering into the transaction are substantially greater than the true economic gain that stands to be realized. that have concluded that a transaction lacks economic substance unless the taxpayer can satisfy both a subjective test and an objective test.

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The Tax Court in Ocumulgee Fields stated it was not ruling, as a matter of law, that a finding of basis shifting precludes the absence of a principal purpose of tax avoidance, but, in the case at hand, the immediate tax consequences resulting from petitioner's deemed exchange resulted in a $1.8 million reduction in taxable gain and the substitution of a 15% tax rate for a 34% tax rate. Still, the Ocumulgee Fields and Teruya Bros. decisions make it difficult to find a more likely than not basis to qualify a related party exchange through a QI particularly in instances where the related party already owned the replacement property.

The Tax Court’s recent decision in Ocumulgee Fields v. Commissioner, places great stress on the ability of a taxpayer to successfully structure a related party exchange under §1031(f) where the related party transfers the replacement property to the taxpayer through a qualified intermediary. The hurdle is the non-tax avoidance prohibition set forth in §1031(f)(4). Ocmulgee Fields is an important development because it highlights the potential tax risk in acquiring replacement property from a related party. After the Tax Court’s prior decision to the same effect in Teruya Brothers, it was not necessarily clear that the acquisition of replacement property from a related party would, in general, be viewed as "abusive" within the meaning of section 1031(f)(4) .The judicial analysis set forth in Ocmulgee Fields confirms what some had suspected that most acquisitions of replacement property from a related party may be "bad" exchanges and will not qualify for tax free treatment.

As many tax advisors know, §1031(a)(1) provides that no gain or loss is recognized with respect to an "exchange" of property of like-kind. Certain properties described in a parenthetical clause to §1031(a), such as interests in a partnership, stocks or securities, inventory, choses in action, etc., are ineligible for tax-free exchange treatment under this provision. Frequently §1031 is used to exchange real property held for productive use in a trade or business or for investment for property of like kind, i.e., replacement property to be held either for productive use in a trade or business or for investment. The cost for avoiding gain (or loss) recognition under §1031(a) is that the owner of the relinquished property uses the same basis in the replacement property decreased by any money receive and increase by any gain recognized. §1031(d). Other special rules are set forth in the regulations, including rules pertaining to a deferred exchange of property. §1031(a)(3). A deferred exchange will that otherwise qualifies under §1031(a) will in fact qualify where the replacement property: (i) is identified within 45 days of the transfer of the relinquished property; and (ii) such replacement is received by the earlier of 180 days after the transfer of the relinquished property or the due date (including extensions) of the transferor's tax return for the taxable year in which the relinquished property is transferred.

Treas. Reg. §1.1031(k)-1(g)(4) permits a taxpayer to use a qualified intermediary (other than the taxpayer, the taxpayer’s agent or a "disqualified person"), to facilitate a like-kind exchange. Treas. Reg. §1.1031(k)-1(g)(4)(i). If the various requirements in inserting a qualified intermediary as well as the identification (45 days) and replacement period (180 days) requirements are met, etc., the taxpayer's transfer of the relinquished property to a qualified intermediary and subsequent receipt of like-kind replacement property from the qualified intermediary through a third party acquired with the sales proceeds from the relinquished property, is treated as an exchange with the qualified intermediary.

Section 1031(f) provides special rules for property exchanged between related persons intended to qualify under §1031(a). In pertinent part, it provides that if a taxpayer exchanges property with a "related person", that otherwise qualifies as a tax-free exchange under §1031(a), and within 2 years after the date of the last transfer which was part of such exchange the related person disposes or the property or the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, the prior exchange will be fully taxable. As an exception, §1031(f)(2) provides that the related party recognition rule which overrides §1031(a) will not apply where it is established by the taxpayer (transferor of the relinquished property) to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax, and provided that the exchange was not part of a transaction or series of transactions structure to avoid the related party rule in §1031(f).

In Ocumulgee Fields, taxpayer transferred appreciated property to a qualified intermediary (QI) under an exchange agreement in conformity with the requirements under Treas. Reg. §1.1031(k)-1(g)(4), whereupon the QI sold the same property to an unrelated third party and used the sales proceeds to purchase from a "related person" like-kind property that was transferred back to taxpayer to complete the exchange.

The IRS, in assessing a deficiency for the income tax on the gain realized from the taxpayer’s receipt of the replacement property, argued that the exchange was part of a transaction structured to avoid §1031(f) and did not make the "lack of tax avoidance" exception under §1031(f)(2)(C) absent credible proof. The Service viewed the interposition of the QI was to reflect a significant basis shifting in the taxpayer’s holding and an immediate cash out that resulted in substantial tax savings.

The Tax Court agreed with the Service and found taxpayer's claim of "no tax avoidance" purpose unpersuasive and concluded that the end result of actual exchange involving QI was the same as if the taxpayer had made the exchange directly with the related person followed by the related person’s making an outside sale to a third party. In essence the taxpayer failed to carry its burden of proof of the absence of a principal purpose of tax avoidance. In Teruya Bros., Ltd.. & Subs, 124 T.C. 45 (2005), aff’d 104 AFTR 2d 2009 (9th Cir. 9/8/09)

Note: the taxpayer negotiated the sale of relatively low basis real property to an unrelated person through a QI structure, same as in the Ocumulgee Fields case. In anticipation of the sale, the taxpayer arranged to purchase relatively high basis replacement property from a related person. To carry out the transaction, the taxpayer arranged for a qualified intermediary to acquire the property the taxpayer had agreed to sell and to sell it to the unrelated person, to use the proceeds to purchase the replacement property from the related person, and then to transfer that replacement property to the taxpayer. On a related note, Teruya Bros. was just affirmed by the 9th Circuit in upholding the Tax Court’s denial of §1031(a) treatment.

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