TAX MATTERS

TAX CASE

DENIAL OF CONTINGENT LIABILITY LOSS DEDUCTION
lthough in the past the government won a number of important victories in its ongoing attempt to stop abusive tax transactions, it has continued to lose on contingent liability transactions. Recently, however, the Court of Appeals for the Federal Circuit reversed a lower court decision that may substantially affect future contingent liability cases.

Coltec Industries recognized significant gain when it sold several of its subsidiaries. To offset this gain it followed a simple tax-savings strategy; it created a subsidiary, Garrison, which received stock in exchange for a $14 million contribution. Garlock, another Coltec subsidiary, transferred its contingent liability for asbestos claims, some assets and a $375 million note from another subsidiary to Garrison in exchange for common stock. The amount of the note and the contingent liability were approximately equal. Garlock then sold the Garrison stock and recognized a loss of $378.7 million. When Garlock took a loss deduction, the IRS denied it. The Court of Federal Claims disagreed with the IRS and permitted the loss deduction. The IRS appealed.

Result. For the IRS. The service presented two arguments against the loss deduction. The first was a technical argument involving the interaction of liabilities and basis, which was contained in IRC sections 357(b), 357(c) and 358. The second was a general argument about whether the transaction had sufficient economic substance to be respected.

Liabilities and basis. IRC section 358(d)(1) addresses liabilities assumed as money paid resulting in a decrease in basis. The claims court held that contingent liabilities were not liabilities for purposes of section 358. The Federal Circuit Court of Appeals disagreed; it held that contingent liabilities, for purposes of that section, were liabilities. However, section 358(d)(2) exempts liabilities excluded under section 357(c)(3). The appeals court had to determine whether these contingent liabilities excluded liabilities under section 357(c)(3) and whether section 357(b) overrode the exclusion.

The government contended that the section 357(c)(3) exclusion applies to liabilities only if they are transferred with the business that created them and if they give rise to a deduction. Although admitting Congress probably intended to limit the exclusion to transfers of businesses and their liabilities, the court rejected the government’s argument because the section does not expressly contain this limitation.

The government also said that under section 357(b) assumed liabilities are treated as boot (usually cash). Although section 357(b) does overrule section 357(c) for liability assumption purposes, section 358 refers to section 357(c)(3) only for its definition of an excluded liability. Therefore, section 357(b) was not relevant in the case and it did not matter that the taxpayer had assumed the liabilities only to avoid taxes. Thus, under section 358, the contingent liabilities did not reduce stock basis.

Congress later amended section 358 to require that the liabilities transferred be part of a transfer of an entire business or of substantially all the assets related to the liabilities in order to be excluded under section 358(d)(2). This change is consistent with the government’s position and prevents future taxpayers from using this tax-planning strategy.

Economic substance. The government’s second and more important argument for disallowing the loss was that the transaction lacked economic substance. The appeals court found that courts can use the economic substance doctrine. To apply this doctrine, a court examines the business purpose of a transaction and respects transactions only if they have a valid business purpose and their sole purpose is not to avoid taxes. It’s up to the taxpayer to prove the transaction’s economic reality. In the Coltec case the court denied the tax benefit after applying the doctrine.

This case demonstrates that the court can prevent tax abuse even if Congress does not actually amend the Internal Revenue Code to include an economic substance test. This doctrine supplements the business purpose, sham transaction and substance vs. form doctrines the government uses to prevent taxpayers from benefiting from a transaction that literally conforms to the statutory language but lacks a real business purpose and substance.

Coltec Industries, Inc. v. United States, Fed. Cir., 2006-2 USTC ¶50,389.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

TAX CASE

VALUE-ADDED PAYMENT RECEIPT NOT DEFERRAL
he Eighth Circuit Court of Appeals affirmed the Tax Court’s decision that when a cooperative makes “value-added” payments to its members and allows them to defer the cash receipts, such payments do not constitute a deferral for tax purposes. In a case argued before the Eighth Circuit, a cooperative had made discretionary yearend, value-added payments based upon its net proceeds, which were determined after its September 30 yearend.

Keith Scherbart, a calendar-year taxpayer, was a corn farmer who belonged to the Minnesota Corn Processor cooperative (MCP), a fiscal-year entity. During the calendar year, Scherbart delivered corn three times to MCP, which processed the corn and sold it to third parties. MCP paid Scherbart upon delivery. In addition, when the fiscal year ended, MCP made value-added payments to its members. Members could elect to receive payment in November of the current year or January of the following year. Scherbart deferred and included the payments in his taxable income for the following year. The IRS disallowed the deferral and assessed a deficiency. The Tax Court (TC Memo 2004-143) held for the IRS.

Result. For the IRS. Scherbart argued that the corn sales qualified as installment sales between him and third parties. He maintained that the transactions were a deferral because MCP required members to select their own payment option. The Tax Court held that MCP was Scherbart’s agent; thus the date that MCP received the payments for the corn was the date Scherbart received them.

The circuit court affirmed the Tax Court’s decision, holding that the corn sales were not installment sales. MCP’s equity disclosure statement did not characterize them as sales, nor did it state that ownership of the corn passed to MCP. Further, because MCP was Scherbart’s agent and the deferrals were self-imposed limitations, the value-added payments were taxable to Scherbart when MCP received them. Self-imposed limitations do not change the principal-agent relationship.

This case illustrates the interplay of the principal-agent relationship and the constructive receipt doctrine. Income is taxable when received by the agent, even when the principal has the option of determining when to take possession.

Keith Scherbart v. Commissioner, 453 F3d 987 (CA8).

Prepared by Michael H. Brown, CPA, PhD, assistant professor of accounting, Tabor School of Business, Millikin University, Decatur, Ill.

TAX CASE

OFFERS IN COMPROMISE ARE REVIEWABLE
he Eighth Circuit Court of Appeals held that courts can review an IRS decision to reject a taxpayer’s offer in compromise.

Ronald Speltz exercised incentive stock options to buy shares of McLeod Network Service worth $745,372 for $34,254. Speltz incurred a $224,869 alternative minimum tax (AMT) liability when the shares were valued at $1,647. He submitted an offer in compromise for $4,457 when the balance was $148,745; the IRS rejected it. Arguing an abuse of discretion, Speltz appealed to the Tax Court (124 TC 165) and then to the Eighth Circuit after the Tax Court held for the IRS.

Result. For the taxpayer and for the IRS. The Eighth Circuit held for the taxpayer on the issue of reviewability. The IRS maintained that its rejection of an offer in compromise was an exercise of its administrative discretion. Citing IRC section 7122(a), which says the Secretary of the Treasury “may compromise any civil … case arising under the internal revenue laws,” the IRS argued that the word may meant that courts could not review these decisions. In its holding the Eighth Circuit, referencing IRC section 7482, said that Congress intended to include offers in compromise when it granted courts of appeal the authority to review Tax Court decisions. The circuit court concluded that the judiciary “does decide whether the executive decisions conform to law or represent an abuse of executive discretion.”

At the same time, though, the Eighth Circuit also held for the IRS in finding it did not abuse its discretion when it rejected Speltz’s offer in compromise. Speltz had failed to meet the factors supporting a claim of “economic hardship” or of “public policy and equity” and the service had followed established procedures.

This case demonstrates the legislative and judicial support for the IRS’s procedures in offer-in-compromise cases. With a reported $300 billion tax gap and increased collection efforts by the IRS, this information is important when dealing with such cases.

Ronald Speltz v. Commissioner, 454 F3d 782 (CA8).

Prepared by Michael H. Brown, CPA, PhD, assistant professor of accounting, Tabor School of Business, Millikin University, Decatur, Ill.