News Notes

News Notes

Lesli S. Laffie, J.D., LL.M.

Court Cases

In a case of first impression for it, the Tax Court held in Teruya Brothers, Ltd., 124 TC No. 4 (2005), that a taxpayer could not avoid the Sec. 1031(f) related-party rules by using a qualified intermediary (QI).

Background: Under Sec. 1031(f), gain or loss on an exchange between related persons must generally be recognized if either the property transferred or the one received is disposed of within two years after the exchange. According to Sec. 1031(f)(4), nonrecognition treatment does not apply to any exchange if it is part of a transaction (or series of transactions) structured to avoid Sec. 1031(f)s purposes. Under Sec. 1031(f)(2)(C), a disposition will not trigger the related-party bar if it is established to the IRSs satisfaction that neither the original transactionnor the later disposition had Federal tax avoidance as one of its principal purposes.

Facts: In 1995, in a series of planned transactions, the taxpayer transferred real properties to a QI, TGE, which then sold them to unrelated third parties. TGE used the sale proceeds, as well as additional taxpayer funds, to buy like-kind replacement properties for the taxpayer from a corporation related to the taxpayer.

Holding: The Tax Court held that the transactions were economically equivalent to direct exchanges of properties between the taxpayer and the related party (with boot from the former to the latter), followed by the related partys sales of the properties to unrelated third parties. The interposition of a QI could not obscure the end result. The court also found that the taxpayer did not meet Sec. 1031(f)(2)(C)s non-tax-avoidance exception; thus, it concluded that the taxpayer could not defer gains realized on the ex-changes. For more discussion on related-party exchanges and the use of QIs, see Briskin, Like-Kind ExchangesCommon Problems and Solutions, this issue.

From the IRS

Appeals Settlement Guidelines on CARDS Transactions

The IRS has issued Appeals Settlement Guidelines (ASG) concluding that losses from custom adjustable rate debt structure (CARDS) transactions are not allowable, and that accuracy-related penalties on CARDS participants may be appropriate, depending on the facts and circumstances.

Background: In Notice 2002-21, the Service announced that it had become aware of a type of transaction used by taxpayers to generate tax losses. It warned that the tax benefits purportedly generated are not allowable.

Allegedly, the transaction creates a permanent deduction when a taxpayer acquires property from a limited liability company (LLC), assumes as consideration joint and several liability for LLC debt that exceeds the propertys value (and claims basis in the property in the full amount of the debt), then disposes of the property at a loss.

On Mar. 17, 2004, the IRS designated the CARDS issue as an Appeals Coordinated Issue.

No loss: The ASG conclude that CARDS transactions do not result in a deductible loss, for the following reasons:

The taxpayers did not provide documentary evidence that the transactions establish a reasonable profit potential in excess of the associated fees;
The transaction was designed as a product to shelter income;
The taxpayers basis should be limited to the fair market value of the assets received, rather than the full loan amount; and
The taxpayers failed to show that their investment in the CARDS transaction was entered into for profit.

Penalties: The ASG state that the determination of whether a Sec. 6662 accuracy-related penalty applies to any portion of the underpayment attributable to a CARDS transaction hinges on the facts and circumstances. It notes that taxpayers generally rely on legal opinions to support the argument that a CARDS transaction met Regs. Sec. 1.6662-4(g)(1)s tax shelter substantial authority exception. Appeals Officers are directed to consider the law and the court decisions discussed and factors listed in the ASG, when evaluating the hazards of litigation when an accuracy-related penalty is asserted. These factors include items such as:

The taxpayers background;
How the taxpayer got involved in the transaction;
The extent to which tax benefits influenced the taxpayer;
Who advised the taxpayer;
The information the taxpayer was given about tax opinions;
How the taxpayer chose the law firm representing it;
Who the taxpayers investment advisers were; and
The advice they gave.

Schedule M-3

By the end of 2005, the IRS may require additional taxpayers to file a form containing the income or loss reconciliation concept of Schedule M-3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More, according to IRS Senior Technical Adviser Bob Adams.

Taxpayers with assets exceeding $10 million who file Form 1120 are required to file Schedule M-3 for tax years beginning on or after Dec. 31, 2004. Taxpayers required to file Schedule M-3 no longer need to file Schedule M-1, Reconciliation of Income (Loss) per Books With Income (Loss) per Return.

The IRS unveiled Schedule M-3 on Jan. 28, 2004, hoping to increase the transparency between financial accounting net income and taxable income, identify taxpayers who may have engaged in aggressive transactions and target high-risk taxpayers for audit. (For background, see Reinstein, News Notes, Final Version of Schedule M-3 Available, TTA, October 2004.)

According to Adams, the Service is considering Schedule M-3s future application to other taxpayers. The filing requirement could take effect for tax years beginning on or after Dec. 31, 2005.

It is not yet known whether additional taxpayers may need to file Schedule M-3 or a similar form. Taxpayers not currently required to file Schedule M-3 may be required to file forms disclosing information on income or loss reconciliation in the future.

Additional filers: The IRS is considering moving the concept of Schedule M-3 to additional entities, including taxpayers filing Form:

1065, U.S. Partnership Return of Income;
1120F, U.S. Income Tax Return of a Foreign Corporation;
1120L, U.S. Life Insurance Company Income Tax Return;
1120PC, U.S. Property and Casualty Insurance Company Income Tax Return; and
1120S, U.S. Income Tax Return for an S Corporation.

While any changes could take effect for tax seasons beginning after 2005, the IRS says it would allow plenty of time for dialogue with affected stakeholders.

Legislation

Permanent Sales Tax Deduction?

A multistate, bi-partisan delegation of 60 members of Congress, led by Cong. Kevin Brady (R-TX) officially introduced HR 519, the Permanent Sales Tax Deduction Act of 2005. The bill would make permanent the current two-year (20042005) sales tax deduction. During the 108th Congress, Brady, who is a member of the House Ways and Means Committee, spearheaded the move to include the sales tax deduction measure in the American Jobs Creation Act of 2004.