New Regs. on Contested Liability Trusts

I n November 2003, Sec. 461(f) temporary and proposed regulations (TD 9095; REG-136890-02) were issued to clarify the rules for accelerating a deduction via use of a contested liability trust. The regulations clarify the types of transfers that do not qualify for an accelerated deduction, as well as the kinds of liabilities that may be satisfied using a contested liability trust. Most of the new rules apply retroactively. The IRS also issued Notice 2003-77 to identify as listed transactions under the tax shelter rules, certain transactions involving transfers to a trust purportedly established under Sec. 461(f).

Background 

In Consolidated Edison Co., 366 US 380 (1961), the Supreme Court held that a taxpayer could not deduct payments made for a contested amount until the year the contest was settled or terminated. In 1964, Congress enacted Sec. 461(f) to overturn this ruling. Sec. 461(f) provides an exception to the general rule disallowing a deduction for a contested liability. A taxpayer may claim a deduction for a contested liability in the taxable year of the transfer if all of the following requirements are met:

1. The taxpayer contests an asserted liability; 

2. The taxpayer transfers money or other property to provide for the satisfaction of the asserted liability;

3. The contest with respect to the asserted liability exists after the time of the transfer; and

4. But for the fact that the asserted liability is contested, a deduction would be allowed for the tax year of the transfer (or for an earlier tax year), determined after application of the Sec. 461(f) economic performance rules.

While Regs. Sec. 1.461-2(c)(1) provided that a transfer to a trust or escrow could qualify under the rules, the following three types of actions did not qualify as a transfer for the satisfaction of an asserted liability: (1) purchasing a bond to guarantee payment of the asserted liability; (2) an entry on the taxpayers books of account; and (3) a transfer to an account in the taxpayers control. However, the regulations were silent on whether transfers of certain types of other property (such as the taxpayers stock or related-party stock or debt), would meet Sec. 461(f). Further, Regs. Sec. 1.461-2(a)(5) reserved guidance on liabilities for which payment is economic performance under Regs. Sec. 1.461-4(g), leading some tax advisers to conclude that transfers to trusts might meet Sec. 461(f)s requirements.

The temporary and proposed regulations address the above issues left open in the regulations. Notice 2003-77 goes even further, by addressing certain taxpayer-retained powers over property transferred to a trust.

Temp. and Prop. Regs.

Transfers of certain property: The new rules remove Regs. Sec. 1.461-2(c)(1) and add Temp. Regs. Sec. 1.461-2T(c)(1). They retain the rules in Regs. Sec. 1.461-2(c)(1) mentioned above, on actions that do not qualify as a transfer for the satisfaction of an asserted liability. The new regulations also state that the following transfers do not result in an accelerated deduction under Sec. 461(f):

1. A transfer of any taxpayer debt or promise to provide services or property in the future; and

2. A transfer (other than directly to the person asserting the liability) of taxpayer stock or of stock or debt of a person related to the taxpayer (as defined in Sec. 267(b)).

The preamble provides that the rules denying a deduction for the issuance of stock to satisfy a contested liability are consistent with Sec. 468B(d)(1)(B), which excludes as a qualified payment to a designated settlement fund the transfer of taxpayer stock or debt (or that of a related person). However, these rules are inconsistent with guidance allowing a deduction for liabilities paid with a corporations own stock (see, e.g., Rev. Rul. 62-217 (corporation paid compensation to employees with shares of its treasury stock)) and the qualified settlement fund rules, which allow a transfer of stock to be treated as a qualified payment (see Regs. Sec. 1.468B-3(a) and (b)).

The rules on transfers of a taxpayers stock or a related-partys stock or debt are effective for transfers after Nov. 18, 2003. The other provisions of Regs. Sec. 1.461-2(c)(1) are effective for transfers of money or other property in tax years beginning after 1953 and ending after Aug. 16, 1954.  

Application of economic performance rules: New Temp. Regs. Sec. 1.461-2T(e)(2) provides that an accrual-method taxpayer cannot take a Sec. 461(f) deduction in the tax year of transfer unless economic performance has occurred. Except as provided in Sec. 468B or the regulations thereunder, according to Temp. Regs. Sec. 1.461-2T(e)(2)(ii), economic performance does not occur when a taxpayer transfers money or other property to a trust, an escrow account or a court to provide for the satisfaction of an asserted workers compensation, tort or other contested liability designated under Regs. Sec. 1.461-4(g), unless the (1) trust, escrow account or court is the person to which the liability is owed or (2) taxpayers payment to the trust, escrow account or court discharges the taxpayers liability to the claimant. (The preamble cites Maxus Energy Corp., 31 F3d 1135 (Fed. Cir. 1994), as an example in which a transfer to a fund discharged the taxpayers liability to a claimant.) Rather, economic performance occurs in the tax year that money or property is transferred to the person asserting the workers compensation, tort or other liability designated under Regs. Sec. 1.461-4(g).

These rules are effective for transfers made after July 18, 1984, of money or other property, to provide for the satisfaction of an asserted workers compensation or tort liability. The rules are effective for transfers made after 1991, of money or other property to provide satisfaction of asserted liabilities designated in Regs. Sec. 1.461-4(g) (other than workers compensation or tort liabilities).

Notice 2003-77

In Notice 2003-77, the IRS identified as listed transactions under the tax shelter rules certain transfers to trusts purportedly established under Sec. 461(f). Consistent with the temporary regulations, the notice states the following transactions (and any substantially similar transactions) are listed transactions:

1. Transactions in which a taxpayer transfers any of its debt or promises to provide services or property in the future in tax years beginning after 1953 and ending after Aug. 16, 1954, to a trust purportedly established under Sec. 461(f) to provide for the satisfaction of an asserted liability.

2. Transactions in which an accrual-method taxpayer transfers money or other property after July 18, 1984, to a trust purportedly established under Sec. 461(f) for the satisfaction of a workers compensation or tort liability (unless the trust is the person to which the liability is owed or payment to the trust discharges the taxpayers liability to the claimant).

3. Transactions in which an accrual-method taxpayer transfers money or other property in tax years beginning after 1991, to a trust purportedly established under Sec. 461(f) to satisfy a liability for which payment is economic performance under Regs. Sec. 1.461-4(g) (unless the trust is the person to which the liability is owed or payment to the trust discharges the taxpayers liability to the claimant), other than a liability for workers compensation or tort.

4. Transactions in which a taxpayer transfers, after Nov. 18, 2003, its own stock or stock or debt of an unrelated third party, to a trust purportedly established under Sec. 461(f) to provide for the satisfaction of any asserted liability.

The notice also sweeps in transactions in which a taxpayer transfers money or other property in tax years beginning after 1953, and ending after Aug. 16, 1954, to a trust purportedly established under Sec. 461(f) to provide for the satisfaction of an asserted liability and the taxpayer retains one or more or the following powers over the money or property transferred:

• To pay any liabilities ultimately due the claimant out of assets other than those transferred to the trust;

• To substitute money or other property for property transferred to the trust;

• To prohibit payment to the claimant by the trustee until instructed by the taxpayer;

• To prohibit notification to the claimant of the trusts establishment;

• To limit the trustees ability to sell the property after it is transferred to the trust; and

• To limit the trustees ability to enforce notes on other property transferred to the trust.

Transactions the same or substantially similar to those identified in Notice 2003-77 are subject to the tax shelter rules. This includes Regs. Sec. 1.6011-4(e)(2), which provides that, if a transaction becomes a listed transaction after the taxpayers filing of a final return reflecting a tax benefit derived from tax consequences or a tax strategy described in the published guidance listing the transaction and the period of limitations is still open for that return, a disclosure statement must be attached to the taxpayers tax return next filed after the date the transaction is listed.

Conclusion 

The new Sec. 461(f) temporary and proposed regulations limit the types of property that can be transferred to a trust that will result in an accelerated deduction, and clarify that a transfer to a trust will generally not constitute economic performance for the liabilities described in Regs. Sec. 1.461-4(g). Taxpayers and advisers should be aware of the retroactive effect of most of these rules, as well as the types of transfers that are listed transactions under Notice 2003-77.

From David Auclair, Washington, DC