CIP on Lease Strips

The IRS released a Coordinated Issue Paper (CIP) on lease-stripping transactions, in which a tax-indifferent party allocates partnership income while a tax-sensitive party takes deductions. Citing ACM Partnership, 157 F3d 231 (3d Cir. 1998), and ASA Investerings Partnership, 201 F3d 505 (DC Cir. 2000), the Service used the sham-transaction doctrine to dismiss the transaction described in the CIP. The CIP illustrates how the IRS may use the sham-transaction doctrine to question tax-favorable transactions.

Under the facts of the CIP, corporation A entered into a sale-leaseback of depreciable equipment with B (a thinly capitalized partnership), in exchange for B's note. C was a 98% partner of B. B sold the rents that it received from A to a bank for cash and allocated the accelerated income to its partners, including C. B used the cash to pay off its note to A. D was a consolidated corporate subsidiary of E, the parent of a consolidated group. B contributed the equipment to D in exchange for D stock in a purported Sec. 351 transaction; E also contributed property and received D stock in the same transaction. D received depreciation deductions that the E group used.

Citing ASA Investerings Partnership the IRS disregarded the transactions as a sham, holding that, in essence, they equated to a basic sale-leaseback transaction between A and D. According to the Service, B's actions should be disregarded, because it acted on E's behalf to create deductions for the E consolidated group. In this case, the E group would still be entitled to depreciation deductions, but would have to take the accelerated income into account.

The IRS also applied the step-transaction doctrine to the transactions. Under the step-transaction theory, the nature of B's and C's involvement in the transactions may support the conclusion that B and C should be ignored. If so, D could be required to recognize the income from the accelerated income payment from the bank. E could still use the depreciation deductions on its consolidated return, but would have to match the accelerated income with the deductions.

In a third alternative, the Service attacked the validity of the Sec. 351 transaction, suggesting that D acquired the equipment in a taxable Sec. 1001 exchange. In such an event, D would not recognize gain or loss on the transaction under Sec. 1032, but would receive a cost basis in the property (based on the fair market value of the D stock exchanged) under Sec. 1012. Thus, the basis of the equipment in D's hands would not support the claimed depreciation deductions.

From Jeffrey A. Erickson, J.D., and David P. Latz, J.D., LL.M.,Washington, DC