Celebration time at the IRS!

Did you hear that champagne cork pop from Washington, D.C.? I think we all did as this past week the Supreme Court denied certiorari in Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). The obvious question becomes - Now What?

Well first the obvious – The opinion as to Jade Trading should be coming out shortly and it should be in the favor of the government. This is not a difficult conclusion to make after all the Court of Claims is bound by the Federal Circuit and the parties had agreed to postpone the Court’s ruling until Coltec’s appeal. It appears that the Court just wanted to see the appeal run its course. Thus, for all those pending cases in the Court of Claims the outcome is pretty well settled and the only remaining question will be one of penalties.

The interesting question is what will the IRS do with it new toy? Well with the Son of Boss cases pending in the United States Tax Court, we can and should expect the IRS to seek to have the Coltec standard applied in these cases. That is, the worst kept secret is that the IRS was disappointed with the result in Salina v. Commissioner, T.C. Memo 2000-352. Yes, the the IRS did win its section 752 argument but Judge Jacob’s refused to accept the Coltec argument as submitted by the IRS. Rather, Judge Jacobs looked at the entire transaction for purposes of applying the economic substance doctrine. As stated in the opinion:

"Contrary to respondent's position, we decline to analyze the economic substance of the disputed transaction by focusing solely on events occurring during the period December 28 through 31, 1992. Segregating FPL's investment in Salina into two parts, as respondent suggests, would violate the principle that the economic substance of a transaction turns on a review of the entire transaction. See Kirchman v. Commissioner, supra at 1493-1494; Winn-Dixie Stores, Inc. v. Commissioner, supra at 280. Although we agree with respondent that Goldman Sachs structured FPL's purchase of the Salina partnership interest to provide FPL with a perceived tax benefit, this factor, standing alone, is insufficient to render the transaction a sham in substance. "

With Coltec out there, one should expect the IRS to try again and persuade the United States Tax Court to reconsider its position. Personally, I hope the entire Court visits the economic substance doctrine.  Even though I question various aspects of the Tax Court’s opinion in Estate of Bongard v. Commissioner, 124 T.C. 95 (2005), Bongard gave tax litigators and planners an opportunity to examine/reexamine the merits of family limited partnerships. I believe most tax litigators/tax planners would likewise want to hear the full court's views on economic substance.  Stated bluntly, the Court is a national forum and there is too much intellectual and judicial talent to have it spent on due process hearing cases and I want to hear, for better or for worse, what the full Court has to say on this important judical doctrine.

But if I were the IRS I would be very careful as to which cases I would seek to apply the Coltec standard. After all not all tax deferral mechanisms are tax shelters. For example, the IRS might be emboldened to bring out the Coltec standard in a LILO case. Yes, I am familiar with the case in North Carolina but that LILO case was the exception not the general rule. Most LILO cases involve legitimate factual issues. The IRS’s pointing to interest earning financial instruments while interest deductions are being claimed may not be sufficient - After all can we say UPS.

In United Parcel Service of America v. Commissioner, 254 F. 3d 1014 (11th Cir. 2001), the Eleventh Circuit in an eight page opinion disposed of the one hundred plus page opinion of the Tax Court. In the Eleventh Circuit’s opinion at page 1019, the Court stated:

“A “business purpose” does not mean a reason for a transaction that is free of tax considerations. Rather, a transaction has a “business purpose,” when we are talking about a going concern like UPS, as long as it figures in a bona fide, profit-seeking business. See ACM P'ship v. Comm'r, 157 F.3d 231, 251 (3d Cir.1998). This concept of “business purpose” is a necessary corollary to the venerable axiom that tax-planning is permissible. See Gregory v. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 267, 79 L.Ed. 596 (1935) (“The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”).”

Thus, I would humbly submit that not even the Coltec standard could withstand the UPS standard if the facts involved an aggressive but legitimate LILO. As they say we shall see.

What is in the Pipeline?

Being that I worked in the IRS’s Office of Chief Counsel for 13 years, the question tends to be asked: What are the issues that the IRS is looking at? My response is usually a shrug because I really do not know how the IRS determines what issues are the “hot issues.” But what I can relay to you is the advice that a very senior and experienced Special Trial Attorney once gave me: “If you want to know the issues that are on the radar screen read the journal.” This blog is not intended as a plug but since that time I have read the daily Tax Notes Reports, the BNA daily reports and the Wall Street Journal. Curiously, his advice has been rather accurate.

These trade journals in the last six moths have revealed that the usual cast of characters, Family Limited Partnerships (See January 6, 2007 Year in Review) and Tax Shelters (See Below), are alive and well. But, because of their success in these ventures, it appears that the IRS’s Office of Chief Counsel appears eager to venture back into the contentious area of section 482 and possibly into a new one Private Foundations.

For example, Tax Notes Today on November 15, 2006 issued a story on IRS Chief Counsel Donald Korb discussing recent internal tax guidance. Per the article, Mr. Korb states “that Chief Counsel is focused on “protecting the integrity of U.S. tax law in a global economy” by ‘keeping an eye on highly engineered and abusive transactions.”.” See Nadal, Korb Discusses International Tax Developments, Praises IRS’s Success, 2006 TNT 220-3. Now fast forward to this past week and another headline concerning the section 482 litigation that the IRS has undertaken. See Nutt, Another Transfer Pricing Dispute in the Litigation Pipeline, 2007 TNT 15-13. It appears due to the IRS recent well publicized settlement  in GlaxoSmithKline, the Office of Chief Counsel had gotten rid of the bad taste of  Xilinx v.  Commissioner, 125 T.C. 37 (2005);  Eli Lilly v. Commissioner, 856 F.2d 855 (7th Cir. 1988) revg. 84 T.C. 996; Bausch & Lomb v.Commissioner, 92 T.C. 525 (1989); Sundstrand v. Commissioner, 96 T.C. 226 (1991); Seagate Technology v. Commissioner, 102 T.C. 149 (1994). Throw in their victories in the tax shelter wars and you can feel the IRS’s confidence permeating through the air. So now the Office of Chief Counsel is seeking section 482 adjustments from Symantec Corp. See Docket No. 12075-06.

Word to the Wise to my fellow tax practitioners - Become familiar with the 482 regulations especially the new regulations issued under 482 during the summer of 2006. See T.D. 9278. See also Nutt, No Saftey in the Harbor: New Transfer Pricing Services Regs., 2006 TNT 167-4. The reason is simple Section 482 does not apply just to large multi-national corporations. It can and will be applied to mid-size corporations or any corporation that ventures into this area. Stated otherwise, the IRS is issuing these regulations for a reason and its litigators are once again becoming conversant in these complex regulations. Thus, expect 482 issues to once again surface. Therefore, it will be time again for lawyers and the accounting firms to work together in addressing the 482 issues and resolving the issue at the exam level and if need be visa vi litigation.

Observation: A successful strategy that I saw during my time with the Office of Chief Counsel was implemented by Baker& McKenzie. The strategy was to turn over a summary report, the economist report, and the underlying source documents that were compliant with the regulations under 6662, while retaining the entire legal analysis. See United States v. Bell, 1994 WL 665295 (N.D.Cal.1994). As to the attorney’s underlying analysis, the strategy was to preserve the work product doctrine and attorney client privilege. See United States v. Roxworthy, 457 F.3d 590 (6th Cir. 2006). Whether this strategy is successful in today’s environment of 26 C.F.R. § 1.6662-6, the tax shelter regulations/wars remains to be seen. See FIN 48 and Textron (Blog dated January 21, 2007).

Another topic that I have been seeing with regularity being discussed in the Wall Street Journal and the tax journals is in regard to non-profits/charitable organizations. A recent article in Tax Notes – VanDenburgh, Harmelink, Nichols, Various Motivations Behind Family Charitable Foundations, 114 Tax Notes 205 (Jan. 15, 2007) - provides an excellent overview of the positive/negatives of family charitable foundations. The article points out as well the abuses of the same and reminds the readers that the IRS has listed certain charitable organizations as “notorious tax scams”. The result was certain changes in the Pension Protection Act of 2006. Therefore, expect the IRS to monitor this area. The only question is who from the IRS will be monitoring the situation – i.e. check how the IRS is organized and you will certain divisions are limited in numbers. Last time I looked the Brahma Bulls of Chief Counsel’s office, the Special Trial Attorneys, were in the Large Business Division and they are rather busy with the shelter wars. The question for Chief Counsel’s office is - who is going to be the enforcer/hammer?

Then here is FIN 48. A blog is not the proper forum to discuss the issues surrounding this area but I would submit the following -both the attorneys and the accountants must work together on these matters. The IRS will be looking at the disclosures emanating from FIN 48 as part of their document request. Word to the wise – Become familiar better yet - know and understand FIN 48. If I were back in the Office of Chief Counsel, I would ask every revenue agent I was working with to issue an IDR as to every issue identified under FIN 48 in the first package of IDR’s.

Finally, there is the old and reliable economic substance doctrine. The government filed its objection to Coltec’s Writ for Certiorari. See 2007 TNT 16-16. No surprise as the Government acknowledges a new test and that there are various formulations to the economic substance test. The Government states that the Supreme Court should not grant Coltec’s Writ as no matter what standard was applied Coltec would lose. Query: Then why the need for the new standard, if not for the reason that the Federal Circuit did not believe that the other standards of its sister circuits were insufficient.

It will be interesting to see whether the Supreme Court accepts this case. For purposes of consistency to fellow taxpayers I hope the Supreme Court does. Otherwise, those living in the Fifth, and to an extent the Eleventh Circuit, will have a certain advantage as to the economic substance doctrine that are not found in the other circuits. See Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001) and United Parcel Service of America v. Commissioner, 254 F. 3d 1014 (11th Cir. 2001).