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Can you welsh on a bad tax shelter deal?

October 02, 2008

Some tax shelters require the help of a tax-exempt third party. If the IRS explodes the shelter, can the taxpayer weasel out of his promises made to the tax-exempt entity in the tax shelter documents? A Mississippi case this week implies "no."

One of the heavily-marketed tax shelters of the late 1990s was "SC2." In a typical fact pattern a taxpayer with lots of interest and dividend-producing assets would contribute them to an S corporation and then contribute non-voting shares of the corporation to a charity for maybe 90% of the company. The charity would have the right to redeem the shares in, say, two years. In the meantime, the interest and dividend income would be allocated on K-1s to the tax-exempt charity, sheltering it from tax.

William Brown, an owner of Brown Bottling Group, Inc. in Mississippi, bought this shelter from national accounting firm KPMG in 2000, with the Austin Firefighters Relief and Retirement Fund acting as the enabling charity for the deal. Things went sour when the IRS declared such arrangements abusive (IRS Notice 2004-30). When the charity went to redeem its shares, the owners declined on the grounds that the shelter had failed. The charity sued.

The court ruled on summary judgement motions this week. Mr.Brown's defenses were shot down. While the case is not done, it looks likely that the charity will eventually get its cash.

One of Mr. Brown's arguments was that the charity had "unclean hands" and should not benefit from its participation in the shelter. The court disagreed:

Again, defendants do not contend that AFF entered into the transaction initially with unclean hands; rather, they argue that after the IRS concluded the SC2 transaction was an abusive tax avoidance transaction and declared that tax-exempt parties in these transactions, including AFF, would be treated as participants in the transactions, AFF, notwithstanding that it had been found to be a participant in the transaction, sued defendants to enforce the Redemption Agreement. Defendants posit that such acts by AFF "constitute wilful inequity toward Defendants which makes the unclean hands doctrine applicable to AFF's claims to enforce key elements of the now known to be illegal SC2 transaction." The court rejects this argument. Even if the court assumes that AFF's claims in this action have no merit, AFF still cannot reasonably be found to have acted with wilful inequity toward defendants merely by virtue of filing this lawsuit to enforce the Redemption Agreement or to otherwise enforce the terms of the SC2 transaction.

In other words, it's not bad faith to sue to enforce a contract.

The moral? Even if the tax shelter fails, promises to third parties made to avoid taxes may survive.

Cite: Austin Fire Fighters Relief and Retirement Fund v. Brown, DC-SD Mississippi, No. 3:07-cv-0028

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