Tax Update Blog: Listed Transactions Archives

Murphy Farms hit with 40% penalty for tax shelter on their sale to Smithfield

August 18, 2010

When big hog farm operator Murphy Farms was acquired by even-bigger Smithfield Foods in 1999, the Murphy family faced a big capital gain tax. Like many taxpayers at the time, the family tried to avoid the tax through a generic tax shelter offered by one of the national accounting firms. They ended up using a "COBRA" transaction sold by Ernst & Young -- a version of the "Son-of-Boss" shelter. The Court of Federal Claims explains (footnotes omitted):

COBRA involved foreign currency options. The strategy called for at least two individuals to each simultaneously sell a short option and purchase a long option at a different strike price. The individuals then transfer the option contracts along with cash to a newly formed general partnership, receiving in return an interest in the partnership. So long as the options expired out of the money, the partnership recognizes a loss. The individuals then transfer the entire partnership interest to a newly formed S corporation, which causes the partnership to be terminated. The partnership liquidates and distributes its investments to the S corporation. The S corporation sells its assets to an unrelated third party, generating a loss for tax purposes.

Because there are offsetting long and short positions, the taxpayer is protected against a real economic loss. The IRS issued a notice attacking these basis-shifting tax shelters, and E&Y stopped marketing the shelters. The family chose to go ahead with the shelter anyway, and the accountants agreed to set it up after the Murphys singed an agreement to hold them harmless from any penalties. According to the court, E&Y earned $2.5 million for their efforts to shelter a $100 million gain.

Flickr image courtesy Laertes under Creative Commons license.

The IRS disallowed the Murphy losses, and, perhaps as a result of universal failure of taxpayers to prevail on these deals in court, the Murphy family conceded to the IRS adjustments. They weren't too crazy about the 40% gross valuation misstatement penalty. They appealed it to the Federal Claims Court, citing reliance on their internal tax guru and Ernst and Young.

Not surprisingly, the court didn't allow the family to rely on their in-house advisor for "independent" advice. As to Ernst and Young:

In the circumstances presented here, reliance on E&Y's advice was not reasonable. As the Federal Circuit stated in Stobie Creek: "Reliance is not reasonable, for example, if the adviser has an inherent conflict of interest about which the taxpayer knew or should have known." 608 F.3d at 1381. The Murphys could not reasonably have expected to receive independent advice from the same firm that was selling them COBRA. Because E&Y had a financial interest in having the Murphys participate in COBRA, the firm had an inherent conflict of interest in advising on the legitimacy of that transaction.

That conflict of interest was exacerbated by the fee structure. The Murphys have conceded that from the beginning they understood that E&Y's fee would be a percentage of their desired tax loss.

Assuming the $100 million Murphy capital gain was taxed at 20%, the penalty is $8 million, on top of the $20 million in tax and the $2.5 million shelter fee.

The Moral? If you want to rely on ouside advice to avoid potential penalties, make sure the advisor isn't on your payroll and doesn't get paid based on the amount of your tax savings.

Cite: Murfam Farms LLC, Ct. Claims Nos. 06-245T, 06-246T, 06-247T

Tags: Ernst & Young.Federal Claims Court.Smithfield Foods.son-of-boss.tax shelters.

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That's a big number

August 20, 2009

In the first test of the "Distressed asset/Debt," or "DAD," tax shelter, a U.S. District Court in Texas Tuesday disallowed $1.1 billion in tax losses claimed by #321 in the Forbes 400 list of rich folks. The TaxProf has the scoop.

Tags: D Andrew Beal.tax shelters.TaxProf.

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Making a list, checking it twice...

July 21, 2009

The IRS has updated its lists of "Listed Transactions (Notice 2009-59) and "Transactions of Interest" (Notice 2009-55). If you do one of these deals and fail to disclose it, the penalties can be ugly. If you do disclose, don't be surprised when the IRS comes by with further questions.

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IRS PUTS 'SECTION 419' DEATH BENEFIT ONLY PLANS ON WATCH LIST

October 23, 2007

You normally can't deduct life insurance premium payments. Some insurance promoters have apparently been telling taxpayers they can get around this by having their company buy the cash-value policies through a welfare benefit plan under Section 419.

Last week the IRS said that not only do these plans not work, they are also "listed transactions" subject to additional reporting requirements and penalties for non-reporting. The IRS issued its guidance in three pieces:

Revenue Ruling 2007-65
Notice 2007-83
Notice 2007-84.

From Notice 2007-83:

Those advocating the use of these plans often claim that the employer is allowed a deduction under § 419(c)(3) for its contributions when the trustee uses those contributions to pay premiums on the cash value life insurance policies, while at the same time claiming that nothing is includible in the owner's gross income as a result of the contributions (or, if amounts are includible, they are significantly less than the premiums paid on the cash value life insurance policies). They may also claim that nothing is includible in the income of the business owner or other key employee as a result of the transfer of a cash value life insurance policy from the trust to the employee, asserting that the employee has purchased the policy when, in fact, any amounts the owner or other key employee paid for the policy may be significantly less than the fair market value of the policy. Some of the plans are structured so that the owner or other key employee is the named owner of the life insurance policy from the plan's inception, with the employee assigning all or a portion of the death proceeds to the trust. Advocates of these arrangements may claim that no income inclusion is required because there is no transfer of the policy itself from the trust to the employees.

If you are looking to buy business-owned insurance through a welfare-benefit plan, with an eye on deducting the premiums, think long and hard about it. If you already have one of these deals, it's time for a chat with your tax advisor.

IRS MAKES A TAX SHELTER SETTLEMENT OFFER TO EXECUTIVES - CAN THEY REFUSE?

February 22, 2005

The IRS has issued a blanket settlement offer for a widely-sold tax shelter for corporate executives involving stock options.

The plan, which was sold by national accounting firms (most famously to Sprint executives), involves executives "selling" stock options to family partnerships using long term notes at bargain prices. Normally an executive recognizes salary income when a stock option is exercised, to the extent the value of the stock exceeds the exercise price. The shelter tried to shift the income to other family members, and to defer it over a period of up to 30 years.

The plan would require executives to pay all of the taxes on the options, but only half of the 20% penalty that the IRS would otherwise seek.

The IRS listed this transaction as "abusive" in Notice 2003-47.

The deadline for taking the offer is May 23, 2005.

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ROTH IRA CORPORATE OWNERSHIP

December 03, 2004

We begin our series on "listed transactions" with transactions "to avoid limitation on Roth IRA contributions." These became listed transactions via Notice 2004-8.

HOW TO SPOT THESE:

Any ownership of a C corporation by a Roth IRA should raise a little red flag. If IRAs only own a small percentage of the corporation, relax. If they own "substantially all" of the corporation, you need to see if the corporation does any business with entities controlled by Roth IRA beneficiaries. If it does, or if you can't be sure, it's time to file form 8886.

HOW IRS DESCRIBES THEM

These deals are described in Notice 2004-8:

   ...arrangements in which an individual, related persons
   described in � 267(b) or 707(b), or a business 
   controlled by such individual or related persons, 
   engage in one or more transactions with a corporation, 
   including contributions of property to such corporation, 
   substantially all the shares of which are owned by one 
   or more Roth IRAs maintained for the benefit of the 
   individual, related persons described in � 267(b)(1), or
   both. The transactions are listed transactions with 
   respect to the individuals for whom the Roth IRAs are 
   maintained, the business (if not a sole proprietorship) 
   that is a party to the transaction, and the corporation 
   substantially all the shares of which are owned by the 
   Roth IRAs.

   Substantially similar transactions include transactions 
   that attempt to use a single structure with the intent 
   of achieving the same or substantially same tax effect 
   for multiple taxpayers. For example, if the Roth IRA 
   Corporation is owned by multiple taxpayers� Roth IRAs,
   a substantially similar transaction occurs whenever 
   that Roth IRA Corporation enters into a transaction 
   with a business of any of the taxpayers if distributions 
   from the Roth IRA Corporation are made to that 
   taxpayer�s Roth IRA based on the purported business 
   transactions done with that taxpayer�s business or 
   otherwise based on the value shifted from that 
   taxpayer�s business to the Roth IRA Corporation.

WHERE THESE CAME FROM

Notice 2004-8 responds to an arrangement marketed by Grant Thornton, and probably others, in which taxpayers would set up C corporations owned by Roth IRAs. This would be done by establishing a corporation within a Roth IRA and funnelling income from another corporation to the Roth IRA corporation, often in the form of "management fees." The fees might be in just the amount needed to use up the lower corporation rate brackets, resulting in reduced current taxes. While the Roth IRA-owned corporation would be subject to tax, dividends and proceeds from the sale of corporate stock would be permanently tax free.

Grant Thorton got into a legal battle with the IRS over this transaction when the IRS sought a list of its clients using the transaction.

WHY IT MATTERS

Individual taxpayers who fail to report a listed transaction on form 8886 are subject to a non-waivable $100,000 penalty. The penalty for trusts, corporations and partnerships is $200,000. For more on these penalties, go here.

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TAX SHELTER REPORTING - FEAR TAKES ON GREED

December 02, 2004

The American Jobs Creation Act signed into law in October adds severe penalties to the tax law for failure to properly report transactions with tax shelter potential. These penalties respond to the lucrative and widely-marketed tax shelters generated by major accounting and law firms beginning in the 1990s.

Legislation against tax abuses is difficult to draft narrowly, and Congress ends up firing into the crowd to stop the tax abusers. This can be nerveracking to the rest of the crowd.

The part of the new legislation that frays our nerves is the severe penalties for failing to properly disclose "reportable" transactions. These rules are designed to force tax shelter-users to let the IRS know about dicey tax shelters by imposing severe penalties if they don't disclose them properly. These penalties apply strictly for failure to disclose - even if the tax benefits of the transaction are upheld, the failure to disclose is subject to penalties.

"REPORTABLE" AND "LISTED" TRANSACTIONS

The new tax law disclosure penalties have two levels. Failure to properly disclose a "reportable" transaction carries a $10,000 fine on an individual return and a $50,000 fine on a corporation, partnership or trust return. This fine can be waived under some some circumstances.

Failure to properly disclose a "listed" transaction carries a $100,000 fine for individuals and a $200,000 fine for other entities. Worse, this fine may not be waived. "Listed" transactions are those that the IRS has identified by published guidance as such - and transactions "substantially similar" to identified transactions.

Most taxpayers won't run into "reportable" or "listed" transactions in their day-to-day financial life, fortunately. The severity of the penalties makes it important for taxpayers to be aware of them.

CONTINGENT FEE TRANSACTIONS

For business taxpayers, contingent fee transactions are the "reportable" transactions most likely to be encountered. These will include any transaction where the fee depends on tax savings or deductions achieved. Common examples include depreciation studies (e.g., building cost component studies) and research credit studies.

PARTNERS: BEWARE FORM 8886

Individuals are most likely to encounter listed or reportable transactions vicariously through partnership investments. Many hedge funds and widely-held partnerships are involved in transactions they feel might be "similar" to listed transactions, so they protect themselves from the $200,000 fine by disclosing them.

Partners in such funds are also required to comply with the disclosure requirements. Partnerships will let partners know about these requirements by providing them with Forms 8886 at the same time they provide their year-end K-1s.

It is crucial for partners to supply their tax preparers with all tax information from their partnerships - including any Forms 8886. Partners can't avoid the $100,000 disclosure penalty by simply not telling their preparers about their Forms 8886.

The Tax Update is beginning a series on various listed and reportable transactions. Why? With $100,000 - $200,000 non-waivable penalties, inquiring minds might want to know what these things are. Meanwhile, you can find the current collection of "listed transactions" in Notice 2004-67. There are 30 of them, so we won't run short of material.

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