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Guest Article

Towards a Trusty Test to Track, and Tax, the Tax Shelters

By Alvin D. Lurie
June 1, 2004

How is one to know the bounds of the law in a universe where no one has been able to draw a generally recognized boundary line between abusive and nonabusive tax shelters?

Try this for a stab at line drawing:

A tax reducing strategy shall not be considered not to be an abusive tax shelter solely because tax liability has not been entirely avoided by means of the arrangement.

Or this:

A tax planning technique shall not be deemed not to constitute an abusive tax shelter solely because business purpose is not totally absent.

Yes, I hear you saying, "You can't be serious." Before you judge me too harshly, let me refer you to my model, taken directly from a key definition in the Code:

An amount paid as tax shall not be considered not to constitute an overpayment solely by reason of the fact that there was no tax liability in respect of which such amount was paid. [IRC section 6401(c).]

Alright, I am not serious. My samples are not models of legislative drafting: but, I would argue, even they are more illuminating than the unlighted sectors of the Code impacting abusive tax shelters, where the search for a workable, generally accepted definition goes unsated to this day. In the following pages, I will try to contribute to that search.

The task is only essential. How can the rule of law work where the "law" is ambiguous at best, and the law of any case is to be discerned only through the eye of the particular beholder on the bench? Congress itself has added to the confusion by sanctioning shelters, some arguably even abusive. Practitioners and judges are left to pick their way through this terra incognita without a compass, their passage only complicated by Judge Learned Hand's maxim that "any one may so arrange his affairs that his taxes shall be as low as possible," written when the Gregory ball was in his court. But, as we shall see, even the Gregory transaction itself did not escape the tax collector's reach. "No business purpose," Hand opined, with the acquiescence of his colleagues on the Second Circuit and, subsequently, with the concurrence of the Supreme Court (Helvering v. Gregory, 69 F.2d 809 (2d Cir.1934), aff'd 293 U.S. 465 (1935)), thereby embedding in the tax law the proposition that to this day provides the most used, if not wholly useful, indicia of tax abuse.

Towards A Definition

Are we to take the Gregory opinions as the beginnings of a definition, if not so much by enunciation of principle as by example? I submit not. Yes, it involved sheltering of income by forcing the basic transaction -- a sale of corporate assets -- through some hoops to diminish tax at the shareholder level (interestingly, not very adeptly, because the transaction could have been more directly attacked as failing to observe the requirements of a tax-free spin-off). But tax planners often establish a structure for a given transaction whose sole object is taxation at its lowest legitimate level, or at least at only a single (shareholder) level, sometimes successfully. General Utilities & Operating Co. (296 U.S. 200 (1936)) illustrates an historic success, until its statutory repeal some 50 years later; Court Holding Co. (324 U.S. 331 (1945)) represents a failure of the effort. But note that five years after that the Supreme Court approved tax planning, in Cumberland Public Service Co. (338 U.S. 451 (1950)), not very different in design from the Court Holding model. All these cases involved assets originating in one corporation that were ultimately transferred to a second unrelated corporation by way of distributions in kind to the shareholders and then formal sale by them.

Judged by comparison with the transactions in such mythic cases of the current era as ACM (157 F.3d 231, 3d Cir. 1998) and Compaq Computer Corp. (277 F.3d 778, 5th Cir. 2001) -- the former lost, the latter won by the respective taxpayers -- those earlier cases do not seem worthy of the "abuse" adjective; and it seems that a principled line could be drawn between them and the more recent varieties that would appropriately confine the "abuse" label in a way that permits government and taxpayer to more exactly delineate abusive sheltering from legitimate business and investment planning. That is not to say that assignment to the latter category assures tax success. But there are many ways to deal with undeserving candidates in that category, like the "step transactions," "sham" and "business purpose" doctrines. These tests are, of course, equally applicable in the abusive tax shelter area; but every transaction lacking business purpose is not -- rather, in a formulation one could propose, should not -- be treated as an abusive shelter.

Thus it was sufficient to reach the proper tax result in Court Holding to require, in the Supreme Court's words: ". . . the transaction must be viewed as a whole, and each step, from the commencement of negotiations to the consummation of the sale, is relevant. A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title." Such a proposition would have been all that was needed to "bell" the Gregory transaction.

The difference of that case from both Compaq and ACM was that the latter two employed a gratuitous structure superimposed on an arrangement, separate and distinct from the basic and distinct transaction giving rise to the taxes that the tax planners sought to avoid, that had no business purpose or economic substance apart from the attempted saving of taxes in the basic arrangement. In Compaq, a so-called dividend-stripping scheme, the taxpayer bought and held for one very critical day (when the stock went from cum-dividend to ex-dividend) ADRs on foreign shares of stock, for the sole purpose of obtaining the related foreign tax credits and the capital loss resulting from the ex-dividend sale, which it applied against a capital gain it had realized from an entirely unrelated sale of stock of another corporation. ACM involved a contingent installment sale device that had the ostensible effect of generating losses to offset capital gains through the instrumentality of a special-purpose partnership designed so as to deconstruct the sale of securities into artificial gain and loss components, with the "gains" shunted to a tax-indifferent partner and the "losses" to the shelter purchaser, when, in fact, there were no material economic gains or losses, and, indeed, no "partnership", as held most particularly in the latest of the ACM line of cases, Boca Investerings (314 F.3d 635, D.C. Cir. 2003). One group of judges accepted the tax efficacy of the separate structure (in Compaq), the other group did not (in ACM).

Parenthetically, among the legislative proposals included in the President's FY 2005 Budget to close particular abusive tax avoidance transactions is one aiming two bullets presumably directly at the Compaq transaction: (1) denying foreign tax credits for foreign withholding taxes imposed on income where the underlying property is not held for a specified minimum period; (2) providing Treasury with regulatory authority to prevent transactions that inappropriately separate foreign taxes from the related foreign income to take advantage of foreign tax credit rules despite absence of risk of double taxation. Resort by the Treasury (as the presumed architect of the Administration's tax proposals) to a rule-based approach, one by one, is understandable, given the government's much publicized failure in the Compaq litigation; but the issue could have been -- should have been -- won under well-established tax principles.

Wholesale Shelter Distribution System

Professor George Yin, now chief of staff of the Joint Committee on Taxation, has posed the possibility of an interesting and valuable means of identifying an abusive tax shelter from just aggressive tax planning. He contrasts individualized tax planning for a particular taxpayer in an effort (not always successful) to achieve an economic objective directly related to a taxpayer's business situation (for example of which he cites Gregory), with the "manufacturing" (his word) of a mass-marketed scheme for a broad cross-section of taxpayers (some reached by cold-calling, as in the program he selects to illustrate the type). See Tax Notes (Feb. 16, 2004 at p. 931).

That particular program involved introducing an accommodating charity briefly into the stock ownership of an S corporation for the sole purpose of "absorbing" the taxable income of the corporation, but only for tax reporting purposes and without economic effect since the charity is cashed out at a preordained figure not commensurate with the profits allocated to it on the Schedule K. That was carrying the Clay Brown "bootstrap"scheme, that surprisingly won in the Supreme Court in a split decision (380 U.S. 563-1965), to an entirely different level. Clay Brown succeeded in laundering the profits of his business through the charity's tax exemption, which rerouted the untaxed profits back to him and his family in the form of payment for the business. But at least there was a colorable substance to the charity's ownership position. (Don't try to emulate Mr. Brown's tactic; Congress killed it with the debt-financed acquisition rules of the 1969 Revenue Act.)

Professor Yin could have cited other similar instances of wholesale marketing of shelters, such as the Merrill Lynch program dealt with in the ACM-and-progeny cases, the well-over-the-edge BOSS scheme of PricewaterhouseCoopers, the recently much-publicized BLIPS and FLIP transactions designed by KPMG (BLIPS alone is reported to have generated fees of $50 million), the COSS program of Ernst & Young, and any number of other such aggressively sold shelters promoted in the high-flying Nineties -- "sold" being the operative word, one individual having paid $4 million just to buy the right to use FLIP.

Professor Yin does not offer such wholesaling (my word, not his) as the sole badge of an abuse. But certainly it is a marker that would have a salutary effect, if only to impose a special evidentiary burden on the taxpayer, and a reporting burden on taxpayers, promoters and others in the chain of distribution (i.e., tax-return reporting, list maintenance and registration). He has made an important contribution in floating this possible approach for consideration before an important body of tax lawyers assembled for a meeting of the Tax Section of the ABA. See Tax Notes (Feb. 9, 2004 at p. 712).

Is It Weakness Of Intellect?

The practical effect of distinguishing cases such as Court Holding from those of the ACM and Compaq type would be to remove the former from the abusive tax shelter regime. The common law of taxation, in conjunction with occasional intervention by Congress (as in the repeal of the General Utilities doctrine by amendment of Code section 336(a)), has been able to cope with such transactions. By contrast, the new-style designer shelters, as typified by the many acronymically named creations noted above, have resulted in decisions that have gone every which way.

Was it weakness of intellect on the bench that enabled some in the bar to slip one over on the court? Was it just the different gestaltic responses of the judges that made for the different outcomes? Did the judges who struck down the transactions know it was obscenity that they were looking at, while the more receptive judges know that it was not, to frame the matter in the famous terms of Mr. Justice Potter?

Law By Legislative Fiat

This perceived variance in the viscera among the judges has led some to try to constrain judicial discretion as much as possible by legislation. Repeated recent legislative attempts to codify the economic substance doctrine have sprung from this approach. None has so far succeeded; and, among those most outspoken in criticism of this type of legislation has been the Treasury Department, its recently departed Assistant Secretary for Tax Policy, Pamela Olson, calling it "wooden . . . less flexible than currently . . . too broad and too narrow . . . adds complexity for the IRS." Another high Treasury official got more judgmental, calling it "an incredibly bad idea," changing an inherently flexible doctrine into a "rigid rule."

Economic Substance and Business Purpose have been the long-standing twin guardians of the fisc, employed by courts and government regulators alike against the many variegated forms of sheltering -- the filters through which a suspected shelter must pass, sometimes one, sometimes the other, often both. Indeed, as the Third Circuit put it in ACM, these are not "discrete prongs of a rigid two-step analysis," but related factors, the former objective, the latter subjective, both necessary to the analysis of a transaction's substance apart from tax effects. Attempts in Congress to articulate a statutory formulation of these principles have proved elusive, as well evidenced by the most recent attempt, introduced by Senators Grassley and Baucus, in S 1637, the so-called JOBS Act. Their bill in fact does not even essay a substantive definition, rather just a "clarification" of "economic substance" to be employed in the adjudication of cases where the court determines that an abusive shelter might be implicated. The taxpayer then has the burden of proving that its transaction has economic substance by establishing: (i) a meaningful change in its economic position, and (ii) that the transaction has a substantial non-tax purpose for the accomplishment of which the transaction provides a reasonable means. Hence, both economic substance and business purpose must be proved.

So far, nothing revolutionary; but the statute gets more specific. Critical to establishing a non-tax purpose is demonstration of a significant profit potential, which is to be accomplished by showing that the present value of a reasonably to be expected pre-tax profit is substantial relative to the present value of the expected net tax benefits. Hence, an insubstantial investment return relative to a large tax benefit doesn't cut it; although note that the statutory test would be the profit reasonably to be expected, not that actually experienced, so even an incurred loss would not necessarily flag the transaction as an abusive shelter, unless losses could reasonably be expected. Substantiality, for purpose of this test, is left undefined -- a flaw shared with various provisions presently in the Code, e.g., section 1258(c) defining a "conversion transaction" in terms of the substantiality of one's investment return attributable to the time value factor) -- thus introducing uncertainty of outcome where the purpose of the statute would presumably be the opposite.

Other Statutes, Other Rules

Thus, this JOBS test is less satisfactory than the "tax shelter ratio" test of IRC section 6111, governing the registration of tax shelters required of tax shelter promoters, that employs a 2-to-1 standard as the limit on the permissible ratio of tax benefits to the investment of an investor that could reasonably be inferred from the offering materials. Note here that 6111 utilizes investment, not return on investment, as one term of the formula; so arguably the statute countenances an investment return as low as, say, 5 percent of the expected tax benefits (i.e., where the transaction achieves a quite respectable 10% return on the investment). It would not seem that one could safely rely on such a low percentage of profit to expected tax benefits as sufficient to satisfy the above "substantiality" test, although some courts have accepted far less than that to establish a profit motive.

In the case of individuals and S corporations Congress has established in section 183 an "engaged in for profit" test, with an objective standard providing taxpayers with a rebuttable presumption of acceptable profit motive if gross income exceeds deductions in at least 3 of the 5 most recent consecutive taxable year. It does not seem that a ratio test or a 3-out-of-5 profits test is particularly meaningful in the context of a tax shelter. A transaction that produces in a single year $90,000 of gross earnings and a $100,000 loss is susceptible of a shelter analysis where that $10,000 of excess loss has been forecast for utilization to offset taxable income in an unrelated business activity. Moreover, even four years of profits followed by one whopping year of losses could produce the scenario for a very attractive tax shelter, where the tax planning over a 5-year horizon is controllable to the extent that one can project with a high degree of probability tax outcomes in that time frame.

So far the Treasury has not been able to come up with a universal definition of the abuse it means to go after. Rather, in its several proposed tax shelter regulations preceding the "final" regulations promulgated in 2003 it employed such terms as transactions "a significant purpose of which is the avoidance or evasion of federal income tax," and transactions structured to produce tax benefits as an "important part of the intended result"; and then, to ameliorate the breadth and sting of such a sweeping standard, it would relieve a taxpayer from the burdens of reporting, under the disclosure portion of the regulations, if the taxpayer "reasonably determines that there is no reasonable basis for the denial of any significant portion of the expected Federal income tax benefits." Now there's a standard one could take to the bank!

Rules vs. Standards

Professor Yin offers a robust argument for a rule-based system of curbing abusive shelters, by statute or regulation, in contrast with the standard-based scheme that generally obtains. (Not surprising given his current post as chief of the experts to whom Congress looks for guidance on tax legislation). But, as he acknowledges, the development of universal rule for spotting abusive shelters can be costly and time-consuming, and, ultimately, less adaptable to the endless variety of exotic promotions than a standard-based system. Inevitably, fixed rules will continually be unequal to the new challenges posed by man and his computers (God-given and Gates-given, respectively).

He need not worry. One can reasonably predict that no single, all-encompassing, universal rule will be developed to embrace the entire shelter terrain. Rather we will have a continuing stream of separate rules, as indeed is already the case; for that is precisely what the listed transaction regime is. They are adequate, insofar as they go and to the extent respected by the courts, as guidance for the adjudication of individual cases the same as, or substantially similar to, those on the list. But the general principles that have developed and the precedents that have been established will continue to be relied upon -- spottily and contradictorily -- for cases in the vast and ever expanding space beyond, in the way that the common law has always worked.

A Test To Catch The Worst Abuse

Still, it is worth trying to compose a rule that, if not universal, has a broad reach, that does not depend upon standards or principles, but rather concrete transactional characteristics specific enough to nail the abusive elements that mark the most egregious of shelters, and is at the same time sufficiently elastic to capture a broad range of strategies having greatly varied designs, i.e., not so specific as to become obsolete with the next generation of shelters. Can one have that pie and eat it? Can one fasten on a core element typically found in certain of the most abusive of schemes that have surfaced, and formulate an objective set of markers that point unfailingly to a suspect shelter, like a litmus test? Let me try.

What is that core element that can be said to characterize many of the shelters that have been found to be most abusive? Look at the very transactions involved in the cases I have already cited. It is the existence of a gratuitous structure, wholly unrelated to and distinct from the taxpayer's business or investment activities (let me call the latter "basic activities", for convenience of reference), having no demonstrable purpose other than the saving of taxes attributable to the basic activities. Thus, it is the conjunction of two separate activities, one, a basic business or investment activity engaged in for legitimate purposes and producing the normal tax consequences flowing from such activity, and, two, a separate business or investment activity entered into for the purpose of avoiding the tax liability or other unwanted tax consequences (e.g., expiring loss carry forwards) associated with the former activity. Let us call the entire arrangement a linked tax construct ("LTC"), since linkage is central to this proposal.

In ACM (the "M" standing for Merrill Lynch) and its progeny of cases of the same design, the taxpayer, a U.S. corporation, had realized substantial capital gains in the course of its ordinary business, and adopted a program designed to look like a contingent instalment sale for the sole purpose of offsetting those capital gains. The gratuitous structure was a special-purpose partnership formed with a foreign (non-U.S. taxpaying) party for the purpose of generating gains and losses on the sale of securities, resulting in only taxable "losses" to the domestic corporation (the one utilizing the shelter). Compaq, the dividend-stripping case, was quite different in design from ACM, but similar in its employment of a gratuitous transaction to offset capital gain realized on the sale of stock of a corporation in a transaction entirely unrelated to the dividend strip at the heart of the shelter.

BOSS (not yet a pending case, but likely to become one) was another variation on the same theme, designed by PriceWaterhouse Coopers to function as an elegant structure superimposed on and entirely unrelated to the capital gains that the taxpayers, an investment group, had previously realized, prompting them to enter into an elaborate construct involving a foreign entity, a domestic corporation owned by a partnership, a check-the-box election made to change the corporation's tax treatment, and the passing of encumbered property among the parties to achieve basis shifting. The strategy was founded on the Crane-Tufts rule of basis building applicable to acquisition indebtedness. The object was obvious: manufacture capital losses for the investors to apply against the gains realized from entirely unrelated business transactions. It was obvious, too, to the Service, that first announced it would deny the losses so created (Notice 99-59), and then, later, added the scheme to its "listed transaction" hit list.

Tax erasing strategies designed to drain the normal tax incidence from taxpayers' business or investment activities by introduction of linked structures were also devised by KPMG, carrying the names BLIPS, FLIP and OPIS, and by Ernst & Young under names like COSS and COBRA, possessing the same dual-structure characteristics, although each vastly different in design. COBRA , as described in a widely reported lawsuit brought by a Mr. Camferdam and others against E&Y and the opinion-writing law firms, was bought from the accountants because the plaintiffs faced the misfortune of having made a $70 million gain on the sale of their business; so COBRA was no less seductive than the Original Snake, because it promised to wipe out that otherwise taxable gain. It merely required the plaintiffs to simultaneously buy and sell offsetting long and short currency options, transfer them to an S corporation formed specially for the currency transaction, which supposedly resulted in a greatly inflated basis to the S corporation by counting the amount paid for the long option but not the essentially identical amount received on sale of the short position. Hence, the promoter claimed, and the opinions so opined, that a sale of the assets of the corporation produced a capital loss equal to the amount paid for the long option, which, as stockholders of the S corporation, the plaintiffs claimed on their 1040s. Here again the LTC is the culprit. KPMG and E&Y have since been subjected to sanctions by various arms of government, stemming from their shelter promotions; but the signature linked structure was not the exclusive property of one or two tax powerhouses, and its promotion was not confined to major accounting firms, or even to practitioners of the accounting profession.

Defining A Linked Tax Construct

The proposal presented in this paper is to treat these linked tax constructs as per se abusive shelters. The requisite elements of an LTC, as suggested here, are: (1) utilization of a one-shot tax construct ("TC"); (2) the TC being completely unrelated to taxpayer's business or investment activity ("B/IA"); (3) the TC having essentially no independent justification apart from the purpose of addressing unwanted tax incidence deriving from B/IA; and (4) the effect of the TC being to eliminate or ameliorate the effect of such B/IA-related tax incidence. The presence of all four elements must be found, and they can be identified objectively without the need to ascertain Congressional intent, or to establish taxpayer intent or purpose, or to resort to spongy doctrines like Economic Substance or Business Purpose to determine whether the TC had economic substance or profit potential standing alone. It would be no defense that the TC, as a stand-alone activity, might have passed muster, because when used as an integral part of an LTC arrangement, it is a very different structure.

I am certainly not the first to observe the significance of this pairing of a business investment with an unrelated tax-sheltering activity having little or no independent raison d'etre. The most forceful disquisition on this linkage that I have read appears in an unpublished paper delivered by David Hariton in December 2003 to his fellow members of the prestigious Tax , Forum study group, entitled "Kafka And The Tax Shelter" (Paper No. 570). Its author would use this identified characteristic somewhat differently -- and less definitively -- than is here proposed, as a step in the judicial analysis of hard cases rather than as a rule of thumb to be applied by the Service, as I would opt for.

One could identify another common characteristic possessed by each of the above cited programs and many others that have surfaced: each was presented to the taxpayer by a promoter as an essentially off-the-shelf product created for sale to a wide market, and actually sold to thousands of reluctant taxpayers for fees estimated in the billions. Professor Yin has invited comment from the bar on his suggestion that such "wholesaling" be treated as a badge of abuse in cases of shelter designs that thread their way through tax statutes in ways that produce tax avoidance that Congress presumably had not anticipated.. He did not relate it to linked structures, of course; and while his suggestion has much to commend it, I would not favor including such a limiting factor in the LTC test, since the inherently abusive nature of the linked structure is no less so because hand-crafted by the taxpayer's own advisers. A sounder limitation on the LTC test might be to exclude its application where the tax benefit is below a certain significant threshold number.

Properly seen, LTC is but a genus of tax shelters, although probably accounting for the largest number of potentially abusive shelters and the largest leakage of tax revenues. There are, of course, many shelters not having its distinctive characteristics, that consequently would not be reached by the LTC test. One such is discussed by Professor Yin, in his abovenoted remarks, where he illustrates his concerns by discussing what has been named SC2, which is the strategy noted above for injecting a charity into a temporary ownership position in an S corporation in such a way as to siphon off a sizeable chunk of reportable profits into the tax account of the charity, greatly in excess of the actual pre-programmed, beneficial share of the charity. His comments anticipated by several weeks a Service notice (Not. 2004-30, 2004-17 IRB 828) designating this type of scheme as a listed transaction. There are many vulnerable features of this obviously abusive arrangement -- the foregoing Notice enumerates several -- but a linked superstructure would not appear to be one of them. There is only a single business structure, and the unwanted taxable profits all flow from it. Assuming one even recognizes the interest of the charity as bona fide, the tax law has anti-abuse doctrines for reassigning the profits to their proper accounts, without trying to fit an SC2-type strategy within the LTC test and thereby undercutting its specificity, and hence its certainty, which is the principal value of the test.

How LTC Test Would Work

The steps of the LTC test are:

  1. Identify taxpayer's B/IA
  2. Ascertain that separate, one-shot TC is utilized by taxpayer
  3. Find that TC not connected with or necessary to conducting the B/IA
  4. Determine tax incidence of conducting the B/IA as if no TC exists
  5. Ascertain tax effects of utilization of TC separate from the B/IA
  6. Calculate tax effects of utilization of TC on taxpayer's overall tax liability
  7. Determine whether tax consequences of utilizing TC affects tax incidence pertaining to B/IA more than de minimis

If answer to Step 7 is "yes", presence of LTC has been established.

The filter of Step 3 is critical to the proper working of the test. The conduct of one's business in the most tax-efficient manner, even if otherwise abusive, is not an LTC. For an LTC type of shelter, there must be a separate, predominantly tax-motivated activity not an integral part of or in any way necessary to the conduct of that business, apart from saving taxes (possibly limited to federal income taxes), to bring the arrangement within the ambit of the test. However, the mere maintenance of two distinct, ongoing business or investment activities, one profitable, one losing, the losses offsetting tax liabilities attributable to the former, does not by itself cause failing the test. Criteria could be established to identify the proscribed linkage, e.g., the tenure of the activity producing the offsetting tax benefits, where the branding of the transaction as an LTC would be made presumptive rather than per se.

Note that Step 2 of the test limits its application to a "one-shot" TC, which is designed to prevent flunking the test where the TC is a continuing activity. That has the effect of restricting the test to constructs designed for a single year's tax benefit, since that is the object for which these strategies are typically designed. But that limitation might inappropriately taint a single investment that has independent validity on its own terms, or conversely might permit ready circumvention of the intent of the LTC approach by establishment of a multi-year loss generator having no purpose other than to replicate an abusive outcome extending over more than one tax year by providing for a series of one-shot transactions. That suggests the advisability of considering a "facts and circumstances" feature for dealing with arrangements that test the limits of the concept and flout its purpose. But the bias should be heavily against exceptions to application of the test, lest the benefits of the fixed-rule approach become mired in exceptions and court-developed rationales for avoiding the "judgment" of the test.

Precedent for LTC Testing

Is there any precedent for bestowing on the Commissioner authority to deny the use of losses from one business or investment activity to offset income from a separate activity just because the losses would otherwise have the effect of avoiding tax on earnings of a business or investment distinct from the activity producing the losses? Yes, the Congress conferred exactly such authority in respect of administration of the passive activity rules of Code section 469, which generally restrict passive activity losses to application against income from passive activities, but extend to the Treasury the authority to further restrict by regulation the use of such losses within the passive activity basket itself, by permitting income or gain from a passive activity to be treated as not from a passive activity. IRC sec. 469(l)(3). The Treasury has exercised this authority by recharacterizing rental income derived from an activity "in which the taxpayer materially participates" as not having a passive source (Treas. Reg. sec. 1.469-2(f)(6)). The Conference Report explains the provision as intended "to protect the underlying purpose of the passive loss provision, i.e., preventing the sheltering of positive income sources through the use of tax losses derived from passive business activities." H. Conf. Rept. 99-841 (1986).

A recent decision of the Tax Court gives a liberal reading of this legislative history to hold that the statute cannot be read "to require a finding of a specific intent to reduce taxes." Cal Interiors Inc., TC Memo 2004-99 (April 7, 2004) The court thus rejected the taxpayer's argument founded on the contention that "it is crystal clear that the rental activity was not contrived as a tax shelter," the court finding nothing in the statute or legislative history "requir(ing) the Secretary to condition the recharacterization rule on the absence of a bona fide purpose for a 'self-rental' such as we have here."

Section 469 is a most detailed statute, very specific to the problem of passive activity losses that loomed so large in the real estate tax shelters that abounded in the Sixties and Seventies offering tax havens for passive investors' unrelated business and investment income, based largely on nonrecourse acquisition indebtedness and resultant depreciation deductions out of all proportion to the taxpayers' investments. It obviously cannot be contended that the Commissioner's authority derived from section 469 directly supports the application of the LTC test to deny tax benefits from tax shelters generally, except as they may fall within the specific reach of that statute and its implementing regulations. However, Congress' concerns regarding abusive tax shelters generally is at least as evident as its distaste for the exploitation of passive activity losses, as manifest in myriad provisions added to the Code in recent years (e.g., secs. 6011, 6012 and 6111) and reflected in the abusive tax shelter regulations that have evolved over the past four years.

"Protecting the underlying purpose" of these provisions is surely no less a goal of the Congress than was protection of the purpose of the passive loss rules in 1986. If conferring on Treasury the extraordinary discretionary power to specify and recharacterize certain kinds of passive income as nonpassive, in order to carry out the anti-tax-shelter policy of section 469 (even without the need for a finding expressly connecting the suspect income to an intent to effect tax avoidance by the proscribed loss utilization, as held in Cal Interiors) is a seemly delegation to the administrative authority in the view of Congress, a fortiori, the implementation by Treasury and IRS of a means to identify abusive tax sheltering by its linked characteristics, would be no less a fitting exercise of the administrative function, within the spirit of the 469 legislation.


Would adoption of the modest LTC proposal of this piece staunch the flow of abusive shelters? I am neither so prescient nor so presumptuous as to claim that. But it clearly would provide a ready means of drawing the bright line that has been missing, with the added virtue of being easily understood and susceptible of consistent application by IRS, bench, bar, promoter, taxpayer and tax return preparer.

The LTC approach is obviously not meant as the definition of an "abusive tax shelter," but a means of halting one type, clearly a large grouping that includes the most abusive of shelters. It is not a particular type of shelter, but a broad range of shelters displaying a common bad gene, that permits their ready tagging as per se (or in some cases presumptive) shelters, without the need to apply such amorphous, eye-of-the-beholder concepts as business purpose and economic substance. If the LTC test does not do all one might wish for, that's still doing a lot.

Copyright 2004, A.D. Lurie
Alvin Lurie has spent many years as a practicing pension attorney, and was appointed as the first person to administer the IRS' ERISA program in the National office in Washington. He is back in practice and can be contacted at Alvin D. Lurie P.C. in New Rochelle, New York, telephone (914) 235-6575.

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