Tax Shelter Can Have Business Purpose


The IRS has been developing policies to attack a variety of tax shelters including the contingent liability shelter, in which a high-basis asset is transferred to a new corporation in exchange for stock in an IRC section 351 transaction. The transferred asset is accompanied by a contingent liability—a liability that the transferor has not yet been able to recognize for tax purposes. Consequently, the stock received has a high basis though its value is low because of the contingent liability, and selling it results in a loss. In notice 2001-17 (2001-1 CB 730) the IRS announced it would disallow losses claimed from contingent liability transactions.

Black & Decker created Black & Decker Healthcare Management Inc. (BDHMI) by transferring $561 million to the newly formed corporation. BDHMI assumed a $560 million contingent liability for health care claims; its resulting value was $1 million ($561 million less $560 million). Black & Decker then sold the BDHMI stock for $1 million and claimed a capital loss of $560 million ($1 million less $561 million), which it used to offset capital gains from the sale of three of its businesses. The IRS disallowed the loss. Black & Decker sued for a refund.

Result. For the taxpayer. The District Court of Maryland (Northern Division), issued a summary judgment holding that the BDHMI transaction had economic substance and therefore must be acknowledged. Pointing out that a sham transaction can be ignored for tax purposes as discussed in Hunt (938 F2d 466, 471 (4th Cir. 1991)), the court reiterated the definition of a sham transaction as one designed solely to create tax benefits rather than to serve a legitimate business purpose. In Rice’s Toyota World (752 F2d 89, 90 (4th Cir. 1985)), the court determined that a transaction would be treated as a sham if “the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and the transaction has no economic substance because no reasonable possibility of profit exists.”

Although Black & Decker conceded that tax avoidance was its sole motivation for the transaction, the court held that the second part of the definition was not satisfied, as the transaction did contain economic substance. Because BDHMI assumed the responsibility for the management, servicing and administration of Black & Decker’s health plan, considered and proposed numerous health care cost containment strategies, and maintained salaried employees, the transaction had very real economic implications for participants in Black & Decker’s health plan and should not be treated as a sham transaction.

The IRS’s plan to challenge tax shelters has important implications for all tax-avoidance plans. Although the IRS lost this case, it will continue to aggressively litigate any transaction considered a tax shelter. Still, this case indicates transactions that have economic substance aside from the tax benefits have a good chance of being upheld in the courts.

Black & Decker Corp. v. United States (DC MD 10/20/2004).

Prepared by Ronald R. Hiner, EdD, and Darlene Pulliam, CPA, PhD, professors of accounting at T. Boone Pickens College of Business, West Texas A&M University, Canyon.


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