IRS Issues Questionnaire on a Transaction of Interest
By David I. Kempler,
Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
The IRS recently issued final
regulations1 in the tax
shelter disclosure area under §§6011, 6111, and 6112 (Final
Regulations) that replace the temporary and proposed regulations
issued in 2006. While the Final Regulations largely adopt the
temporary regulations, there are some new aspects. Generally, under
the tax shelter disclosure rules, a taxpayer is required to disclose
participation in certain reportable, tax shelter-type transactions as
an attachment to the taxpayer's federal income tax return.
The Final Regulations eliminate from the disclosure rules
transactions with a significant book-tax difference. Under the former
regulations,2 if the amount of
any item(s) of income, gain, expense, or loss from a transaction for
tax purposes differed by more than $10 million on a gross basis from
the treatment for book purposes, there would be a significant book-tax
difference that had to be reported. The IRS now has the ability to
collect the same information from Schedule M-3, so this filter has
been eliminated from the list of reportable transactions.
The Final Regulations also eliminate transactions involving a brief
asset holding period from the reportable transactions category.
Changes to §901 made this filter unnecessary.
The Final Regulations added a new category of reportable
transactions, “transactions of interest,” which are
transactions that the IRS and the Treasury believe have the potential
for tax avoidance or evasion but for which the IRS and Treasury lack
sufficient information to identify as tax avoidance
transactions.3 The new rules
permit the IRS to obtain information about certain types of
transactions that are not yet listed transactions and for which no
penalties will be assessed. Pursuant to the Final Regulations, the IRS
will publish guidance on which transactions constitute transactions of
interest. After the IRS obtains information about the transactions, it
will either delete them or make them “listed
transactions.” The Final Regulations have an effective date of
November 2, 2006, for transactions subsequently identified as
transactions of interest.
On August 16, 2007, the IRS announced that it had identified its
first two transactions of interest.
In Notice 2007-72,4 the IRS
described a potentially abusive transaction involving the use of a
successor member interest to claim charitable contributions that may
be excessive. According to the IRS, these deals arise when a taxpayer:
• buys
a successor member interest, directly or indirectly, in real
property;
• transfers
the interest to a tax-exempt organization more than a year after the
acquisition; and
• claims
a charitable contribution deduction significantly higher than the
amount that the taxpayer paid for the interest.
In a typical transaction, the IRS stated in Notice 2007-72, an
adviser owns all of the membership interests in a limited liability
company (LLC) that directly or indirectly owns real property subject
to a long-term lease. The adviser and taxpayer reach an agreement in
which the adviser keeps the membership interests in the LLC but the
taxpayer buys a successor member interest after a period of years.
After holding that successor interest for more than a year, the
taxpayer transfers it to a charity described in §170(c). The
taxpayer then claims a charitable deduction significantly higher than
the purchase price, based on an appraisal of the fee interest in the
underlying real property.
The IRS stated that the government is concerned about
“apparent irregularities” in such deals. Specifically, it
said, the significant discrepancy between the successor interest price
and the amount claimed as a deduction raises a red flag.
Additional concerns cited by the IRS include:
• any
mischaracterization of the ownership interests in the LLC;
• a
charity's agreement not to transfer the successor member interest for
a period of time; and
• any
sale by the charity of the successor member interest to a party
elected by or related to the adviser or taxpayer.
In October 2007, the IRS issued a sample letter, which it stated
will be sent to exempt organizations and government entities to inform
them that they will be examined because they have received a successor
member interest in a real property transaction that might involve an
excessive deduction for a charitable contribution.
Organizations will be asked to describe each instance in which they
received or disposed of a successor member interest (involving an
interest in real property) in a transaction like the one described in
Notice 2007-72 or one that is substantially similar.
Any person participating in such a deal, or a substantially similar
one, must report it to the IRS if the person's participation was on or
after November 2, 2006, the IRS stated. However, a charitable
organization is not considered to be a participant if it received the
successor member interest on or before August 14, 2007, according to
the letter.
According to the IRS, the transactions involve charitable
deductions of approximately $271 million taken by investors who later
donated properties to charities at what appeared to be inflated
values.
The other “transaction of interest,” described in
Notice 2007-73,5 concerns a
transaction whereby a taxpayer forms a trust and contributes cash and
currency options to the trust. The four options relate to currencies
that are likely to offset in value so that at any time, two of the
options will have built-in gains and two will have built-in
losses.
The trust documents provide the taxpayer with a power of
substitution with respect to the trust assets, which begins after a
date certain in the future. The taxpayer then sells a unitrust
interest in the trust to one person (A) and later sells the remainder
interest to a second person (B). The sale of the trust interests is
treated as a termination of the trust's grantor trust status. After
the power of substitution becomes effective, the taxpayer takes the
position that the trust again becomes a grantor trust and entitles the
taxpayer to claim the deduction for the loss on the close-out of two
of the options. B then purchases A's unitrust interest in the trust
and terminates the trust. B claims a fair market value basis in the
remaining options in the trust and does not recognize gain or loss on
the transaction.
Notice 2007-73 identifies a variation of the transaction where the
taxpayer uses the same transaction to eliminate gain on the sale of an
appreciated asset by contributing it to the grantor trust in
substitution for cash or other assets, then having B purchase the
unitrust interest to terminate the trust (taking a fair market value
basis in the substituted property). The Notice declares that the
transaction of interest designation is effective as of August 14,
2007, for transactions entered into after November 1, 2006. The Notice
identifies the taxpayer, A, and B as participants.
The IRS's identification of these “transactions of
interest” will be helpful to taxpayers and their advisors.
For more information, in the Tax Management Portfolios, see
Paravano and Reynolds, 798 T.M., Tax Shelters, and in Tax
Practice Series, see ¶3820, Tax Returns and Information
Returns.
1
T.D.s 9350, 9351 and 9352 (8/3/07).
2
Former Regs. §1.6011-4(b)(6)(1).
3
Regs. §1.6022-4(b)(6), (c)(3)(i)(E), as revised by T.D. 9350, 72 Fed. Reg. 43146 (8/3/07), applicable to transactions of interest entered into on or after Nov. 2, 2006. Transactions of interest are identified in published guidance. Once the IRS and Treasury have gathered enough information to determine if a transaction is a tax-avoidance-type transaction, they would take one or more actions, including: (i) removing the transaction from the transactions-of-interest category in published guidance; (ii) designating the transaction as a listed transaction; or (iii) providing a new category of reportable transaction. A transaction, however, would not have to be identified first as a transaction of interest before it is identified as a listed transaction. See Preamble to REG-103038-05, 71 Fed. Reg. 64488 (11/2/06).
4
2007-36 I.R.B. 544.
5
2007-36 I.R.B. 545.
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