A Ponzi Scheme And Filing Late

I am reading a case involving a late tax return, a Ponzi scheme, and an IRS push for penalties.

It made me think of this form:

It is used for one of two reasons:

(1)  Someone is filing a tax return with numbers different from a Schedule K-1 received from a passthrough entity (such as a partnership).

(2)  Someone is amending a TEFRA partnership return.

That second one is a discussion for another day. Let’s focus instead on the first reason. How could it happen?

Easy. You are a partner in a partnership. You bring me your Schedule K-1 to prepare your personal return. I spot something wrong with the K-1, and the numbers are large enough to matter. We contact that partnership to amend the return and/or your K-1. The partnership refuses.

COMMENT: We would use Form 8082 to inform the IRS that we are not using numbers provided on your K-1.

This is a tough spot to be in. File the form and you are possibly waiving a flag at the IRS. Fail to file it and the IRS has procedural rights, and those include the right to change your numbers back to the original (and disputed) K-1.

There is another situation where you may want to file Form 8082.

Let’s look at the Rosselli case.

Mr. Roselli (Mr. R) was a housing appraiser. Mrs. Rosselli was primarily a homemaker. Together they have five children, three of whom have special needs.

Through his business, Mr. R came to know the founder of a solar energy company (DC Solar). Turns out that DC Solar was looking for additional capital, and Mr. R knew someone looking to invest. The two were introduced and – in gratitude – Mr R became a managing member in DC Solar via his company Halo Management Services LLC.

This part turned out well for the R’s. In 2017 DC Solar paid Halo approximately $300 grand. In 2018 DC Solar paid approximately $414 grand. Considering they had no money invested, this was all gravy for the R's.

COMMENT: Notice that Halo was paid for management services. Halo in turn was Mr. R, so Mr. R got paid over $700 grand over two years for services performed. This was a business, and Mr. R needed to report it on his tax return like any other business.

In late 2018 the FBI raided DC Solar’s offices investigating whether the company was a Ponzi scheme. The owners of DC Solar were eventually indicted and pled guilty, so I guess the company was.

Let’s roll into the next year. It was tax time (April 15, 2019) and there was not a K-1 from DC Solar in sight.

COMMENT: You think?

The accountant filed an extension until October 15. It did not matter, as the R’s did not file a tax return by then either.

The IRS ran a routine check on DC Solar and its partners. It did not take much for the IRS to flag that the R’s had not filed a 2018 return. The IRS contacted the R’s, who contacted their accountant, eventually filing their 2018 return in January 2022.

You know what was on that 2018 return? The $414 grand in management fees.

You know what was not on that 2018 return? A big loss from DC Solar.

Here is Mr. R:

Mr. Carpoff informed me that I was to receive Schedule K-1s showing large ordinary losses for 2018 from DC Solar, and as a result I would not have a tax liability for that year. However, before the K-1s could be issued … DC Solar’s offices were raided by the FBI.”

All of DC Solar’s documents and records were seized by federal authorities in the ensuing investigation. As a result, I was unable to determine any tax implications because I did not receive a K-1 or any other tax reporting information from DC Solar.”

Got it: Mr. R was expecting a big loss to go with that $414 grand. And why not? DC Solar had reported a big loss to him for 2017, the prior year.

But the IRS Collections machinery had started turning. By August 2022, the IRS was moving to levy, and the R’s filed for a Collection Due Process (CDP) hearing.

COMMENT: There is maddening procedure about arguing underlying tax liability in a CDP hearing, which details we will skip. Suffice to say, a taxpayer generally wants to fight any proposed tax liability like the third monkey boarding Noah’s ark BEFORE requesting a CDP hearing.

At the conclusion of the CDP hearing, the IRS decided that they had performed all the required procedural steps to collect the R’s 2018 tax. The R’s disagreed and filed with the Tax Court.

The R’s presented three arguments.

• They reasonably assumed that they would not be required to file or pay tax for 2018 because of an expected loss from the DC Solar K-1.

The Court was not buying this. Not owing any taxes is not the same as not being required to file. This was not a case where someone did not work, meaning they dd not have enough income to trigger a filing requirement. The Rs instead had a more complicated return, with income here and deductions or losses there. Granted, it might compress to no tax due, but they needed to file so one could follow how they got to that answer.

• The R’s reasonably relied on advice from their accountant and others.

The Court did not buy this either. For one thing, the Rs had never informed their accountant about the $414 grand in management fees. If one wants to rely on a professional’s advice, one must provide all available pertinent information to the professional. The Court was not amused that the R’s had not shared the LARGEST number on their return with their accountant.

• The R’s argued that they would experience “undue hardship” from paying the tax on its due date.

The R’s argued that their income died up when DC Solar was raided. Beyond that, though, they had not provided further information on what “drying up” meant. Without information about their assets, liabilities and remaining sources of income, the Court found the R’s argument to be self-serving.

Also, the Court did not ask – but I will – what the R's had done with the $700 grand in management fees they received in 2017 and 2018.

Yeah, no. The Court found for the IRS, penalties and all.

And here is what I am thinking:

What if they had timely filed their 2018 return, showing a loss from DC Solar equal to the management fees?

Problem: there was no K-1 from DC Solar.

Answer: attach the 8082.

I think the tax would eventually have turned out the same.

But I also think they would have had a persuasive case for abatement of penalties for late filing and late payment. The penalty for late file and pay is easily 25%, so that abatement is meaningful.

Our case this time was Rosselli v Commissioner, TC Bench Opinion, October 23, 2023.

Basis Basics

I am looking at a case involving a basis limitation.

Earlier today I accepted a meeting invite with a new (at least to me) client who may be the poster child for poor tax planning when it comes to basis.

Let’s talk about basis – more specifically, basis in a passthrough entity.

The classic passthrough entities are partnerships and S corporations. The “passthrough” modifier means that the entity (generally) does not pay its own tax. Rather it slices and dices its income, deductions and credits among its owners, and the owners include their slice in their own respective tax returns.

Make money and basis is an afterthought.

Lose money and basis becomes important.

Why?

Because you can deduct your share of passthrough losses only to the extent that you have basis in the passthrough.

How in the world can a passthrough have losses that you do not have basis in?

Easy: it borrows money.

The tax issue then becomes: can you count your share of the debt as additional basis?

And we have gotten to one of the mind-blowing areas of passthrough taxation.  Tax planners and advisors bent the rules so hard back in the days of old-fashioned tax shelters that we are still reeling from the effect.

Let’s start easy.

You and I form a partnership. We both put in $10 grand.

What is our basis?

                                     Me             You

         Cash                  10,000       10,000                  

 

The partnership buys an office condo for $500 grand. We put $20 grand down and take a mortgage for the rest.

What is our basis?

                                     Me             You

         Cash                  10,000       10,000                  

         Mortgage        240,000       240,000

                                250,000       250,000

So we can each have enough basis to deduct $250,000 of losses from this office condo. Hopefully that won’t be necessary. I would prefer to make a profit and just pay my tax, thank you.

Let’s change one thing.

Let’s make it an S corporation rather than partnership.

What is our basis?

                                     Me             You

         Cash               10,000        10,000                   

         Mortgage             -0-              -0-

                                10,000        10,000

Huh?

Welcome to tax law.

A partner in a general partnership gets to increase his/her basis by his/her allocable share of partnership debt. The rule can be different for LLC’s taxed as a partnership, but let’s not get out over our skis right now.       

When you and I are partners in a partnership, we get to add our share of the mortgage - $480,000 – to our basis.

S corporations tighten up that rule a lot. You and I get basis only for our direct loans to the S corporation. That mortgage is not a direct loan from us, so we do not get basis.

What does a tax planner do?

For one thing, he/she does not put an office condo in an S corporation if one expects it to throw off tax losses.

What if it has already happened?

I suppose you and I can throw cash into the S. I assure you my wife will not be happy with that sparkling tax planning gem.

I suppose we could refinance the mortgage in our own names rather than the corporate name.

That would be odd if you think about. We would have personal debt on a building we do not own personally.

Yeah, it is better not to go there.

The client meeting I mentioned earlier?

They took a partnership interest holding debt-laden real estate and put it inside an S corporation.

Problem: that debt doesn’t create basis to them in the S corporation. We have debt and no tax pop. Who advised this? Someone who should not work tax, I would say.

I am going to leverage our example to discuss what the Kohouts (our tax case this time) did that drew the Tax Court’s disapproval.               

Let’s go back to our S corporation. Let’s add a new fact: we owe someone $480,000. Mind you, you and I owe – not the S corporation. Whatever the transaction was, it has nothing to do with the S corporation.

We hatch the following plan.

We put in $240,000 each.

You: OK.

We then have the corporation pay the someone $480,000.

You: Hold up, won’t that reduce our basis when we cut the check?

Ahh, but we have the corporation call it a “loan” The corporation still has a $480,000 asset. Mind you, the asset is no longer cash. It is now a “loan.”  Wells Fargo and Fifth Third do it all the time.

You: Why would the corporation lend someone $480,000? Wells Fargo and Fifth Third are at least … well, banks.

You have to learn when to stop asking questions.

You: Are we going to have a delay between putting in the cash and paying - excuse me - “loaning” someone $480,000?

Nope. Same day, same time. Get it over with. Rip the band-aid.

You: Wouldn’t a Court have an issue with this if we get caught … errr … have the bad luck to get audited?

Segue to our court case.

In Kohout the Court considered a situation similar enough to our example. They dryly commented:

Courts evaluating a transaction for economic substance should exercise common sense …”

The Court said that all the money sloshing around could be construed as one economic transaction. As the money did not take even a breather in the S corporation, the Court refused to spot the Kohouts any increase in basis.

Our case this time was Kohout v Commissioner, T.C. Memo 2022-37.

Deducting “Tax Insurance” Premiums

 There is an insurance type that I have never worked with professionally: tax liability insurance.

It is what it sounds like: you are purchasing an insurance policy for unwanted tax liabilities.

It makes sense in the area of Fortune 500 mergers and acquisitions. Those deals are enormous, involving earth-shaking money and a potentially disastrous tax riptide if something goes awry. What if one the parties is undergoing a substantial and potentially expensive tax examination? What if the IRS refuses to provide advance guidance on the transaction? There is a key feature to this type of insurance: one is generally insuring a specific transaction or limited number of transactions. It is less common to insure an entire tax return.  

My practice, on the other hand, has involved entrepreneurial wealth – not institutional money - for almost my entire career. On occasion we have seen an entrepreneur take his/her company public, but that has been the exception. Tax liability insurance is not a common arrow in my quiver. For my clients, representation and warranty insurance can be sufficient for any mergers and acquisitions, especially if combined with an escrow.

Treasury has been concerned about these tax liability policies, and at one time thought of requiring their mandatory disclosure as “reportable” transactions. Treasury was understandably concerned about their use with tax shelter activities. The problem is that many routine and legitimate business transactions are also insured, and requiring mandatory disclosure could have a chilling effect on the pricing of the policies, if not their very existence. For those reasons Treasury never imposed mandatory disclosure.

I am looking at an IRS Chief Counsel Memorandum involving tax liability insurance.

What is a Memorandum?

Think of them as legal position papers for internal IRS use. They explain high-level IRS thinking on selected issues.

The IRS was looking at the deductibility by a partnership of tax insurance premiums. The partnership was insuring a charitable contribution.

I immediately considered this odd. Who insures a charitable contribution?

Except …

We have talked about a type of contribution that has gathered recent IRS attention: the conservation easement.

The conservation easement started-off with good intentions. Think of someone owning land on the outskirts of an ever-expanding city. Perhaps that person would like to see that land preserved – for their grandkids, great-grandkids and so on – and not bulldozed, paved and developed for the next interchangeable strip of gourmet hamburger or burrito restaurants. That person might donate development rights to a charitable organization which will outlive him and never permit such development. That right is referred to as an easement, and the transfer of the easement (if properly structured) generates a charitable tax deduction.

There are folks out there who have taken this idea and stretched it beyond recognition. Someone buys land in Tennessee for $10 million, donates a development and scenic easement and deducts $40 million as a charitable deduction. Promoters then ratcheted this strategy by forming partnerships, having the partners contribute $10 million to purchase land, and then allocating $40 million among them as a charitable deduction. The partners probably never even saw the land. Their sole interest was getting a four-for-one tax deduction.

The IRS considers many of these deals to be tax shelters.

I agree with the IRS.

Back to the Memorandum.

The IRS began its analysis with Section 162, which is the Code section for the vast majority of business deductions on a tax return. Section 162 allows a deduction for ordinary and necessary expenses directly connected with or pertaining to a taxpayer’s trade or business.

Lots of buzz words in there to trip one up.

You my recall that a partnership does not pay federal tax. Instead, its numbers are chopped up and allocated to the partners who pay tax on their personal returns.

To a tax nerd, that beggars the question of whether the Section 162 buzz words apply at the partnership level (as it does not pay federal tax) or the partner level (who do pay federal tax).

There is a tax case on this point (Brannen). The test is at the partnership level.

The IRS reasoned:

·      The tax insurance premiums must be related to the trade or business, tested at the partnership level.

·      The insurance reimburses for federal income tax.

·      Federal income tax itself is not deductible.

·      Deducting a premium for insurance on something which itself is not deductible does not make sense.

There was also an alternate (but related argument) which we will not go into here.

I follow the reasoning, but I am unpersuaded by it.

·      I see a partnership transaction: a contribution.

·      The partnership purchased a policy for possible consequences from that transaction.

·      That – to me - is the tie-in to the partnership’s trade or business.

·      The premium would be deductible under Section 162.

I would continue the reasoning further.

·      What if the partnership collected on the policy? Would the insurance proceeds be taxable or nontaxable?

o  I would say that if the premiums were deductible on the way out then the proceeds would be taxable on the way in.

o  The effect – if one collected – would be income far in excess of the deductible premium. There would be no further offset, as the federal tax paid with the insurance proceeds is not deductible.

o  Considering that premiums normally run 10 to 20 cents-on-the-dollar for this insurance, I anticipate that the net tax effect of actually collecting on a policy would have a discouraging impact on purchasing a policy in the first place.

The IRS however went in a different direction.

Which is why I am thinking that – albeit uncommented on in the Memorandum – the IRS was reviewing a conservation easement that had reached too far. The IRS was hammering because it has lost patience with these transactions.

Faxing A Return To The IRS

We recently prepared a couple of back California tax returns for a client.

The client had an accounting person who lived in California – at least on-and-off -for part of one year. The client itself is located in Tennessee and had little to do with California other than perhaps shipping product into the state. It is long-standing tax doctrine that having an employee in a state can subject a company to that state’s income tax, so I agreed that the client had to file for one year.

The second year was triggered by a one-off Form 1099 issued by someone in Los Angeles. The dollar amount was inconsequential, and I am still at a loss how California obtained this 1099 and why they burned the energy to trace it back to Tennessee. I am not convinced the client sold anything into California that second year. One could sell into Texas, for example, but have the check issued by corporate in Los Angeles.

The client did not care about the details. Just get California off their back.

California requested that we fax the returns to a unit rather than sending them through the regular system

And therein can exist a tax trap.

Let’s talk about it.

Seaview Trading LLC got itself into Tax Court for transacting in a tax shelter. The tax-gentle term is “listed transaction,” but you and I would just call it a shelter. At issue was a $35 million tax deduction, so we are talking big bucks.

The transaction happened in 2001.  The examination started in 2005. On July 27, 2005 the IRS sent Seaview a letter stating that it had never received its 2001 return.

Oh, oh.

This was a partnership, and for the year we are talking about there existed rather arcane audit rules. We will not need to get into the weeds about these rules, other than to say that failing to file a return was bad news for Seaview.

In 2005 Seaview’s accountant faxed a copy of the 2001 tax return to the IRS agent, stating that the return had been timely filed and that Seaview was providing a copy of what it had filed in 2002. He also included a certified mail receipt for the return.

The IRS maintained its position that it had never received the 2001 return. In 2010 the IRS issued its $35 million disallowance.

Fast forward to the Tax Court.

$35 million will do that.

The Court decided to review the case in two steps:

(1)  Did faxing the return to the agent in 2005 constitute “filing” the return?

(2)  If not, does the certified mail receipt constitute evidence of timely filing?

Personally, I would have reversed the order, as I consider certified mailing to be presumptive evidence of timely filing. That is why accountants recommend certified mail. It is less of an issue these days with electronic filing, but every now and then one may decide – or be required – to paper file. In that situation I would still recommend that one use certified mail.

The Court held that faxing the return to the agent did not constitute the filing of a return.

The tax literature observed and commented that faxing does not equal filing.

But there is a subtlety here: Seaview’s accountant indicated that he was supplying the agent a copy of a timely-filed 2001 return. By calling it a copy, the accountant was saying – at least indirectly – that the agent did not need to submit the return for regular processing. That said, it would be unfair for Seaview to later reverse course and argue that it intended for the agent to submit the return for processing.

The IRS won this round.

Now they go to round two: does the certified mail receipt provide Seaview with presumptive proof of timely mailing?

Seaview presents issues that we do not have with our client. We are not playing with listed transactions or obscure audit rules. California just wants its $800 minimum fee for a couple of years. They do not really care if our client actually owes. They want money.

Our administrative staff tried to fax the returns this past Friday but had problems with the fax number. I called the unit in California to explain the issue and discuss alternatives, but I never got to speak with an actual human being. I will try again (at least briefly; I have other things to do) on Monday. If California blows me off again, we will mail the returns.

I fear however that mailing the returns to general processing will cause issues, as the unit will probably issue some apocalyptic deathnote before gen pop routes the returns back to them. We will mail the returns to the specific unit and cross our fingers that not everyone there is “busy serving other customers.”

How I wish I had one of those jobs.

BTW, you can bet we will certify the mail.

What’s Fair Got To Do With It?

I am reading a tax case with an unfortunate result.

It does not seem that difficult to me to have planned for a better outcome.

I have to wonder: why didn’t they?

Let’s set it up.

We have a law firm in New York. There is a “heavy” partner and the other partners, which we will call “everybody else.” The firm faced hard times, and “everyone else” kept-up their bleed rate (the rate at which they withdraw cash), with the result that their capital accounts went negative.

COMMENT: A capital account is increased by the partner’s share of the income and reduced by cash withdrawn by said partner. When income goes down but the cash withdrawn does not, the capital account can (and eventually will) go negative. 

Let’s return to our heavy partner.

He was concerned about the viability of the firm. He was further concerned that New York law imposed on him a fiduciary responsibility to assure that the firm be able to pay its bills. I applaud his sense of responsibility, but I have to point out that any increased uncertainty over the firm’s capacity to pay its bills might have something to do with “everybody else” taking out too much cash.

Just sayin’.

Our partner’s share of firm income was almost $500 grand.

Problem is that the cash did not follow the income. His “share” of the income may have been $500 grand, but he left around $400 grand in the firm to make-up for the slack of his partners.

And you have one of those things about partnership taxation:   

·      The allocation of income does not have to follow the allocation of cash.

There are limits to how far one can push this, of course.

Sometimes the effect is beneficial to the partner:

·      A partner tales out more cash than his/her share of the income because the partnership owns something with big-time depreciation. Depreciation is a non-cash expense, so it doesn’t affect his/her distribution of cash.

Sometimes the effect is deleterious to the partner:

·      Our guy took out considerably less cash than the $500K income.

Our guy did not draw enough cash to even pay the taxes on his share of the income.

OBSERVATION: That’s cra-cra.

What did he do?

He reported $75K of income on his tax return. Seeing how did not receive the cash, he thought the reduction was “fair.”

Remember: his partnership K-1 reported almost half a million.

The number on his personal return did not match what the partnership reported.

COMMENT: By the way, there is yet one more form to your tax return when you do not use a number reported by a partnership. The IRS wants to know. He might as well just have booked the audit.

Sure enough, the IRS sent him a notice for over $140,000 tax and $28,000 in penalties.

Off to Tax Court they went.

And he had … absolutely … no … chance.

Partnerships have incredibly flexible tax law. There is a reason why the notorious tax shelters of days past were structured around partnerships. One could send income here, losses there, money somewhere else and muddy the waters so much that you could not see the bottom.

In response, Congress and the IRS tightened up, then tightened some more. This area is now one of the most horrifying, unintelligible stretches in the tax Code.  It can – with little exaggeration – be said that all the practitioners who truly understand partnership tax law can fit into your family room.

Back to our guy.

The Court did not have to decide about New York law and fiduciary responsibility to one’s law firm or any of that. It just looked at tax law and said:

Your income did not match your cash. You set this scheme up, and – if you did not like it – you could have changed it. Once decided, however, live with your decision.

Those are my words, by the way, and not a quote.

Our law partner owed the tax and penalties.

Ouch and ouch.

I must point out, however, that the law firm’s tax advisors warned our guy that his “fiduciary” theory carried no water and would be disregarded by the IRS, but he decided to proceed nonetheless. He brought much of this upon himself.

What would I have recommended?

For goodness’ sake, people, change the partnership agreement so that the “everybody else” partners reported more income and our guy reported less. It is fairly common in more complex partnerships to “tier” (think steps in a ladder or the cascade of a fountain) the distribution of income, with cash being the second – if not the first – step in the ladder. The IRS is familiar with this structure and less likely to challenge it, as the movement of income would make sense.

Another option of course would be to close down the law firm and allow “everybody else” to fend for themselves.

I would argue that my recommendation is less harsh.

When A Tax Shelter Blows Up

Can you image losing a tax case with the IRS and owing a billion dollars?

Who did this? We are talking about Dow Chemical Company (“Dow”). They lost in the District Court for the Middle District of Louisiana. I suppose they have no choice but to appeal. It is a billion dollars, after all.

What got them in this mess? 

A couple of tax shelters, one marketed by Goldman Sachs and both implemented by the law firm of King & Spalding. The IRS sued for tax years 1993 to 2003. 

Let’s talk about the first of the shelters – called a SLIP – which lasted from 1993 to 1997. Dow was not the only one that tried to SLIP the IRS. Merck and International Paper tried also.

SLIP stands for “Special Limited Investment Partnership.”  Its claim to fame was taking low-basis assets and turning them into tax deductions.  How would you do this? Well you could contribute them to a partnership, but that low basis would carryover. You would get no increased tax deduction by putting it a partnership.

Hmmm.

What if you put low-basis assets into a partnership and then leased them back?  Wait, the partnership would then have taxable income. Who would own the partnership? If you owned it, then the whole effort would be circular. 

What if there are other partners? Problem: you do not want other partners. 

What if you limit the other partners to a fixed return? It would be the same as paying interest to a bank, right? In partnership taxation we call this a priority or preference distribution. 

Problem: most of that income would be coming back to you. How can we solve this puzzle?

We delink the income distribution from the cash distribution. We bring in partners who will accept 6 or 7 percent priority, and we allocate virtually all the income to them.

Now why would someone agree to this?

If someone doesn’t pay U.S. tax, that’s why. Someone like a foreign bank.

Eureka!

You offer a foreign bank the deal, now referred to as a “structured financial transaction.” This means that it is complicated, and you will be paying top dollar for investment, legal and accounting advice. You explain to the bank that it would:

·        Receive a significant premium over a corporate bond

·        Take on less credit risk than a corporate bond

·        Escape any U.S. tax

Sure enough, Dow and Goldman Sachs rounded up five foreign banks willing to contribute $200 million. Dow set up a maze of subsidiaries, into which it dumped 73 patents. The interesting fact about these patents is that Dow had amortized them virtually to zero, Dow still used them in current operations and retained enough of the processes to make it unlikely anyone would want to buy the patents, though.  The patents appraised at $867 million.

One of those Dow subs contributed the patents into a partnership called Chemtech I, taking back an 81 percent ownership.

Dow paid Chemtech I around $143 million for use of the patents.

Chemtech I paid the foreign banks 7 percent as their priority return. Since the banks had invested $200 million, this was a cool $14 million in their pockets. Chemtech I paid a couple of other things, took the remaining cash and put in a subsidiary. That subsidiary loaned the money back to Dow. How much cash did it loan back, you ask? About $136 million. For one year.

On its tax return Chemtech I reported approximately $122 million in income. It allocated $115 million of that to the banks. Only $28 million in income went back to Dow itself.

What we have just talked about is known in tax lingo as a “strip.”

And there is the SLIP. All Dow did was move money around. It paid the foreign banks $14 million in interest but called it a priority, thereby dragging over $115 million of income with it. As the banks did not pay U.S. tax, they did not care. Dow however did.

In 1997 there was a change in U.S. tax law, and Dow had to switch to another tax strategy. Dow wanted to cash out the banks and start something else.

The banks wanted their share of the market value of those patents on the way out. Seems fair, as they were “partners” and all. Dow said “no way”. The partnership agreement stipulated how the patents were to be valued and how to calculate the banks’ share. Dow paid the banks approximately $8 million. The banks complained, but to no avail. Dow controlled the calculation of value.

Once the banks were out of the way, Dow created a second tax shelter using a fully-depreciated chemical plant in Louisiana. This strategy did not require banks, but it did employ a very clever maneuver to pump-up the basis of the plant, thereby creating depreciation deductions that Dow could use to offset real income from other sources.

Oh, there was a formidable tax issue that Dow resolved by ripping up a piece of paper and replacing it with another.

OBSERVATION: And there you see the IRS’ frustration: Dow is not dealing with independent parties. In Chemtech I, it was dealing with banks acting as banks. Dow called them partners, but it may as well have called them peanut –butter sandwiches for the difference it made. In the second deal (called Chemtech II), Dow did not even leave the ranch. It replaced a deal between its subsidiaries with another deal between its subsidiaries. Really?  No wonder the IRS was hot around the ears.

So the IRS gets into Dow’s tax returns. In 2005 it issued a Notice of Final Partnership Administrative Adjustment for tax years 1993 and 1994. Dow responds that the IRS did not give the notice to the properly designated person – the Tax Matters Partner – and the notice was therefore invalid.

OBSERVATION: The tax matters partner rule is to protect both the partnership and the IRS. It means something when you have big partnerships with hundreds if not thousands of partners. Dow however was setting up partnerships like they were jellybeans. I find it cheeky – to be polite – that Dow’s defense was “you sent the mail to the wrong cubicle.”

This thing goes back and forth like a tennis match. In the end, a court has to decide. The IRS had scooped up additional years – through 2003 – by the time this was resolved.

How would the IRS attack the shelters?

There are a couple of ways. The first is the “economic substance” doctrine. Think of it as the tax equivalent of “where’s the beef?” The court looks at the transactions and determines if there is any reality to what supposedly is going on. There are three prongs to this test:

(1) Does the transaction have economic substance compelled by business or regulatory realties;

(2) Does the transaction have tax-independent considerations; and

(3)  Is the transaction not designed in toto with tax avoidance intent?

The Court looks at the SLIPS and observes the obvious:

(1) The SLIPs did not change Dow’s financial position in any way. Chemtech I could not have licensed those patents to a third party if it wanted to, as it did not own all the rights. This means that Chemtech I could not produce independent revenue. That is a problem.

(2) The cash flow was circular. The little bit that left (to the banks) was the equivalent of interest. Big problem.

(3) Dow argued that it was preserving its credit rating and borrowing power, but it could not prove any increase in its credit rating or borrowing power. Dow also stumbled explaining why it structured the transaction this way rather than another way – like having domestic banks in Chemtech I.

The second way the IRS attacked was by arguing the partnership was a sham. This argument is slightly different from “economic substance,” as that argument looks at transactions. The sham partnership argument looks at the partnership itself and asks: is this a real partnership?

The Court notes the following:

·        The banks got a priority of 7%.

·        The only room left for the banks to profit was if the patents went up in value. The banks were only allocated 1% of that number, and Dow controlled how to calculate the number.

·        When the banks complained about their lousy 1%, a Dow executive called them “greedy.”

OBSERVATION: It was clear the Court was not impressed with this executive’s comment.

·        It was virtually impossible for the banks to lose money.

·        The one risk to the banks – IRS challenge – was indemnified by Dow.

The Court observed that true partners have the risk of loss and the hope of gain. The banks had virtually no risk of loss and sharply limited room for gain. There may have been a banking relationship, but there was no more a partnership here than in a Kardashian marriage.

The Court said the shelters were bogus and Dow owed the tax.

And a 20 percent penalty to boot.

MY TAKE:  Those who know me, or who follow this blog, know that I generally side with the taxpayer. After all, it is the taxpayer who sets an alarm clock, takes on a mortgage or builds a website that actually works, whereas the government is little more than weight in the trunk.

Still, at least pretend that there is some business reason for all the tax fireworks that are going off.

This court opinion is 74 pages long. While I am somewhat impressed with the tax wizardry that Dow brought to bear, I must admit that I am reading tax planning for its own sake. That may groove someone like me, but that is not enough to pass muster. There has to be a business purpose for moving all the pieces around the board, otherwise the IRS can challenge your best-laid plans.

The IRS challenged Dow. 

Dow lost.