Beware the inadvertent tax shelter.

• Author: Bortnick, Steven D.

Congress and the Internal Revenue Service continue to view tax shelters with a high level of scrutiny, with Congress enacting legislation and the IRS promulgating rules designed to limit the ability of taxpayers to take certain tax positions. One of the weapons in the IRS's arsenal is its ability to identify certain transactions as "listed transactions." Once a transaction is identified as a listed transaction, certain rules applicable to tax shelters come into play, and the failure to comply

with these rules can subject the participants and their advisers to very substantial penalties.

Why should tax practitioners care about this? Because earlier this year, the IRS issued a notice that may cause many business buyers and sellers to fall inadvertently within these broadened tax shelter rules. Thus, taxpayers could be subject to severe monetary penalties with regard to typical, non-tax driven, transactions as a result of events about which they were not aware. This article addresses the IRS notice, as well as the recent U.S. district court decision in Enbridge Energy Co. v. United States, (1) which deals with the tax strategy the IRS notice attempts to thwart.

IRS Guidance

"Intermediary transaction tax shelters" are transactions structured to avoid the corporate income tax with respect to gain on the sale of assets. In Notice 2001-16, (2) the IRS identified these as listed transactions. Notice 2001-16 applies to two types of transactions, as well as transactions "substantially similar" to those explicitly covered:

* An intermediary (which is a corporation with net operating loss carryovers (NOLs) or other tax benefits) purchases another corporation's stock and, in turn, sells some or all of the acquired corporation's assets to a buyer. The buyer claims a stepped-up basis in the assets equal to the buyer's purchase price, and the affiliated group, of which the intermediary and acquired corporation are members, files a consolidated return that uses the losses of the intermediary to offset the gain from the sale of the assets; or

* The intermediary is a tax indifferent entity (such as a tax-exempt corporation) that purchases a corporation's stock, then liquidates (in a tax-free liquidation) the acquired corporation and sells the assets. This results in no reported gain on the sale of the assets.

If respected, both transactions avoid ordinary income taxes on the sale of the corporation's assets. The transactions are structured as stock sales as to the seller so that the seller only pays tax on the capital gains from the sale of the corporation's stock; and as asset sales as to the ultimate buyer (i.e., the entity that buys from the intermediary) so that the buyer takes a step up in basis on the assets.

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Earlier this year, the IRS ruled that, depending on the facts, Notice 2001-16 can be either too broad or too narrow. Notice 2008203 identifies those transactions that will be treated as intermediary transaction tax shelters. Under the notice, a transaction will be viewed offside if it involves the following four components:

* A corporation owns assets that, if sold, would result in taxable gain and, at the time of the stock sale (described below), the corporation has insufficient tax benefits to offset the gain in whole or in part.

* At least 50 percent of the stock of the corporation is disposed of by the shareholders in one or more related transactions within a 12-month period.

* All or most of the corporation's assets are sold to one or more buyers in one...