New regs. on contested liability trusts.

• Author: Auclair, David

In November 2003, Sec. 461(f) temporary and proposed regulations (TD 9095; REG-136890-02) were issued to clarify the rules for accelerating a deduction via use of a contested liability trust. The regulations clarify the types of transfers that do not qualify for an accelerated deduction, as well as the kinds of liabilities that may be satisfied using a contested liability trust. Most of the new rules apply retroactively. The IRS also issued Notice 2003-77 to identify as listed transactions under the tax shelter rules, certain transactions involving transfers to a trust purportedly established under Sec. 461(f).

Background

In Consolidated Edison Co., 366 US 380 (1961), the Supreme Court held that a taxpayer could not deduct payments made for a contested amount until the year the contest was settled or terminated. In 1964, Congress enacted Sec. 461(f) to overturn this ruling. Sec. 461(f) provides an exception to the general rule disallowing a deduction for a contested liability. A taxpayer may claim a deduction for a contested liability in the taxable year of the transfer if all of the following requirements are met:

1. The taxpayer contests an asserted liability;

2. The taxpayer transfers money or other property to provide for the satisfaction of the asserted liability;

3. The contest with respect to the asserted liability exists after the time of the transfer; and

4. But for the fact that the asserted liability is contested, a deduction would be allowed for the tax year of the transfer (or for an earlier tax year), determined after application of the Sec. 461(f) economic performance rules.

   While Regs. Sec. 1.461-2(c)(1) provided that a transfer to a trust or escrow could qualify under the rules, the following three types of actions did not qualify as a transfer for the satisfaction of an asserted liability: (1) purchasing a bond to guarantee payment of the asserted liability; (2) an entry on the taxpayer's books of account; and (3) a transfer to an account in the taxpayer's control. However, the regulations were silent on whether transfers of certain types of other property (such as the taxpayer's stock or related party stock or debt), would meet Sec. 461(f). Further, Regs. Sec. 1.461-2(a) (5) "reserved" guidance on liabilities for which payment is economic performance under Regs. Sec. 1.461-4(g), leading some tax advisers to conclude that transfers to trusts might meet Sec. 461 (f)'s requirements.

   The temporary and proposed regulations address...