A Brief Follow-Up On The Stock Loss Economic Substance Case: Future Deductions Versus Tax Basis and Loss Duplication Versus Acceleration
August 23, 2013
by Monte A. Jackel
Yesterday, I wrote about the WFC Holdings case where the Eighth Circuit Court of Appeals held that the economic substance doctrine was violated when underwater leases and other assets were transferred to a corporation in exchange for preferred stock which the taxpayer promptly sold for a very large claimed loss. Both the District Court and the Court of Appeals held that the loss was a sham and was not allowed under the common law economic substance and sham transaction doctrines.
At its core, the transaction was designed to create a large tax basis in the preferred stock of the corporation because, it was claimed, the future deductions are not a “tax liability” under the rules of sections 357 and 358. This issue is quite similar to the partnership transaction which is now dealt with under Treasury regulation sections 1.752-6 and 1.752-7. The latter regulations arose out of section 358(h), which was enacted in 2000 effective back to October 18, 1999. As I mentioned yesterday, WFC’s transaction predated section 358(h). Otherwise, there would have been no loss in the stock to sell.
A friend of mine asked me whether I thought this was loss acceleration or loss duplication. It appears clear to me that this is loss duplication because the stock basis remains high and the corporate entity retains the future deductions. That is, if the transaction had worked. Thus, this seems to be a classic loss duplication case.
A couple of follow-up points to my post of yesterday:
1. The “future deductions” are not technically a “tax loss” although some in the partnership tax bar have asserted that future deductions are in fact the same as tax basis. Proposed reg. section 1.362-4, dealing with section 362(e) and the importation of built-in losses, only treats property as having a “net built-in loss” if the aggregate adjusted basis exceeds the aggregate fair market value. There is no mention in either the proposed regulations or its preamble attempting to equate future deductions with tax basis.
2. As already mentioned, the case pre-dated section 358(h) and, even if future deductions were indeed tax basis, the case predated section 362(e) as well (October 22, 2004).
3. T.D. 9207, May 23, 2005, dealing with reg. section 1.752-7, the partnership analogue to the transaction in WFC, if you want to call it that, stated in the preamble in terms of equating a future tax deduction with tax basis:
“It is possible to view the contribution of property with an adjusted tax basis equal to the fair market value of the property, determined without regard to any § 1.752-7 liabilities, as “built-in loss” property after the § 1.752-7 liability is taken into account in those cases where the § 1.752-7 liability is related to the contributed property. Although a partnership’s assumption of a § 1.752-7 liability as part of the contribution of property to the partnership can be analogized to a property with an adjusted tax basis greater than fair market value, the purposes of section 704(c)(1)(C) and § 1.752-7 are different in certain respects. Section 704(c)(1)(C) and the other changes in section 833 of the Act are directed toward loss duplication whereas § 1.752-7 is directed at both loss duplication and loss acceleration. Therefore, to the extent of any built-in-loss attributable to a § 1.752-7 liability, § 1.752-7 shall be applied without regard to the amendments made by the Act, unless future guidance provides to the contrary. Any such guidance would be prospective in application.”
4. Thus, based on the above statement, it looks like Treasury would view the case at issue as a loss duplication case and not just loss acceleration.
5. It will be interesting to see if, when the Passthrough folks at Chief Counsel work on the guidance relating to section 743 and contingent liabilities as that issue is on the next IRS and Treasury business plan, it will also perform surgery on prop. reg. section 1.362-4 and related corporate guidance and attempt to treat the term “adjusted basis” in section 362(e) as equating to future tax deductions and abandon section 358(h). The same question would arise with respect to the treatment of assumed liabilities under reg. section 1.752-7 and the possibility left open by the preamble to the final regulations there that the approach of the regulations not treating future deductions as tax basis could change. The question here is whether the government will be able to distinguish the treatment of future deductions as not equating to tax basis under section 358(h) and its partnership companion but still treat future deductions as tax basis in computing a partnership’s inside tax basis in its assets under reg. section 1.743-1(d).
Since the only real guidance under section 358(h) deals with partnerships (meaning with the sole exception of a regulation relating to the transfer by a partnership to a corporation there is no other section 358(h) corporate guidance out there), perhaps it is not too late to change the approach under subchapter C as well as subchapter K. Time will tell.