Distressed asset trust DAT tax problem

Distressed asset trust transactions identified as listed transactions

Mike Habib, EA

In a Notice, the IRS has identified a distressed asset trust (DAT) transaction as a listed transaction under Reg. § 1.6011-4(b)(2), Code Sec. 6111 and Code Sec. 6112. In such a transaction, a tax-indifferent party contributes one or more distressed assets with a high basis and low fair market value to a trust or series of trusts and sub-trusts, and a U.S. taxpayer acquires an interest in the trust for the purpose of shifting a built-in loss from the tax-indifferent party to the U.S. taxpayer that has not incurred the economic loss.

Background. Under Code Sec. 6011 and its regs, taxpayers must disclose their participation in reportable, tax-shelter-type transactions by attaching an information statement to their income tax returns. Under Code Sec. 6111, material advisors must disclose reportable transactions (e.g., identify and describe them and the claimed tax benefits) and under Code Sec. 6112, material advisors must prepare and maintain lists for reportable transactions (e.g., identifying each person with respect to whom the advisor acted as a material advisor for the transactions).

A listed transaction is a reportable transaction which is the same as, or substantially similar to, a transaction specifically identified by IRS as a tax avoidance transaction for Code Sec. 6011 purposes. (Code Sec. 6707A(c))

Fact pattern. IRS has learned that a variation of the distressed asset transaction using a trust is being promoted in an attempt to avoid recent law changes that prevent taxpayers from shifting a built-in loss from a tax indifferent party to a U.S. taxpayer through the use of a partnership. In the DAT transaction, a tax indifferent party creates a trust (Main-Trust) with trustee X. The tax indifferent party contributes distressed assets directly or indirectly (through a partnership or otherwise) to Main-Trust, and is described as the grantor and beneficiary of Main-Trust. A U.S. taxpayer (Taxpayer) transfers cash or a note (approximately equaling the fair market value of the distressed asset) to Main-Trust in exchange for certificates evidencing units of beneficial interest in Main-Trust. As a result, under the terms of the Main-Trust agreement, Taxpayer becomes a beneficiary of Main-Trust.

The parties contend that Main-Trust is a trust for tax purposes, taxable as a trust and not as a business entity. As a result, the parties contend that under Code Sec. 1015(b), Main-Trust’s basis in the distressed assets is the same as the grantor’s basis in the distressed assets (in this case, the tax indifferent party’s basis).

As allowed under the Main-Trust agreement, the trustee creates a separate sub-trust (Sub-Trust), transfers certificates evidencing units of beneficial interest in Sub-Trust (Sub-Trust Certificates) to Taxpayer, and allocates the distressed assets to Sub-Trust for the sole benefit of the beneficiary of the Sub-Trust. The Main-Trust agreement entitles the holder of Sub-Trust Certificates to various rights including the right to direct the trustee to vest the holder’s ratable share of the corpus or the income of Sub-Trust in the holder.

The Taxpayer contends that these rights causes the Taxpayer to be considered the owner of Sub-Trust under Code Sec. 678, and that Sub-Trust is a grantor trust. As a result, the Taxpayer takes into account those items of income, deductions, and credits against tax, which are attributable to Sub-Trust, to the extent that the items would be taken into account in computing taxable income or credits against the tax of an individual. The Taxpayer further contends that Sub-Trust’s basis in the distressed assets is the same as the grantor’s basis in the distressed assets (in this case Main-Trust’s basis). Within a short period of time, the distressed assets held by the Sub-Trust are written off as wholly worthless under Code Sec. 166, or alternatively, they are sold, and Taxpayer claims a deduction under Code Sec. 165.

DATs are targeted. Notice 2008-34 alerts taxpayers and their representatives that the DAT transaction is a tax avoidance transaction and identifies it, and substantially similar transactions, as listed transactions for purposes of Reg. § 1.6011-4(b)(2), Code Sec. 6111 and Code Sec. 6112 .

IRS says that the transaction in Notice 2008-34 attempts to shift built-in losses from a tax indifferent party to a U.S. taxpayer who has not incurred an economic loss so that the U.S. taxpayer may claim a deduction of the built-in losses from the distressed assets. The built-in loss purportedly transferred to Main-Trust and Sub-Trust and improperly shifted to the Taxpayer isn’t an allowable loss for the Taxpayer. IRS may attack the DAT on a number of grounds, including asserting that:

o the Taxpayer’s transfer of cash or a note to Main-Trust in exchange for certificates of beneficial interest is a transfer of the distressed assets under Code Sec. 1001;
o Main-Trust doesn’t meet the trust requirements of Reg. § 301.7701-4;
o Main-Trust is not a taxable trust;
o one or more of the entities is properly classified for Federal tax purposes as a partnership;
o the claimed loss deduction under Code Sec. 165 wasn’t incurred in a transaction undertaken for profit;
o the judicial doctrines, including substance over form, lack of economic substance, and step transaction apply; and
o the distressed debt was worthless under Code Sec. 166 at the time of contribution to Main-Trust and Sub-Trust.

Notice 2008-34 also provides that persons required to:

o disclose these transactions under Reg. § 1.6011-4 but fail to do so may be subject to the penalty under Code Sec. 6707A , which applies to returns and statements due after Oct. 22, 2004;
o disclose these transactions under Reg. § 1.6011-4, but fail to do so may be subject to an extended period of limitations under Code Sec. 6501(c)(10);
o disclose or register these transactions under Code Sec. 6111, but fail to do so may be subject to the penalty under Code Sec. 6707(a);
o maintain lists of investors under Code Sec. 6112, but fail to do so (or fail to provide such lists when requested by IRS) may be subject to the penalty under Code Sec. 6708(a).

IRS says it may also impose penalties on persons involved in these transactions or substantially similar transactions, including the accuracy-related penalty under Code Sec. 6662 or Code Sec. 6662A.

In addition, tax-exempt entities (under Code Sec. 4965(c)) or an entity manager (under Code Sec. 4965(d)) may be subject to excise tax, disclosure, filing or payment obligations under Code Sec. 4965, Code Sec. 6033(a)(2), Code Sec. 6011, and Code Sec. 6071. Some taxable entities may be subject to disclosure obligations under Code Sec. 6011(g) , that apply to prohibited tax shelter transactions (under Code Sec. 4965(e)), including listed transactions.

IRS recognizes that some taxpayers may have filed tax returns taking the position that they were entitled to the purported tax benefits described in Notice 2008-34. It advises these taxpayers to ensure that their transactions are disclosed properly and to take appropriate corrective action.

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