Insight Center: Publications

Beware the Inadvertent Tax Shelter

Tax Update

Author: Steven D. Bortnick


Congress and the IRS continue to view tax shelters with a high level of scrutiny, and to enact legislation and 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/or their advisors to very substantial penalties. So why do you care about this? Because earlier this year, the IRS issued a notice that may cause many business buyers/sellers to inadvertently come within these tax shelter rules. Taxpayers could be subject to severe monetary penalties with regard to typical, non-tax driven, transactions as a result of events about which they may not even have been aware. This article addresses the IRS notice, as well as the Enbridge Energy Co.1 case, which deals with the tax strategy the IRS notice attempts to thwart.

IRS Notices

“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, the IRS identified these as listed transactions. Notice 2001-16 gives two examples of this type of transaction:

  1. 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
  2. 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 the basis of the assets.

Earlier this year, the IRS indicated that, depending on the facts, Notice 2001-16 can be either too broad or too narrow. The IRS released Notice 2008-20 to identify those transactions that will be treated as intermediary transaction tax shelters. Under Notice 2008-20, a transaction will be so viewed if it involves each of the following four components:

  1. 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.
  2. 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.
  3. All or most of the corporation’s assets are sold to one or more buyers in one or more transactions either 12 months before, at the same time, or 12 months after the 50 percent stock disposition.
  4. All or most of the corporation’s taxable gain resulting from the sale of its assets is offset, avoided or not paid.

The broad scope of this notice poses a serious risk of inadvertent participation in a tax shelter for both sellers and buyers. For example, assume that a majority shareholder sells stock in a corporation to an entity (the “buyer”) who, unbeknownst to the seller, has substantial NOLs. Within 12 months of the stock sale, in a wholly unrelated transaction, the buyer turns around and sells the corporation’s assets. Assuming that the buyer’s NOLs are sufficient to offset most of the gain on the asset sale, the four components under Notice 2008-20 will be satisfied and the seller may now be subject to significant penalties for failing to notify the IRS of the transaction.

A buyer is at comparable risk when engaged in a direct purchase of a corporation’s assets. For example, assume that the purchaser of assets is unaware that the seller itself was acquired by a corporation with NOLs, or that the seller is the successor of the assets following a stock sale 12 months prior. If the seller avoids tax on most of the tax that would be owed from an asset sale (with respect to gain existing at the time of the stock sale), the buyer is sucked into the tax shelter rules as a result of prior transactions and circumstances of which it may reasonably be unaware.

Many aspects of Notice 2008-20 place both the seller and buyer in extremely precarious positions:

  • A transaction need not even contemplate an “intermediary” in order for it to be considered an intermediary tax shelter. It is enough for a buyer to purchase a corporation’s stock and turn around within 12 months to sell the corporation’s assets.
  • No “bad faith” or tax avoidance motive is necessary to fall within the scope of the Notice.
  • There is no de minimus rule regarding the tax avoided; the threshold is that “most” of the taxable gain be offset or avoided. There also is no guidance as to how to deal with post acquisition appreciation in the assets (i.e., are tax benefits deemed to offset pre-acquisition gain or post-acquisition gain).
  • There is no de minimus rule regarding the sale of the corporation’s assets; again, the requirement is that “most” of the assets be sold.
  • No safe harbor is provided; this is significant given the vast reach the IRS has over “substantially similar” transactions to the listed transaction rules.

Tax Shelter Disclosure Requirements and Penalties

The potential penalties involved here are severe. Failure to disclose the listed transaction, or a substantially similar transaction, on a return or statement will result in a penalty of $200,000. Each “material advisor” (i.e., any person who materially aids or advises on, inter alia, the promotion, organization, or implementation of such transaction, where such person directly or indirectly derives a threshold amount of gross income) to the listed transaction is required to disclose a description of the transaction, including any potential tax benefits that are expected to result. Failure to do so, including filing an incomplete disclosure regarding the transaction, results in a penalty equal to the greater of: $200,000 or 50 percent of the gross income derived by the advisor. The penalty may be increased to 75 percent of the gross income derived if the failure to comply is intentional.

In addition, a material advisor must maintain a list identifying any person the advisor materially advised concerning the reportable transaction. If the advisor does not provide the list within 20 days as requested by the IRS, the advisor is subject to a $10,000 per day penalty.

Protecting Yourself

A seller of stock or purchaser of assets should obtain representations as to facts that lead to the conclusion that the transaction is not part of an intermediary transaction tax shelter, as well as a covenant to notify the party of any stock or asset disposition within 12 months so that the parties may comply with the disclosure requirements and reporting obligations. The transaction agreement should contain an indemnification provision to protect the parties for failure to notify.

IRS Response to Criticism

Recently, the IRS acknowledged that Notice 2008-20 has a broad reach that results in unintended consequences. The Service intends to issue guidance to clarify Notice 2008-20 within the next several weeks. This clarification will hopefully delineate the type of transactions the IRS seeks to prevent so that the Notice no longer catches transactions that are not tax motivated.

Enbridge Energy Co. v. United States

This past March, in Enbridge Energy Co., Inc. v. United States, the U.S. District Court for the Southern District of Texas granted summary judgment in favor of the government after concluding that the substance of an asset purchase in 1999 by Enbridge, doing business at the time as Midcoast Energy Resources (Midcoast), was a transaction structured to include a third-party intermediary for tax avoidance purposes. The court focused on the substance of the transaction in order to determine its legitimacy, and denied Midcoast (the buyer in the transaction) fair market value basis in the assets purchased and imposed penalties for understatement of income tax.

Bishop Group, Ltd. wanted to sell its stock rather than its assets so that any taxable gain on the assets could be avoided. Midcoast was only interested in purchasing Bishop’s assets. At the advice of Bishop’s tax advisors, PriceWaterhouseCoopers, an intermediary, K-Pipe Holdings, was introduced in order to facilitate an agreement between Bishop and Midcoast. K-Pipe purchased Bishop’s stock for approximately $123 million, merged downstream into Bishop and immediately sold the assets to Midcoast for approximately $6 million more than the amount it paid for the stock. K-Pipe’s parent contributed high basis, low value assets to K-Pipe. These assets were sold and the loss was used to offset gain on the sale of Bishop’s assets. The intent was to allow Bishop to avoid a tax liability on any sale of its assets and enable Midcoast to take a stepped up basis in Bishop’s assets. In its holding, the court reasoned that:

  • K-Pipe’s sole purpose in the transaction was to allow a basis step up to Midcoast. Therefore, K-Pipe was a mere conduit for the real transaction at issue.
  • K-Pipe’s parent company contributed high basis, low fair market value assets to K-Pipe in order for K-Pipe to offset the gain resulting from the asset sale.
  • K-Pipe bore no independent business risk because Midcoast secured the loans K-Pipe incurred to purchase the Bishop stock and, through various side agreements, agreed to indemnify K-Pipe for its obligations in connection with the stock purchase.
  • K-Pipe engaged in virtually no business activity subsequent to this transaction and was later acquired.

Accordingly, the transaction was recast as (1) a purchase of stock by Midcoast, followed by (2) a tax-free liquidation of Bishop (giving Midcoast a carryover basis in Bishop’s assets), and (3) a sale of assets by Midcoast at a gain. Additionally, the court upheld the IRS’s assessment of penalties against Midcoast for substantial understatement of income tax. Moreover, the court found that Midcoast could not avail itself of the reasonable cause exception to the imposition of penalties because the record reflected a knowing participation on Midcoast’s part to “obfuscate the real transaction at issue,” thus, its reliance on the advice of PriceWaterhouseCoopers was not reasonable.


1 Enbridge Energy Co., Inc. v. United States, 2008 U.S. Dist. LEXIS 36597 (S.D. Tex. 2008).

Steven D. Bortnick

The author would like to recognize the assistance of Jaclyn Ruocco, a summer associate in the Princeton office of Pepper Hamilton LLP, in compiling information for this article.

The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.