CIP on lease strips.

The IRS released a Coordinated Issue Paper (CIP) on lease-stripping transactions, in which a tax-indifferent party allocates partnership income while a tax-sensitive party takes deductions. Citing ACM Partnership, 157 F3d 231 (3d Cir. 1998), and ASA Investerings Partnership, 201 F3d 505 (DC Cir. 2000), the Service used the sham-transaction doctrine to dismiss the transaction described in the CIE The CIP illustrates how the IRS may use the sham-transaction doctrine to question tax-favorable transactions.

Under the facts of the CIE corporation A entered into a sale-leaseback of depreciable equipment with B (a thinly capitalized partnership), in exchange for B's note. C was a 98% partner of B. B sold the rents that it received from A to a bank for cash and allocated the accelerated income to its partners, including C. B used the cash to pay off its note to A. D was a consolidated corporate subsidiary of E, the parent of a consolidated group. B contributed the equipment to D in exchange for D stock in a purported Sec. 351 transaction; E also contributed property and received D stock in the same transaction. D received depreciation deductions that the E group used.

Citing ASA Investerings Partnership the IRS disregarded the transactions as a sham, holding that, in essence, they equated to a basic sale-leaseback transaction between A and D. According to the Service, B's actions should be disregarded, because it acted on E's behalf to create deductions for the E consolidated group. In this case, the E group would still be entitled to depreciation deductions, but would have to take the accelerated income into account.

The IRS also applied the step-transaction doctrine to the transactions. Under the step-transaction theory, the nature of B's and C's involvement in the transactions may support the conclusion that B and C should be ignored. If so, D could be required to recognize the income, from the accelerated income payment from the bank. E could still use the depreciation deductions on its consolidated return, but would have to match the accelerated income with the deductions.

In a third alternative, the Service attacked the validity of the Sec. 351 transaction, suggesting that D acquired the equipment in a taxable Sec. 1001 exchange. In such an event, D would not recognize gain or loss on the transaction under Sec. 1032, but would receive a cost basis in the property (based on the fair market value of the D stock exchanged) under Sec. 1012. Thus, the basis of the equipment in D's hands would not support the claimed depreciation deductions.

JEFFREY A. ERICKSON, J.D., AND DAVID E LATZ, J.D., LL.M.,WASHINGTON, DC