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Denial of contingent liability loss deduction.

Although in the past the government won a number of important victories in its ongoing attempt to stop abusive tax transactions, it has continued to lose on contingent liability transactions. Recently, however, the Court of Appeals for the Federal Circuit reversed a lower court decision that may substantially affect future contingent liability cases.

Coltec Industries recognized significant gain when it sold several of its subsidiaries. To offset this gain it followed a simple tax-savings strategy; it created a subsidiary, Garrison, which received stock in exchange for a $14 million contribution. Garlock, another Coltec subsidiary, transferred its contingent liability for asbestos claims, some assets and a $375 million note from another subsidiary to Garrison in exchange for common stock. The amount of the note and the contingent liability were approximately equal. Garlock then sold the Garrison stock and recognized a loss of $378.7 million. When Garlock took a loss deduction, the IRS denied it. The Court of Federal Claims disagreed with the IRS and permitted the loss deduction. The IRS appealed.

Result. For the IRS. The service presented two arguments against the loss deduction. The first was a technical argument involving the interaction of liabilities and basis, which was contained in IRC sections 357(b), 357(c) and 358. The second was a general argument about whether the transaction had sufficient economic substance to be respected.

Liabilities and basis. IRC section 358(d)(1) addresses liabilities assumed as money paid resulting in a decrease in basis. The claims court held that contingent liabilities were not liabilities for purposes of section 358. The Federal Circuit Court of Appeals disagreed; it held that contingent liabilities, for purposes of that section, were liabilities. However, section 358(d)(2) exempts liabilities excluded under section 357(c)(3). The appeals court had to determine whether these contingent liabilities excluded liabilities under section 357(c)(3) and whether section 357(b) overrode the exclusion.

The government contended that the section 357(c)(3) exclusion applies to liabilities only if they are transferred with the business that created them and if they give rise to a deduction. Although admitting Congress probably intended to limit the exclusion to transfers of businesses and their liabilities, the court rejected the government's argument because the section does not expressly contain this limitation.

The government also said that under section 357(b) assumed liabilities are treated as boot (usually cash). Although section 357(b) does overrule section 357(c) for liability assumption purposes, section 358 refers to section 357(c)(3) only for its definition of an excluded liability. Therefore, section 357(b) was not relevant in the case and it did not matter that the taxpayer had assumed the liabilities only to avoid taxes. Thus, under section 358, the contingent liabilities did not reduce stock basis.

Congress later amended section 358 to require that the liabilities transferred be part of a transfer of an entire business or of substantially all the assets related to the liabilities in order to be excluded under section 358(d)(2). This change is consistent with the government's position and prevents future taxpayers from using this tax-planning strategy.

Economic substance. The government's second and more important argument for disallowing the loss was that the transaction lacked economic substance. The appeals court found that courts can use the economic substance doctrine. To apply this doctrine, a court examines the business purpose of a transaction and respects transactions only if they have a valid business purpose and their sole purpose is not to avoid taxes. It's up to the taxpayer to prove the transaction's economic reality. In the Coltec case the court denied the tax benefit after applying the doctrine.

This case demonstrates that the court can prevent tax abuse even if Congress does not actually amend the Internal Revenue Code to include an economic substance test. This doctrine supplements the business purpose, sham transaction and substance vs. form doctrines the government uses to prevent taxpayers from benefiting from a transaction that literally conforms to the statutory language but lacks a real business purpose and substance.

* Coltec Industries, Inc. v. United States, Fed. Cir., 2006-2 USTC [paragraph] 50,389.

Does Your Car Qualify?

These model 2007 cars and trucks are eligible for the tax credit for hybrid vehicles:

$ Chevrolet Silverado 2WD and 4WD Hybrid Pickup Truck

$ Ford Escape Hybrid 2WD and 4WD

$ GMC Sierra 2WD and 4WD Hybrid Pickup Truck

$ Lexus GS 450h

$ Lexus RX 400h 2WD and 4WD

$ Mercury Mariner 4WD Hybrid

$ Saturn Vue Green Line

$ Toyota Camry Hybrid

$ Toyota Highlander 2WD and 4WD

$ Toyota Prius

Source: IRS,

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.
The difference in delivery time for electronic vs. snail
mail refunds is about seven days. For example,

 If transmitted and Direct Paper
accepted (by 11:00 a.m.) deposit check
 between sent mailed

January 12 and January 18 January 26 February 2
 March 1 and March 8 March 16 March 23
 April 12 and April 19 April 27 May 4

Source: IRS e-file 2007 Refund Cycle Chart,
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Article Details
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Author:Schnee, Edward J.
Publication:Journal of Accountancy
Date:Jan 1, 2007
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