Tax Court Disallows Loss from Dissolution of S Corporation Due to Lack of Economic Substance

(Parker Tax Publishing November 2017)

The Tax Court disallowed the losses claimed by a married couple who transferred personal assets to a wholly owned S corporation which in turn transferred the assets to a family limited partnership, then dissolved the S corporation and received the partnership interest with a discounted value as a liquidating distribution. The Tax Court found that because the transaction was organized for the sole purpose of tax avoidance and lacked economic substance, the taxpayers were not entitled to deduct any loss relating to the arrangement. Smith v. Comm'r, T.C. Memo. 2017-218.

Facts

Robert Smith worked for National Coupling Co., a manufacturer of couplings and valves, for 36 years. He owned approximately 58 percent of the company. Smith was a vice president and was in charge of manufacturing, engineering, intellectual property work, and trademarks. Smith is also an inventor and the owner of hundreds of patents. In 2009, National Coupling was sold and Smith retired. He received a $600,000 bonus, $248,000 from the sale of his stock, and $181,000 from the surrender of two company sponsored life insurance policies. Smith's total employee compensation was $664,000 for 2009. After the sale, Smith signed a two year consulting contract with National Coupling and received around $38,000 under the contract in 2009.

Smith had worked on a patent for a sprinkler system while working at National Coupling. Smith had worked on the sprinkler device in 2005 or 2006, and a U.S. patent application was filed in 2006. The U.S. patent was issued in 2014 and a Canadian patent was issued in 2009. Smith believed he would retain patent rights to the sprinkler system after the sale of National Coupling, although the documents relating to the sale did not grant Smith the right to the patent.

Smith's financial adviser recommended that Smith and his wife obtain estate planning advice. He referred them to Richard Shanks, an experienced attorney and CPA, who prepared various estate planning documents for the Smiths including wills and medical directives. Shanks also recommended a tax planning strategy intended to reduce the tax on Smith's 2009 compensation. He proposed that the Smiths transfer their cash and securities to a wholly owned S corporation, which would then transfer the assets to a family limited partnership (FLP). Shanks said the FLP would provide asset protection. The S corporation would own the FLP, and the FLP would hold the cash and securities. The S corporation would be formed and dissolved in the same year. In the dissolution, it would distribute the partnership interest to the Smiths as a liquidating distribution. Shanks would determine the fair market value of the distributed partnership interest using large discounts for lack of marketability and lack of control, generating a tax loss on the dissolution. Shanks charged a flat fee of $23,200 for his services. He did not charge a separate fee for the dissolution of Ventures.

In July 2009, the Smiths organized RACR Ventures, Inc., an S corporation, RACR Partnership, Ltd., an FLP, and Smith Management Trust, a revocable management trust. Smith and his wife each owned 50 percent of Ventures. Ventures owned a 98 percent limited partnership interest RACR Partnership. Smith and his wife were each 1 percent general partners until they transferred their interests to the Smith Trust and became cotrustees and beneficiaries.

From the outset, the Smiths understood that Ventures would not hold any assets. They were aware that Ventures would immediately transfer its assets to RACR Partnership and be dissolved by the end of 2009. The Smiths understood that Ventures was the vehicle they would use to minimize their 2009 tax liability. Their handwritten notes from their meeting with Shanks identified the RACR structure as a vehicle to minimize tax for 2009. Emails between the Smiths and Shanks acknowledged a "liquidation" in 2009 and stated that Ventures "goes away" that year. Ventures had no business activities. It did not have a bank account, did not issue stock certificates, did not keep meeting minutes, and did not follow corporate formalities.

The Smiths filed dissolution documents in December 2009 stating that they had organized Ventures to pursue business opportunities and were dissolving it to reduce overhead because they had not found any profitable opportunities. In the dissolution, Smith and his wife each received a 49 percent limited partnership interest in RACR Partnership. They transferred 1 percent limited partnership interests to two trusts in the names of each of their sons. At the end of 2009, the Smith Trust owned a 2 percent general partnership interest in RACR Partnership, Smith and his wife each owned a 48 percent limited partnership interest, and the children's trusts owned 1 percent limited partnership interests.

On their 2009 tax return, the Smiths reported income of approximately $850,000 and an ordinary loss deduction of around $750,000 from the Ventures dissolution. The IRS issued a notice of deficiency disallowing the loss on the grounds that the transaction lacked economic substance. The Smiths petitioned the Tax Court for redetermination.

Analysis

The Smiths argued that Ventures was organized to manufacture and sell Smith's sprinkler device once he received a U.S. patent. They claimed that they transferred their personal assets to Ventures to finance this new business and that the assets were then transferred to RACR Partnership for asset protection purposes. According to the couple, Ventures was dissolved due to the unforeseeable circumstances of the patent not being issued and Smith's increased involvement in his consulting work.

The Tax Court found that the RACR transaction lacked economic substance and disallowed the losses. It found that under Fifth Circuit precedent, a transaction is respected for tax purposes only if it exhibits an objective economic reality, a subjectively genuine business purpose, and some motivation other than tax avoidance. A transaction is void if it fails to meet any one of these three factors. The Fifth Circuit has recognized that the second and third factors overlap and that if a transaction is shaped totally by tax avoidance features, it lacks a genuine business purpose.

The Tax Court held that the transaction failed to alter the Smiths' economic position in any way that affected objective economic reality. It found that the RACR structure was a circular flow of funds among related entities used to generate an artificial tax loss to offset the couple's income. The court noted that the couple had constant control over the assets they contributed to Ventures. It found that the structure of the transaction did not affect their financial position and did not cause real dollars to meaningfully change hands. The Smiths understood from the beginning that they would not lose control over their personal assets. The Tax Court further determined that, contrary to their testimony at trial, the Smiths always intended to dissolve Ventures by the end of 2009 and never intended that it would manufacture the sprinkler device.

The Tax Court also analyzed the subjective business purpose element and found that the Smiths' subjective purpose was solely tax avoidance. The Tax Court did not find credible the couple's claims that they organized Ventures to manufacture the sprinkler device. It found that Smith should have expected the U.S. patent to be issued shortly after October 2009, but that Ventures was dissolved only one month later. Based in part on the couple's handwritten notes from their initial meeting with Shanks, the Tax Court determined that the couple intended from the beginning to organize and dissolve Ventures within the same year to generate a tax loss. The fact that Shanks received a flat fee for the RACR structure, and did not charge a separate fee for the dissolution of Ventures, was further evidence to the Tax Court that the couple lacked a business purpose in forming Ventures.

The Tax Court found that Shanks designed the tax structure to include the application of a substantial discount of the Smiths' assets used in the strategy so that the structure would produce a loss even if the assets appreciated in value during Ventures' short existence. The Tax Court also noted that the Smiths could have protected their assets through the limited partnership framework without first transferring the assets to Ventures. Accordingly, the Tax Court concluded that Ventures lacked economic substance and the couple was not entitled to deduct any loss relating to Ventures or the RACR structure.

The Tax Court also upheld the IRS's determination of an accuracy related penalty. It found that the Smiths were not acting in good faith because they continued to represent that Ventures had a business purpose even though they never intended to conduct any business activities through Ventures. Their knowledge from the outset that Ventures would not last past 2009 negated the defense that they reasonably relied on Shanks, the Tax Court found.

For a discussion of the economic substance doctrine, see Parker Tax ¶99,700.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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