Tax Court Rejects Attempt to Deduct Artificially Created $37 Million Loss; Penalties Upheld
(Parker's Federal Tax Bulletin: September 13, 2012)

Where the essence of the taxpayers' transaction was to simply create an artificial multimillion-dollar tax loss that the taxpayers could report as an offset to their unrelated capital gains of a similar amount, the loss was disallowed. Gerdau Macsteel, Inc. & Affiliated Subs. v. Comm'r, 139 T.C. No. 5 (8/30/12).

Gerdau Macsteel, Inc. (GMI) and its subsidiaries are an affiliated group. During the affiliated group's tax year ended October 31, 1997 (FY 1997), the group actively pursued two sales expected to result in millions of dollars in taxable capital gains for FY1997 and FY 1998. The affiliated group's outside accountants were Deloitte & Touche, LLP (D&T). Mindful of the expected gains, D&T approached the taxpayers with an idea that it promoted to create a multimillion-dollar tax loss to shelter the gains for federal income tax purposes. The scheme involved the group benefits plan under which GMI provides health and welfare benefits to its eligible employees and their dependents and two inactive corporations. In order to report a desired tax loss of approximately $38 million to shelter the affiliated group's taxable gains, the group entered into a series of interrelated transactions in late October 1997 that included, among others, a recapitalization of one of the inactive subsidiaries (QHMC) and GMI's transfer to the other inactive subsidiary and its transfer to the recapitalized inactive subsidiary in exchange for newly issued Class C stock of $38 million and the assumption of certain contingent liabilities (i.e., GMI's obligations to pay medical plan benefits (MPBs) under its benefits plan), which the affiliated group valued at $37,989,000.

GMI and its subsidiaries reported that the transfers qualified for nonrecognition under Code Sec. 351(a) and that the basis of the subsidiary in the class C stock was determined by taking into account the $38 million transferred to the other inactive subsidiary but not the value of the MPBs. Each share of class C stock was entitled to receive annual dividends of $9.50 and was not allowed to receive any other dividend. Upon the class C stock's redemption, which the subsidiary and the class C shareholders could respectively cause five and seven years after the stock's issuance, the class C shareholders were entitled to receive for each share the greater of $125 or an amount equal to the lesser of a percent of any cumulative cost savings in MPBs or of the subsidiary's book net equity. The transactions were structured in such a way that it was highly likely when the class C stock was issued that the class C stock would be redeemed within the five- and seven-year periods and that the redemption payment would be $125 per share. Shortly after the transfer to the second inactive subsidiary, the first inactive subsidiary sold its class C stock to a former employee of a GMI subsidiary for $11,000 (the difference between $38 million and $37,989,000). The affiliated group claimed that the first inactive subsidiary realized a $37,989,000 short-term capital loss on the sale, and used that loss to offset the group's unrelated capital gains totaling a similar amount.

After the transactions, GMI continued to process claims for MPBs, and GMI's handling of the claims transferred to the second inactive subsidiary was the same as the handling of claims with respect to individuals whose MPBs were not transferred to that subsidiary. The reimbursements by the second inactive subsidiary to GMI for claims were made through intercompany entries recorded on GMI's books as a receivable due from the second inactive subsidiary and recorded on that subsidiary's books as a payable. The second inactive subsidiary lent the $38 million to a subsidiary of the affiliated group, and it eventually reimbursed GMI for the MPBs when it received payments on the loan.

The Tax Court held that the class C stock was nonqualified preferred stock under Code Sec. 351(g) because it did not participate in corporate growth to any significant extent within the meaning of Code Sec. 351(g)(3)(A). Accordingly, pursuant to the agreement of the parties, GMI was not entitled to deduct the claimed capital loss.

The Tax Court also concluded that the transactions underlying the claimed capital loss lacked economic substance. According to the court, the QHMC transactions were structured as an elaborate and devious multistep transaction, each individual step of which D&T promoted as meeting a literal reading of the Code, the regulations thereunder, and various judicial and administrative interpretations. The essence of the transactions, however, was simply to create an artificial multimillion-dollar tax loss that the taxpayers could report as an offset to their unrelated capital gains of a similar amount. Although taxpayers may structure their business transactions in a manner that produces the least amount of tax, the court stated, the economic substance doctrine requires that a court disregard a transaction that a taxpayer enters into without a valid business purpose in order to claim tax benefits not contemplated by a reasonable application of the language and the purpose of the Code or the regulations. Such a transaction is disregarded even though it may otherwise comply with the literal terms of the Code and the regulations. The court concluded that the QHMC transactions lacked economic substance and affirmed the IRS's determination that none of the related transaction costs of $352,000 were deductible.

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

Taxpayer's Attempt to Take Double Deduction Fails>

A capital loss claimed by the taxpayer in an earlier year could not later be claimed again as environmental remediation expense deductions. Thrifty Oil Co. & Subs. v. Comm'r, 139 T.C. No. 6 (2012).

Thrifty Oil Co. and Subsidiaries filed consolidated federal income tax returns for its fiscal years ending Sept. 30, 2000, 2001, and 2002. On those returns, it claimed environmental remediation expense deductions. The IRS disallowed the claimed deductions after determining that they were each the second tax deduction P had claimed for a single economic loss. The first deduction had been reported as a capital loss on Thrifty's federal income tax return for Sept. 30, 1996, and carried forward, with the last portion claimed on its federal income tax return for its fiscal year ending Sept. 30, 2001.

The IRS argued that the claimed deductions duplicated $18,347,205 in capital loss deductions Thrifty claimed for years not before the Tax Court, and thus Thrifty was not entitled to up to $18,347,205 of the claimed environmental remediation expense deductions. Thrifty asserted that the capital loss and the environmental remediation expense deductions did not represent the same economic loss.

The Tax Court agreed with the IRS and held that the capital loss and the environmental remediation expense deductions represented costs associated with the cleanup of the Golden West Refinery property. The capital loss represented the unpaid liability, and the environmental remediation expense deductions represented the actual cost when paid.

According to the court, Thifty's deducting the unpaid liability in the form of a capital loss, and then deducting it again when paid, was the core problem of the case. Since the capital loss deductions and the environmental remediation expense deductions represented the same economic loss, the court said Thrifty had to point to a specific provision authorizing the double deduction. Thrifty failed in this regard because it could only point to Code Sec. 162. General deduction provisions are insufficient, the court said. Citing its decision in O'Brien v. Comm'r, 79 T.C. 776 (1982), the Tax Court noted that it had previously held that Code Sec. 162 does not reflect a clear declaration of intent to allow a double deduction.

Parker Tax Publishing

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