News & Articles


04 / 09 / 2015

CNT Investors, LLC v. IRS, 144 T.C. No. 11 (March 23, 2015)

In this Tax Court case, the patriarch of a funeral home business operating out of S corporation solution (formerly a C corporation) sought advice from his trusted, long-term counsel as to what he thought of a variation of the class Son-of-BOSS transaction that was recommended for use by a large law firm, Jenkins & Gilchrist, and its attorney, Erwin Mayer.  The patriarch's trusted advisor concluded that the proposed transactions appeared feasible and a viable way to resolve a "low basis" dilemma.  The CPA, one of two partners in a small accounting firm, that had advised the patriarch "went along with it," but did so intimidated by the Jenkins & Gilchrist brand.  

At the age of 73, in early 1999, the patriarch, Charles Carroll, faced a dilemma, as he contemplated retirement, wanting to sell the funeral home business, but retaining ownership of the real estate comprised of 5 mortuaries located on real estate ostensibly owned by the S corporation.  Mr. Carroll knew that a large mortuary chain would not want to buy the underlying real estate, but rather, just the business, and leasing the real estate would provide a steady income stream in retirement.  The long-time advisors to the company patriarch knew that in order to facilitate a sale of the funeral home business, the real estate needed to be separated from the business.  They could not figure out how to do it in a way that would not trigger a substantial tax from a large built-in gain existing in the real estate consisting of the 5 parcels or buildings and land, due to the FMV being $4,020,000 and the adjusted tax basis being $523,777.  Even a sale of just the assets left open the problem of a loss of S corporation status because of the passive loss limitations under IRC 1362(d)(3).  

It was over a lunch meeting that the trusted legal advisor had with a local financial advisor that led the patriarch and his trusted advisors to learn about "basis-boosting" transactions structured by Jenkins & Gilchrist lawyer Erwin Mayer.  A bit unique to the situation here was that unlike the customary use made of using the Son-of BOSS transaction to offset unrelated, recognized gains, here, it was being utilized to eliminate gain prospectively.  In other words, to forestall gain recognition.  

What is interesting about this case is how the transaction ultimately got to the patriarch.  The financial advisor met with the trusted legal advisor to the patriarch, and put him in touch with the Mayer, and this led the advisor to request and receive a memorandum describing the transaction and providing legal authorities, some of which he then reviewed.  Only then did the trusted legal advisor to the patriarch and his wife seek to bring in the financial advisor, who then described the transaction to the patriarch in "broad strokes" using a short sale of securities to create basis in a new entity.  It was at this point that the financial advisor told the patriarch how Ted Turner had engaged in a similar transaction and prevailed in a dispute, presumably with the IRS.  The patriarch's daughter reasoned that if someone could afford the very best legal and tax advice had engaged in this kind of transaction, it must be effective.  It was at that point that the patriarch and his family decided to proceed.

Notably, the financial advisor stood to receive a "finder's fee" in the form of a percentage of Fortress Financial's fee if the Carrolls went forward.  The case notes how the trusted legal advisor, Mr. Meyers, did not know all of the details of the transaction, did not know how much money was actually at risk in the Son-of-BOSS component of the transaction, had no financial information about the short sale, and was unaware that the short sale would almost certainly generate no profit, and he did not know how much Jenkins & Gilchrist were charging to implement the transaction.  On the basis of what he did know only, did he advise that he viewed the transaction as "legitimate and proper."  

The Tax Court duly notes that once the transaction was a go, Mr. Mayer and the Jenkins & Gilchrist firm formed 4 Delaware LLCs, including the Plaintiff, CNT Investors, LLC, which elected to be treated as a partnership for Federal income tax purposes, and 3 other LLCs, one for the patriarch, and one each for the patriarch's two twin daughters.  The parties stipulated that these LLCs were a "sham entity" with no business purpose. (NOTE:  when preparing the tax returns, it appears that even though CNT was a tax partnership, filing IRS Form 1065, on the K-1s issued to each of the family members, the K-1s did NOT identify the LLCs as being the owner (but a disregarded entity for Federal income tax purposes)).  

The steps of the transaction were that on November 18, 1999, the 5 real estate properties were transferred by deed to CNT, with the book value of each credited to the capital account of the funeral home business, CCFH, with CCFH taking back an initial outside basis in its interest of $523,777 equal to the adjusted tax basis of each of these properties.  Then the Son-of-BOSS short sale transactions were engaged in by the family, via their respective LLCs, all of which were viewed as sham transactions.  

On December 1, 1999, the family purported to transfer their partnership interests in CNT to the business, CCFH, meaning that at that point, CNT stopped being a "partnership" because it was at that point owned 100% by CCFH.  It then terminated for Federal income tax purposes, meaning that for tax purposes, CNT treated as it it liquidated, with its assets transferred out pro rata to its partners, and then each of those partners deemed to have contributed those assets to CCFH, leaving CCFH (still) holding the underlying real estate.  See Rev. Rul. 99-6, 1999-1 C.B. 432.  At that point, each of the family members believe themselves to have taken a tax basis in the assets they received equal to the partner's outside basis, such that the real estate's aggregate adjusted tax basis rose from $523,377 to $3,396,716, "ostensibly without any taxable event's having occurred."  With the deemed contribution of CNT's assets to CCFH, the real estate's newly boosted basis transferred to CCFH, and the family member's aggregate basis in their CCFH stock increased by the same amount, thereby purporting to align the inside and outside bases.  The parties were then ready to transfer the real estate out of CCFH, on December 31, 1999.  They did so by having CCFH distribute 100% of the interests it then held in CNT to the family members, pro rata.  All of this is only in the tax world, of course, because in actuality, title to the real estate did not change, it still being held by CNT.  But for tax purposes, with the December 1, 1999 termination, and the December 31, 1999 events, this deemed distribution of the real estate to the CCFH shareholders, was followed by a deemed contribution of the real estate to a new CNT.  See Rev. Rul. 99-5.  Note, that at the point of a deemed distribution, CCFH was to recognize gain of $623,284, equal to the difference between the aggregate adjusted tax basis in the real estate of $3,396,716 and the real estate's then FMV of $4,020,000.  As a S corporation, this then passed on out to the shareholders.  

Absent the basis boost, the amount of gain would have been $3,496,623, but because of it, only $623,284 was to be reported to the IRS.  After extensions of the statute of limitations, IRS mailed out a FPAA with respect to the CNT return, as of December 1, 1999, adjusting the reported losses to -0-, on the basis that CNT was not a valid partnership, lacked economic substance, and the whole thing was a sham.  The IRS also sought to assert penalties.  The IRS successfully argued that the statute of limitations for these 1999 returns were held open through August 25, 2008 due to extensions and the 6-year period under 6501(e)(1)(A).  Rejecting the petitioner's argument that omission only occurred by way of bootstrapping, the Tax Court found that all of the steps to the transaction could be ignored, other than the actual distribution of the real estate, compelling income tax recognition.  

The Tax Court rejected the effort on the part of the Petitioner to disregard the tax consequences flowing from a transfer of the real estate out of the corporation, to then hold that CCFH still owns the real estate.  The Tax Court refused to disregard the "income-producing" event simply because it was coupled with an abusive tax shelter transaction designed to offset the gain.  The Tax Court found that an adequate disclosure was not made by the patriarch on his returns, and therefore, the statute of limitations did not run as to him.  By not "fully reporting," their transactions consistent with their desired tax treatment, such that no amount reported hinted as the source of any alleged omission of income.  

The Tax Court found that the patriarch reasonably relied on the advice of the trusted legal counsel, who then had reasonably relied on the advice of Jenkins & Gilchrist.  Therefore no accuracy related penalty was imposed.