It’s a 213-page spectacular, with Judge Marvel unwinding the tangled trail of phony corporate reorganizations, and put-and-take with carefully manufactured but imaginary losses, in 139 T. C. 5, filed 8/30/2012, and bearing the improbable but delightful name Gerdau Macsteel, Inc. & Affiliated Subsidiaries.
Gerdau Macsteel’s street name is Quanex, which runs a lot of specialty steelmakers. Quanex unloaded two of its dozen subsidiaries for a ferocious gain, part of which was capital gains but part of which was big-time recapture. Now, loath to pay taxes, Quanex turned to its hotshot accountants, Deloitte, to jury-rig some short-term capital losses to sop up the gains, provided it didn’t cost Quanex any real money.
Quanex had had a health insurance plan for its employees for years. Quanex was trying to reduce the costs thereof, like every other employer.
Deloitte’s hotshot Mr. Singer, relying on Rev. Rul. 95-74, 1995-2 C. B. 36, which allowed a corporation to transfer environmental liabilities (or liabilities for future medical costs) to a liability management corporation in a joint venture, figures out a way to use the joint venture to create a capital loss. Judge Marvel takes up the story: “In the revenue ruling the IRS ruled that certain contingent environmental liabilities that a transferee assumed in a section 351 exchange were not liabilities for purposes of sections 357(c)(1) and 358(d) and that the transferee, in accordance with its method of accounting, could, as appropriate, either deduct the liabilities as business expenses under section 162 or capitalize the liabilities as capital expenditures under section 263.” 139 T. C. 5, at pp. 25-26.
So Quanex would use a dormant subsidiary, which is carrying on its books a reserve for liabilities that has not been deducted from income, to act as liability manager, assign it the job of managing the liabilities, do an intra-company mix-and-match with notes and stock, have the preferred stock bought by a shill and take a huge short-term capital loss, which it would take on its consolidated return (after first deconsolidating and then reconsolidating) against the capital gain and recapture generated by the sale of the two live subsidiaries.
Of course, the accountant/architect of the scheme insisted the engagement letter provide “…as a condition of the engagement that Quanex agree in the engagement letter that it would indemnify … from any liability, cost, or expense (including attorney’s fees and expenses) stemming from the engagement, absent … bad faith or willful misconduct.” 139 T. C. 5, at p. 37.
The accountant set up the joint venture with Quanex’s existing healthcare benefits consultant. Of course, the liability manager corporation was ignored throughout.
IRS called a halt to the charade. “Respondent explained that he disallowed the loss because petitioners failed to establish that Quanex’s basis in the stock exceeded $11,000; the loss arose from transactions ‘that have no economic substance or business purpose, were entered into solely for tax avoidance, and were prearranged and predetermined’; and petitioners failed to establish that the loss otherwise met the deduction requirements under the Code.” 139 T. C. 5, at pp. 138-139.
In short, an elaborate, multistep transaction was orchestrated to create a paper loss.
But if corporate wheeling and dealing floats your boat, read the decision.
On an unrelated topic, I withdraw my bright idea in my blogpost “The Unanswered Question”, 6/13/12. Section 296 won’t work with a Sub S because the losses attach to the shareholder and cannot be transferred by any means. I was awake at the IRS Nationwide Tax Forum this week, really I was.