Tax Shelters at Risk With IRS Appeals Court Victory

The subject of tax shelters and financial transactions meant to reduce taxable income has been a perpetual source of contention between taxpayers and the IRS. A recent and prominent case, Superior Trading LLC et al. v Commissioner of Internal Revenue, No. 12-3367, tipped the issue in favor of the IRS. In a hit to taxpayers seeking to reduce taxes through some types of distressed asset/debt (“DAD”) transactions, the Seventh Circuit Appeals Court in Chicago, IL sided with the IRS. The court ruled that such transactions are not legitimate tax shelters. Using such financial engineering in an attempt to reduce taxable income will very likely result in the original tax and additional penalties owed to the IRS. This is not the first time that the IRS won such cases. This appeals court decision is likely to influence an up-coming Supreme Court case about a similar question in “United States v. Woods.” The Supreme Court is scheduled to hear arguments in October 2013. In both instances, the issue at hand is whether DAD transactions generate “economic value” that can be compared to tax-deductible business losses. Economic value is contrasted with financial operations that have no purpose or no relation personal or business operations. Rather, transactions absent economic value are done for no other purpose than to generate a tax shelter of questionable legality. Critically, Superior Trading LLC’s transactions were found to be outside the scope of “economic value,” thus taxable. The IRS was judged to be within its bounds of authority to impose additional fines on top of the original tax that Superior Trading LLC unsuccessfully tried to avoid. The Supreme Court issued a statement acknowledging that though the IRS often wins these types of cases, the issue is not black-and-white. Importantly, in 2007 the IRS ruled that DAD transactions could be construed as tax shelters. It is interesting to note that the attorney for Superior Trading et al. was barred from promoting tax shelters after the DOJ found that he promoted over $370M of invalid tax deductions for previous clients.