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IRS Amends Answer in Tax Court Regarding Economic Substance

OCT. 20, 2022

Nat S. Harty et al. v. Commissioner

DATED OCT. 20, 2022
DOCUMENT ATTRIBUTES

Nat S. Harty et al. v. Commissioner

NAT S. HARTY & APRIL D. HARTY,
Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

UNITED STATES TAX COURT

 

AMENDMENT TO ANSWER

RESPONDENT, pursuant to Tax Court Rule 41(a), and in further answer to the petition filed in the above-entitled case adds the following paragraph and modifies the prayer for relief, as follows:

7. FURTHER ANSWERING the petition, and in support of respondent's assertion of the Codified Economic Substance Doctrine (“CESD”) under I.R.C. § 7701(o)(1)(A) and accuracy-related penalty under the provisions of I.R.C. § 6662(b)(6), at the rate prescribed in I.R.C. § 6662(i), for the 2016 tax year, respondent alleges:

BACKGROUND

Monetized Installment Sale

a. Monetized Installment Sale Promoters (“promoter”) are marketing to taxpayers selling property (the “seller”) with substantial unrealized gain. Normally, in a straight sale, the taxpayer will receive a single, immediate cash payment for their property and have to immediately recognize all of the gain realized from the sale. In an installment sale, the cash payments are spread over a period of years. Therefore, the seller only has to recognize an amount of the gain in proportion to the installment received in any given year. The purpose of the MIS transaction is to allow the buyer to be involved in a straight sale, give the seller installment sale treatment, but still give the seller nearly all of the purchase price in cash immediately via a loan from a related lender.

b. Stanley Dean Crow (“Crow”) is the President and Director of S Crow Collateral Corporation, EIN: * * * (hereafter referred to as “SCCC”), located in Crow’s personal residence in Boise, Idaho. SCCC began business in 1982 as a consulting firm. In 2005, Crow states that SCCC changed roles, from that of a consulting company to that of “a dealer in capital assets”. In 2005, Crow began promoting his Collateralized Installment sales (C453) and later his Monetized Installment sales (M453). After beginning his C453 and M453 promotions, he voluntarily relinquished his license to practice law in the state of Idaho.

c. Crow changed the C453 product to include “loan monetization” in early January of 2011. He called this product the “C453 with loan monetization”. His website and newsletters continued to call the product a “C453 with loan monetization” until he formally changed the name of the product to “M453” in late 2014; the “M” standing for “monetization”. The Monetized Installment Sale transaction (“MIS transaction”) is described below:

i. Generally, the seller has identified an ultimate buyer of the property willing to pay cash for all or a substantial portion of the purchase price negotiated by the seller and the buyer. Then the seller finds or is introduced to a promoter who has developed a scheme to assist the taxpayer with deferring the recognition of the gain on the sale of the property for up to 30 years, while simultaneously allowing the taxpayer to receive cash upon sale of the property to the ultimate buyer. The seller enters into an installment contract with the promoter.

ii. The promoter purportedly purchases the property from the seller in exchange for an installment note.

iii. The promoter refers the seller to a non-bank lender that purportedly lends cash to the seller in approximately the same amount that the seller was to receive for the property from the ultimate buyer.

iv. The promoter purportedly transfers ownership of the property to the ultimate buyer for the agreed upon purchase price between the seller and the ultimate buyer.

v. The terms of the loan between the lender and the seller generally mirror the terms of the installment note so that the promoter's annual payment to the seller required by the installment note equals the seller's annual payment on the loan to the lender. In addition, pursuant to the loan agreement, the lender may not demand repayment from the seller in excess of the amount the promoter pays the seller on the installment note.

vi. It appears that no payments are actually transmitted either by the seller to the lender or by the promoter to the seller. Instead, offsetting book entries are made by the lender or the escrow company.

vii. The promoter either never takes title to the property or takes title only momentarily before transferring it to the ultimate buyer.

viii. The promoter either directs the sales proceeds to the lender to fund the loan to the seller, or to an escrow or investment account of which the lender is the beneficiary.

ix. A recourse note is given by the lender to the promoter.

x. A non-recourse note is given by the seller to the lender, for a percentage of the sale price.

xi. The installment note and both loans terminate at or around the same time.

xii. The seller reports the sale on his or her federal income tax return for the year of sale as an installment sale under section 453.1

xiii. Because the “installment payments” made by the promoter only represent interest on the unpaid balance of the installment agreement, no gain will be reported until the end of the 30-year term.

xiv. The final transaction of the “principal” will again be an off-setting book entry from Seller to Lender to Promoter and back to Seller.

d. At the same time as the loan amount is purportedly paid out to the Seller, the Promoter purportedly makes the first installment payment. This “payment” is sent from the Seller to the Lender, then from the Lender back to the Promoter (as payment under the non-recourse note). This one payment circulates for the term of the loan and installment sale.

Stowe Properties Trust

e. In 2016, petitioners had a trust called “Stowe Properties Trust Dated May 4, 1984, and Restated In Its Entirety On December 7, 2005, Nat S. Harty, Trustee”, (“Hartys” or “Taxpayer”).

Property A

f. In 2016, the Hartys negotiated the sale of at 470 Capricorn Street, Brea, California, 92821 (“Property A”) to Mark A. Cooper (“Cooper”) for $1,407,480.00.

g. The Hartys and Cooper entered into a sales agreement concerning Property A.

h. The Hartys sold their 51% interest ($717,815) in Property A.

i. The Hartys entered into an “installment agreement” with SCCC. SCCC as “qualified intermediary” purportedly purchased the property from Hartys and then immediately sell it to Cooper under the terms of the original sales agreement entered into between the Hartys and Cooper. Cooper received clear and full title to Property A and made full payment.

j. Under the terms of the installment agreement, the Hartys' gain on the Property A is deterred for 30 years.

k. The Hartys received approximately 95% of the net sales proceeds as a “loan” from Alpha Holding Company, LLC (“Alpha”).

l. The Hartys purchased Property A in 1985. Property A is an industrial warehouse building used in connection with a trade or business, or an activity engaged in for the production of income. The Hartys reported an original cost basis of $27,080.00 and adjusted basis of $27,080.00. In the notice of deficiency, respondent accepted the reported basis.

m. The Hartys reported this transaction as an installment sale in 2016 with $650,803.00 gross profit.

Property B

n. The Hartys negotiated the sale of 430 ½ Acacia Ave., Newport Beach (Corona Del Mar), California, 92625 (“Property B”) to Allison Cohen (“Cohen”) for $1,345,000.00.

o. The Hartys and Cohen entered into a sale agreement regarding Property B.

p. In 2016, the Hartys sold Property B.

q. The Hartys entered into an “installment agreement” with SCCC. SCCC as “qualified intermediary” purportedly purchased the property from the Hartys and then immediately sell it to Cohen under the terms of the original sales agreement entered into by the Hartys and Cohen. Cohen received clear and full title to Property B and made full payment.

r. Under the terms of the installment agreement, the Hartys' gain on the Property B is deferred for 30 years.

s. The Hartys received a “loan” from Alpha for approximately 95% of the net sales proceeds.

t. The Hartys purchased Property B in 2004. Property B is a single-family residence, which was rented to unrelated parties and reported on Taxpayers' Schedule E. Taxpayers reported an original cost basis of $825,037.00 and adjusted basis of $549,758.00. In the notice of deficiency, respondent accepted the reported basis.

u. The Hartys reported this transaction as an installment sale in 2016 with $718,269.00 gross profit.

Property C

v. In 2016, the Hartys sold property at 710 Goldenrod Ave., Newport Beach (Corona Del Mar), California, 92625 (“Property C”). The Hartys negotiated the sale of Property C to Louis J. Dennis (“Dennis”) and Andrew Paul Goetz (“Goetz”) for $3,519,125.00.

w. The Hartys then entered into an installment agreement with SCCC. SCCC as “qualified intermediary” purportedly purchased the property from the Hartys and then immediately sell it to Dennis and Goetz under the terms of the original sales agreement entered into by the Hartys, Dennis, and Goetz.

x. Under the sales agreement, Dennis and Goetz obtained a loan from the Hartys in the amount of $2,719,125.00 to secure the sale of the property (“Seller Loan”).2

y. Dennis and Goetz received clear and full title to Property C in 2016 when they made full payment, including paying back the Seller Loan.

z. Under the terms of the installment agreement, the gain on the Property C is deterred for 30 years. The Hartys received a “loan” from Alpha for approximately 95% of the Seller Loan.

aa. The Hartys purchased Property C in 2003. In 2003, Property C was a single-family residence; however, by 2016 the property housed a condominium. This property was used in connection with a trade or business, or an activity engaged in for the production of income. Taxpayers reported an original cost basis of $726,657.00 and adjusted basis of $516,269.00. In the notice of deficiency, respondent accepted the reported basis.

bb. The Hartys reported this transaction as an installment sale in 2016 with $2,836,721.00 gross profit.

Installment Sale and Purchase Agreements

cc. On March 17, 2016, the Hartys and SCCC entered into an Installment Sale and Purchase Agreement (“Installment Agreement”) for SCCC to purchase Property A from the Hartys and sell it per the terms of the original agreement with Cooper. The Installment Agreement defined the Total Purchase Price as the amount of money disbursed to SCCC at closing plus the amount of seller's indebtedness paid at closing. No down payment was required. Interest was a fixed monthly payment of $6,650.00. SCCC agreed to pay the Hartys monthly interest through escrow with the purchase price due April 30, 2046, also through escrow.

dd. On June 7, 2016, the Hartys and SCCC entered into an Installment Agreement for SCCC to purchase Property B from the Hartys and sell it per the terms of the original agreement with Cohen. The Installment Agreement defined the Total Purchase Price as the amount of money disbursed to SCCC at closing plus the amount of seller's indebtedness paid at closing. No down payment was required. Interest was a fixed monthly payment of $6,069.00. SCCC agreed to pay the Hartys monthly interest through escrow with the purchase price due July 31, 2046, also through escrow.

ee. On March 11, 2016, Hartys and SCCC entered into an Installment Agreement for SCCC to purchase Property C from the Hartys and sell it per the terms of the original agreement with Dennis and Goetz. The Installment Agreement defined the Total Purchase Price as the amount of money disbursed to SCCC at closing plus the amount of seller's indebtedness paid at closing. No down payment was required. Interest was a fixed monthly payment of $16,715.84. SCCC agreed to pay the Hartys monthly interest through escrow with the purchase price due April 30, 2046, also through escrow.

Loan Agreements

ff. On March 17, 2016, the Hartys and Alpha entered into a Loan Agreement and Promissory Note (“Loan”), related to Property A, for $645,309.24. The Loan was unsecured with no collateral and no recourse. The Hartys assured Alpha that all payments received on the March 17, 2016 Installment Agreement would be applied, through escrow, to this Loan. Alpha agreed not to compel payment from funds other than those received, through escrow, on the Installment Agreement. Interest was a fixed monthly payment of $6,650.00. Monthly interest payments were paid through escrow. The Maturity Date was April 30, 2046, with the principal repayment through escrow.

gg. June 7, 2016, the Hartys and Alpha entered into a Loan, related to Property B, for $1,205,086.68. The Loan was unsecured with no collateral and no recourse. The Hartys assured Alpha that all payments received on the June 7, 2016 Installment Agreement would be applied, through escrow, to this Loan. Alpha agreed not to compel payment from funds other than those received, through escrow, on the Installment Agreement. Interest was a fixed monthly payment of $6,069.00. Monthly interest payments were paid through escrow. The Maturity Date was July 31, 2046, with the principal repayment through escrow.

hh. On March 11, 2016, the Hartys and Alpha entered into a Loan, related to Property C, for $2,583,518.63. The Loan was unsecured with no collateral and no recourse. The Hartys assured Alpha that all payments received on the March 11, 2016 Installment Agreements would be applied, through escrow, to these Loans. Alpha agreed not to compel payment from funds other than those received, through escrow, on the Installment Agreements. Interest was a fixed monthly payment of $16,715.84. Monthly interest payments were paid through escrow. The Maturity Date was April 30, 2046, with the principal repayment through escrow.

Escrow Accounts

ii. Escrow accounts were set up with Alpha Lending, LLC (“Lending”) as the escrow holder for these transactions:

i. Installment Escrow for payments from SCCC to the Hartys on the three Installment Agreements listed above.

ii. Funding Escrow to transfer payments from Installment Escrow to Loan Escrow. The accounts also held the Hartys' first month's interest payment on the Loans, which was paid from the Loan proceeds.

iii. Loan Escrow for payments from the Hartys to Alpha on the Loans described above.

jj. All payments offset and were made through journal entries. No funds ever physically changed hands with this arrangement.

Mariners' Seller's Closing Statement and Borrower Statement

kk. The Mariners Escrow Seller's Closing Statement dated April 13, 2016, reflects a sales price of $1,407,480.00 for Property A, with $407,717.15 due to SCCC after all fees and disbursements. SCCC is identified as the Seller as “Qualified Intermediary” for the Hartys.

ll. The Mariners Escrow Seller's Closing Statement dated June 15, 2016, reflects a sales price of $1,345,000.00 for Property B, with $776,970.08 due to seller after all fees and disbursements. SCCC is identified as the Seller as “Qualified Intermediary” for the Hartys.

mm. The Mariners Escrow Seller's Closing Statement dated September 16, 2016, reflects a sales price of $2,360,000 for Property C, with $2,159,000.00 due to “LOAN PAYOFF: Nat S Harty, Trustee Of The Stowe Properties Trust,” $62,695.00 due to The Stowe Properties Inc., and $19,885.59 due to seller after all fees and disbursements. Goetz is identified as the seller.

nn. The Mariners Escrow Borrower Statement dated November 16, 2016, shows $560,493.30 due to “LOAN PAYOFF: Nat Stowe Harty.”

Closing Instructions to First American Title Company (“FATC”)

oo. The March 17, 2016 Closing Instructions to First American Title & Escrow Company for Escrow No. 4102-2617616 (PC) are for the Loan by Alpha to the Hartys, related to Property A. The Principal Sum is defined as the amount FATC received for SCCC's benefit from the sale of Property A, plus the amount of the Hartys' indebtedness related to Property A at closing, less 5% of the sum of the first two amounts. Alpha is to provide the Principal Sum to FATC for the Loan. However, if Alpha does not provide the funds for the loan, FATC is instructed to deem the funds received and proceed with the disbursements, reducing SCCC's payment by this Loan-Funding Guarantee Amount.

pp. The June 7, 2016 Closing Instructions to First American Title & Escrow Company for Escrow No. 4102-2669247 (PC) are for the Loan by Alpha to the Hartys related to Property B. The Principal Sum is defined as the amount FATC received for SCCC's benefit from the sale of Property B, plus the amount of the Hartys' indebtedness related to Property B at closing, less 5% of the sum of the first two amounts. Alpha is to provide the Principal Sum to FATC for the Loan. However, if Alpha does not provide the funds for the loan, FATC is instructed to deem the funds received and proceed with the disbursements, reducing SCCC's payment by this Loan-Funding Guarantee Amount.

qq. The March 11, 2016 Closing Instructions to First American Title & Escrow Company for Escrow Nos. 4102-2606401 (PC) and 2606401a are for the Loan by Alpha to the Hartys related to Property C. The Principal Sum is defined as the amount FATC received for SCCC's benefit from the sale of Property C, plus the amount of the Hartys' indebtedness related to Property C at closing, less 5% of the sum of the first two amounts. Alpha is to provide the Principal Sum to FATC for the Loan. However, if Alpha does not provide the funds for the loan, FATC is instructed to deem the funds received and proceed with the disbursements, reducing SCCC's payment by this Loan-Funding Guarantee Amount.

FATC Buyer's and Borrower's Final Settlement Statements

rr. The FATC Borrower's Settlement Statement from dated April 13, 2016, related to Property A, details the disbursements from Escrow No. 4102-2617616 (PC) that were provided for by the above March 16, 2016 Closing Instructions. After fees to SCCC, Alpha, and FATC, the remaining $366,320.42 was disbursed to the Hartys.

ss. The FATC Buyer's Final Settlement Statement dated June 17, 2016, related to Property B, details the disbursements from Escrow No. 4102-2669247 (PC) that were provided for by the above June 7, 2016 Closing Instructions. After fees to SCCC, Alpha, and FATC, the remaining $694,394.60 was disbursed to the Hartys.

tt. The FATC Borrower's Settlement Statement dated September 21, 2016, related to Property C, details the disbursements from Escrow No. 4102-2606401 (PC) that were provided for by the above March 11, 2016 Closing Instructions. After fees to SCCC, Alpha, and FATC, the remaining $2,012,793.66 was disbursed to the Hartys.

uu. The FATC Buyer's Final Settlement Statement dated November 22, 2016, details the disbursements from Escrow No. 2606410a that were provided for by the March 11, 2016 Closing Instructions. After fees to SCCC, Alpha, and FATC, the remaining $526,413.94 was disbursed to the Hartys.

Property A — Exam traced the flow of the sale proceeds from Mariners Escrow to FATC to the final recipients:

vv. Mariners Escrow's Seller's Closing Statement dated April 13, 2016, for Escrow No. 50385-BF, shows a $407,717.15 disbursement to SCCC.

ww. An FATC Incoming Wire Details Report dated April 13, 2016, for Escrow No. 4102-2617616, shows $407,717.15 wired from Mariners Escrow to FATC.

xx. FATC's Borrower's Final Settlement Statement dated April 13, 2016, for Escrow No. 4102-2617616, shows the receipt of $407,717.15 from Mariners Escrow, and a $366,320.42 disbursement to First Republic Bank.

yy. A FATC Disbursement Summary Report and Wire Transfer Order, dated April 14, 2016, for Escrow No. 4102-2617616, shows $366,320.42 wired from FATC's account, First American Trust, FSB-002, to First Republic Bank account #xxxxxxxx771. The beneficiary of the account ending -771 is Stowe Properties Trust.

zz. The Harty's First Republic Bank statement for account ending -771 shows an April 14, 2016 wire transfer in for $366,320.42 from FATC.

Property B — Exam traced the flow of the sale proceeds from Mariners Escrow to FATC to the final recipients:

aaa. Mariners Escrow's Seller's Closing Statement dated June 15, 2016, for Escrow No. 51021-BF, shows a $776,970.08 disbursement to the seller.

bbb. An FATC Incoming Wire Details Report dated June 16, 2016, for Escrow No. 4102-2669247, shows $776,970.08 wired from Mariners Escrow to FATC.

ccc. FATC's Buyer's Final Settlement Statement dated June 17, 2016, for Escrow No. 4102-2669247, shows the receipt of $776,970.08 from Mariners Escrow, and a $694,394.60 disbursement to First Republic Bank.

ddd. A FATC Disbursement Summary Report and Wire Transfer Order, dated June 17, 2016, for Escrow No. 4102-2669247, shows $694,394.60 wired from FATC's account, First American Trust, FSB-002, to First Republic Bank account #xxxxxxxx771. The beneficiary of the account ending -771 is Stowe Properties Trust.

eee. The Harty's First Republic Bank statement for account ending -771 shows a June 17, 2016 wire transfer in for $694,394.60 from FATC.

Property C — Exam traced the flow of the sale proceeds from Mariners Escrow to FATC to the final recipients:

fff. Mariners Escrow's Seller's Closing Statement dated September 16, 2016, for Escrow No. 51724-BF, shows a $2,159,000.00 disbursement to “LOAN PAYOFF: Nat S Harty, Trustee Of The Stowe Properties Trust,” and an additional disbursement of $62,695.00 to The Stowe Properties Inc.

ggg. FATC's Borrower's Final Settlement Statement dated September 21, 2016, for Escrow No. 4102-2606401, shows the receipt of $2,159,000.00 from First American Title/Scottsdale, AZ, and a $2,012,793.66 disbursement to Stowe Properties (First Republic Bank).

hhh. A FATC Disbursement Summary Report and Wire Transfer Order, dated September 20, 2016, for Escrow No. 4102-2606401, shows $2,012,793.66 wired from FATC's account, First American Trust, FSB, to Stowe Properties' First Republic Bank account #xxxxxxxx771. The beneficiary of the account ending -771 is Stowe Properties Trust.

iii. The Harty's First Republic Bank statement for account ending -771 shows a September 20, 2016 wire transfer in for $2,012,793.66 from FATC.

jjj. Mariners Escrow's Borrower Statement dated November 16, 2016, also for Escrow No. 51724-BF, shows a $560,493.30 disbursement to “LOAN PAYOFF: Nat Stowe Harty.”

kkk. FATC's Buyer's Final Settlement Statement dated November 23, 2016, for Escrow No. 2606401a, shows the receipt of $560,493.30 from First American Title-Scottsdale, AZ, and a $526,413.94 disbursement to Stowe Properties (First Republic Bank).

lll. A FATC Disbursement Summary Report and Wire Transfer Order, dated November 23, 2016, for Escrow No. 2606401a, shows $526,413.94 wired from FATC's account, First American Trust, FSB, to Stowe Properties' First Republic Bank account #xxxxxxxx771. The beneficiary of the account ending -771 is Stowe Properties Trust.

mmm. The Harty's First Republic Bank statement for account ending -771 shows a November 23, 2016 wire transfer in for $526,413.94 from FATC.

LEGAL ANALYSIS OF ECONOMIC SUBSTANCE DOCTRINE

nnn. Under the common law economic substance doctrine, a transaction is disregarded for federal tax purposes if the taxpayer did not enter into the transaction for a valid business purpose, but rather sought to claim tax benefits not contemplated by a reasonable application of the language and purpose of the Internal Revenue Code or its regulations. See, e.g., Horn v. Commissioner, 968 F.2d 1229, 1236 (D.C. Cir. 1992). The doctrine originated in Gregory v. Helvering, 293 U.S. 465 (1935). In Gregory, the Court recognized the taxpayer's right to minimize taxes through legal means but stated that “the question for determination is whether what was done, apart from the tax motive, was the thing which the statute intended.” 293 U.S. at 469.

Section 7701(o) and Codified Economic Substance Doctrine

ooo. Section 1409 of the Health Care and Education Reconciliation Act of 2010 (Act) added section 7701(o) to the Code to provide clarification of the economic substance doctrine. That section applies to transactions entered into on or after March 31, 2010, and in the case of an individual, only where the transaction is entered into in connection with a trade or business or an activity engaged in for the production of income.

ppp. Section 7701(o) applies to taxpayers who have entered into the transaction after March 31, 2010. In all cases where the Monetized Installment Sale issue has been identified, the transaction occurs after March 31, 2010. The tax year at issue is 2016. The exception for personal transactions of individuals provided under section 7701(o)(5)(B) does not apply because the properties sold by the Hartys are in connection with a trade or business or an activity engaged in for the production of income. Most of the identified Monetized Installment Sale cases involve the sale of business or rental property. To the extent that a case only involves the sale of personal property, respondent would assert the judicial economic substance doctrine.

qqq. When determining if a transaction falls within the scope of section 7701(o), the first inquiry is whether the economic substance doctrine is relevant to the transaction. If the doctrine is relevant, the second inquiry is whether the transaction is treated as having economic substance under section 7701(o).

Economic Substance Doctrine is Relevant

rrr. Section 7701(o)(5)(C) provides that the determination of whether the economic substance doctrine is relevant to the transaction should be made as if section 7701(o) had never been enacted. There are several similar cases where the common law economic substance doctrine was applied.

sss. In this case, the Hartys used a series of transactions to avoid recognizing the gain from the sale of Property A, Property B, and Property C (“Properties”).

Phase 1

ttt. After finding the third-party buyers, the Hartys convinced the third-party buyers to use the promoter's proposed structure.

Phase 2

uuu. The Hartys entered into three MIS transactions with SCCC (conduit entity) with respect to the sale of the Properties.

vvv. In cases where it was shown that the seller, under the installment contract, (1) had effective control over the buyer, viz, the buyer was acting as an agent of the original seller in reselling the property, or (2) the seller reserved to himself significant rights with respect to the proceeds of the buyer's later sale (e.g., where there is an escrow agreement), the courts have tended to find that the installment sale was a mere sham transaction, lacking economic reality and held that the installment sale was to be disregarded for income tax purposes. See Griffith v. Commissioner, 73 T.C. 933 (1980); Lustgarten v. Commissioner, 639 F.2d 1208 (5th Cir. 1981); Trivett v. Commissioner, T.C. Memo. 1977-161, affd. 611 F.2d 655 (6th Cir. 1979); Wrenn v. Commissioner, 67 T.C. 576 (1976); Pozzi v. Commissioner, 49 T.C. 119 (1967). There are no similar cases where section 7701(o) was applied.

www. There are no prior cases involving this exact transaction. However, the Hartys entered into MIS transactions to delay recognition of gain without delaying the receipt of sales proceeds, without incorporating any risk, and for a modest fee. As a transaction that serves no purpose other than to change the tax treatment of gain on a sale, it is the definition of a transaction lacking economic substance. The codified economic substance doctrine is relevant to the transaction at issue.

Transaction Lacks Economic Substance under Section 7701(o)

xxx. Section 7701(o)(1) provides that a transaction is treated as having economic substance only if: (a) the transaction changes the taxpayer's economic position in a meaningful way apart from federal income tax effects (the objective prong), and (b) the taxpayer has a substantial purpose for entering into the transaction apart from federal income tax effects (the subjective prong).

The transaction does not change the taxpayer's economic position in a meaningful way, apart from the federal income tax effects of the transaction.

yyy. As outlined in section 7701(o)(1)(A), if a transaction does not change the taxpayer's economic position in a meaningful way, then the transaction may lack economic substance. Here, without the tax benefit, the Hartys are worse off financially by entering into the MIS transactions. The Hartys identified the ultimate buyers prior to entering into the purported installment agreements with the promoter and obtaining purported loans. By entering into the MIS transactions, the only economic difference is that the Hartys paid a small percentage of the sale price as a fee and in exchange avoided recognizing gain from the sale for 30 years. The Hartys received all of the sales price (less the fee) in the form of loan principal while incurring no risk of default due to the recycling loan payment through the escrow accounts. Further, the title to the properties are directly transferred from the Hartys to the ultimate buyers.

The taxpayer does not have a substantial purpose for entering into the transaction apart from the federal income tax effects.

zzz. As outlined in section 7701(o)(1)(B), if a transaction does not have a substantial business purpose apart from the tax benefits, then the transaction may lack economic substance. The Hartys' intent for entering into these transactions was to obtain a tax benefit by avoiding the recognition of gain on the sale of real property. Here, the MIS transactions adds several layers of complexity to a sale without serving a business purpose independent of the tax deferral. The promoter makes a vague claim about improving the credit worthiness of the seller and potentially increasing the sale price available to the seller, but this is not logical. The seller has assets of known value. Adding the promoter as an intermediary will not increase the value of that asset at all, let alone make up for the fee charged by the promoter. Similarly, any warranties that are included as part of the sale usually pass directly between the seller and ultimate buyer. The promoter serves no purpose as an intermediary other than to create the installment-escrow-loan structure which creates the tax benefit.

aaaa. Respondent has also analyzed whether the transaction is a statutory or regulatory election and whether it is subject to a detailed statutory or regulatory scheme. While there is an election to opt out of installment sale treatment, there is no election required before an installment sale and the resulting tax treatment will be deemed valid. Whether and how an installment sale is treated for tax purposes is determined by section 453 and its associated regulations. The installment sale treatment exists so the seller does not have to recognize the gain of the sale until he actually receives sale proceeds from the buyer. Here, the Hartys already had the ultimate buyers who were willing to pay the full price of the Properties. The Hartys could have sold the Properties directly to the ultimate buyers. Rather, they “sell” the Properties to the promoter under an “installment sale” then the promoter sells the Properties to the ultimate buyers. Furthermore, the seller has no risk of the promoter defaulting because the transactions are fully funded on day one. The seller receives his “loan” proceeds and the promoter and the lender each receive their fees, immediately. The remainder of the transactions are a rotating bookkeeping entry. The structure of the MIS transaction, in its entirety, perverts the purpose of the installment sale treatment — allocating gain in proportion to actual proceeds received — to create a tax shelter. Therefore, the application of the ESD is appropriate.

Section 6662(b)(6) Penalty

bbbb. Section 6662(b)(6) imposes an accuracy-related penalty on any portion of an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance. Section 6664(c) precludes the reasonable cause exception from applying to any portion of an underpayment attributable to one or more section 6662(b)(6) transactions.

cccc. Based on the analysis provided above the section 6662(b)(6) penalty is appropriate in this case because the entire underpayment was attributable to transactions lacking economic substance.

dddd. Section 6662(i) increases the section 6662(b)(6) accuracy-related penalty from 20 percent to 40 percent for any portion of an underpayment that is attributable to a “nondisclosed noneconomic substance transaction” if the relevant facts affecting the tax treatment are not adequately disclosed in the return or a statement attached to the return.

eeee. Adequate disclosure occurs if a taxpayer discloses the relevant facts affecting the tax treatment of the transaction on a timely filed original return or a qualified amended return. See 26 CFR § 1.6662-4(e)(1) & (f)(1)-(2).

ffff. Section 6662(d)(2)(B)(ii) provides that an understatement is reduced by the portion of the understatement attributable to any item if the relevant facts affecting the item's tax treatment are adequately disclosed on the return or in a statement attached to the return, and there is a reasonable basis for the tax treatment of such item by the taxpayer.

gggg. Regulations under section 6662 and Notice 2010-62 provide that disclosure will be considered adequate only if it is made on a Form 8275 or 8275-R, or as otherwise prescribed in forms, publications, or other guidance subsequently published by the IRS, consistent with the instructions and other guidance associated with those subsequent forms, publications, or other guidance. See 26 CFR § 1.6664-(f)(1).

hhhh. Petitioners did not make a proper disclosure. Petitioners did not file Forms 8275 or 8275-R, nor did they make any other attempt to disclose the relevant facts affecting the items' tax treatment.

iiii. Here, petitioners filed Forms 6252, Installment Sale Income, but this alone would be insufficient as it does not adequately describe the transaction. It does not detail the relationship between the promoter and the lender, nor does it reference the loan proceeds at all.

jjjj. Accordingly, a 40-percent penalty is appropriate for any portion of the underpayment attributable to the transaction described herein.

8. This amendment to answer is signed below by Jordan S. Musen, supervisor of respondent's attorney Justine Coleman, as the written supervisory approval of the attorney's initial determination pursuant to section 6751(b)(1).

WHEREFORE, it is prayed:

(1) That the relief sought in the petition be denied;

(2) That respondent's determination, as set forth in the notice of deficiency, be in all respects approved, as modified by respondent's newly asserted penalty;

(3) That the accuracy related penalty under the provisions of I.R.C. § 6662(b)(6) at the rate prescribed in I.R.C. § 6662(i) for the year 2016, as set forth in this amendment to answer, be in all respects approved.

DRITA TONUZI
Deputy Chief Counsel (Operations)
Internal Revenue Service

 

By: JUSTINE S. COLEMAN
General Attorney (Tax)
(Small Business/Self Employed)
Tax Court Bar No. CJ1820
950 Hampshire Road
East Pavilion
Thousand Oaks, CA 91361-2819
Telephone: 805-367-0078
justine.s.coleman@irscounsel.treas.gov

Date:

By: JORDAN S. MUSEN
Associate Area Counsel
(Small Business/Self Employed)
Tax Court Bar No. MJ1957
950 Hampshire Road
East Pavilion
Thousand Oaks, CA 91361-2819
Telephone: 805-367-0099
jordan.s.musen@irscounsel.treas.gov

Date:

OF COUNSEL:
JOSEPH W. SPIRES
Division Counsel
(Small Business/Self-Employed)
SHERRI SPRADLEY WILDER
Area Counsel
(Small Business/Self-Employed: Area 8)

FOOTNOTES

1While the taxpayer is using I.R.C. § 453 to delay his gain, this transaction is not a true installment sale. The property goes to the ultimate buyer, while nearly all the sales proceeds go to the seller in the form of a loan. The promoter and his related lender take a cut of the proceeds and make a small deposit into an escrow account. This small amount circulates, via book entry, from promoter to seller to lender and back to promoter until the loan terminates. There is no economic risk, which would normally arise in an installment sale, as the seller has already been fully paid. Furthermore, the seller receives nearly the full amount of the proceeds immediately via the related loan, which could never be secured independently of this transaction.

2Also known as a Seller Take-Back or Vendor Take-Back mortgage.

END FOOTNOTES

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