DATs – Distressed Asset Trust Transactions
IRS Notice 2008-34

Promoters: MAIN TRUST is a trust for Federal income tax purposes, with the stated purpose of preserving and protecting assets, and NOT a “business entity” under the check-the-box regulations. As a result, under IRC § 1015(b), Main-Trust’s basis in the distressed assets is the same as the tax-indifferent party’s basis. Since, under the Main Trust Agreement, trustee X is permitted to establish one or more sub-trusts, transfer certificates of beneficial ownership to taxpayers, and allocate distressed assets to a sub-trust, for the sole benefit of a beneficiary of the sub-trust. The holder of any sub-trust certificate is then given various rights to direct the trustee to vest the holder’s ratable share of the corpus or income in the holder of that certificate. The existence of these rights causes the taxpayer to be treated as the owner of the sub-trust under IRC § 678. As a result, built-in losses once held by the tax-indifferent party are shifted through these sub-trust arrangements, and into the hands of the taxpayer.

IRS:
The IRS believes that the built-in loss purportedly transferred to MAIN TRUST and then into a sub-trust, is then improperly shifted to the taxpayer. The IRS will make a number of arguments on this, including, but not limited to:

1. The taxpayer’s transfer of cash or not to MAIN TRUST, in exchange for certificates of beneficial interests, is a transfer of the distressed assets under IRC § 1001;
2. MAIN TRUST is not a trust for Federal income tax purposes, under the check-the-box regulations (Regs. § 301.7701-4);
3. MAIN TRUST is not a taxable trust;
4. One or more of the entities involved are properly classified as de facto partnerships for Federal income tax purposes, subject to IRC §§ 704(c)(1)(C); 734(b); 743;
5. Claimed worthless deduction under IRC § 165 was not incurred in transaction undertaken for profit;
6. Judicial doctrines like substance over form, lack of economic substance, step-transaction;
7. Distressed debt was worthless under IRC § 166 at the time of the contribution to MAIN TRUST (and sub-trust).

Section 1012 of the Internal Revenue Code provides that the basis of property is equal to the cost of the property and Regulations Section 1.1012-1(a) define “cost” to mean the amount paid for the property in cash or other property. General tax law principles establish that the amount paid for property includes the amount of the seller?’s liabilities assumed by the buyer.

NOTE: The IRS and Treasury Department are aware that, prior to the JOBS Act of 2004 (October 23, 2004), taxpayers used partnerships improperly to engage in variations of distressed asset transactions. See, e.g., Coordinated Issue Paper Distressed Asset/Debt Coordinated Issue Paper, LMSB 04-0407-031 (April 18, 2007)(discussing distressed asset transactions involving partnerships, called DAD). However, the JOBS Act of 2004 amended IRC §§ 704, 734, and 743, effective October 23, 2004, for contributions of built-in loss property to a partnership, for basis adjustment rules in the case of a distribution for which there is a substantial basis reduction and for basis adjustment rules in the case of a transfer of a partnership interest for which there is a built-in loss. These provisions generally: (1) require that a built-in loss may be taken into account only by the contributing partner and not the other partners; (2) make the basis adjustment mandatory in cases with a substantial basis reduction or substantial built-in loss. In other words, the JOBS Act of 2004 were aimed at preventing taxpayers from attempting to shift a built-in loss from a tax-indifferent party to a US taxpayer, through the use of a partnership.

The IRS and Treasury Department learned that a variation of DAD soon developed, using trusts, and this is being promoted as a means by which to avoid the JOBS Act of 2004 revisions. By “listing” these transactions, the IRS leaves no doubt that they do not believe it appropriate for taxpayers to attempt to acquire built-in loss positions held by promoter-types (i.e., tax-indifferent parties).

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If you believe that you may have engaged in a transaction that is the same or substantially similar to the transaction described above, Federal law may require you to disclose your and other parties’ participation in any such “listed transaction”on IRS Form 8886.   For more information, please contact us.