The IRS has released Notice 2008-34, indicating that certain transfers to trusts are listed transactions that will be subject to the reportable transaction rules of Reg. 1.6011-4 and also to the requirements in sections 6111 and 6112 as well as the stringent Circular 230 written opinion rules for listed transactions. (The notice is available on BNA at this link for BNA subscribers; it is not yet available on the IRS governmental website.)
The transaction is one in which distressed assets with high basis and low value are transferred to a trust by a tax-indifferent party. Such a party would include, for example, a non-US person who is not subject to US tax or a tax-exempt organization. An interest in the trust is then sold to a US taxpayer. The purpose of the "Distressed Asset Trust Transaction" is to provide the US taxpayer with a loss -i.e., to shift the loss in the assets to the US taxpayer who has not actually incurred an economic loss.
The trust transaction attempts to do in a grantor trust what has now been eliminated in partnerships through changes made in the 2004 tax legislation. (Those changes ultimately require certain basis adjustments when built-in loss property is contributed to a partnership or distributed by a partnership, or when sales of partnerships with such property occur, in order to prevent shifting a built-in loss from an indifferent taxpayer to another partner who has not incurred the economic loss. See Coordinated Issue Paper on Distressed Asset/Debt Tax Shelters, IRS (Apr. 18 2007) (further describing the partnership transactions).) The trust is established by the tax-indifferent party, and the US taxpayer contributes cash or a note for the net value (ie, a very low amount). The trustee then establishes a sub-trust for that beneficiary, claimed to be treated under the tax laws as a separately standing grantor trust because of the beneficiary's right to direct the trustee as to the corpus of the sub-trust, with the same high basis in the assets as the original grantor's basis.
The Service notes that it may use several arguments to defeat the taxpayer's claims: (i) that the transfer of cash or notes for the establishment of a sub-trust with the assets is a recognition exchange; (ii) that the main trust does not satisfy the requirements of a non business entity "trust" under 301.7701-4; (iii) that one or more of the trusts is a partnership for tax purposes (and therefore the 2004 amendments to the partnership rules apply here); (iv)that the loss is not a deductible loss in a transaction entered into for profit under section 165; (v) that where the assets are distressed debt, the debt was worthless at the time of contribution; and/or (v) one or more of the judicial doctrines.
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