What's the Difference Between A Real and A Tax Shelter Transaction?

What follows is from "A Practitioner's Perspective on Substance, Form and Business Purpose in Structuring Business Transactions and Tax Shelters." by Peter C. Canellos. It was published in the SMU Law Review in the Winter of 2001. This is one of my favorite legal passages because it really gets to the heart of the difference between a "real" tax planner, and the marketed tax shelter business.

Real transactions, most obviously, have as their origins and purpose making money in the short-run or the long-run by increasing revenues or reducing (non-tax) expenses. As a subset, business-based financings attempt to raise capital for the company's business. Taxes of course play a role in analyzing financings and other business transactions, but they do not provide the primary motivation for undertaking the transaction. Tax shelters by contrast exist principally to reduce taxes by generating tax benefits usually derived from losses or credits that reflect outlays, expenses, and negative economic items. The equity investment in a real *53 transaction is aimed at generating a sufficient economic return to exceed, on a risk-adjusted basis, the entity's cost of capital. The investment in a tax shelter is a fee paid for tax benefits. The investor either expects to lose it or expects a return with an economic yield that is below market on a risk-adjusted basis. The economic return, if present, is often a carefully calibrated item designed to satisfy a perceived talismanic business purpose standard. The economic risk is likewise circumscribed so that, while predictable small losses may exist, large unpredictable losses do not.

Real transactions generally arise from commercial contacts, in-house corporate development and similar departments, business brokers and outside investment advisers. If not originated in-house, they are generally marketed to the sectors of corporate management dealing with acquisitions, divestitures, finance, corporate development, etc. They usually reflect a business or financing idea, not a tax-savings idea. Tax shelters are generally created by specialized tax professionals, usually but not always independent of the corporation in question. If developed outside the corporation they are generally marketed to the tax or finance department of the corporation, although in some high profile, large dollar cases the pitch is made to the highest management levels.

Real transactions generally involve real parties in interest (e.g. buyer and seller) with financing parties supplying capital at market rates of return. Tax shelters often, probably most of the time, involve accommodation parties that are not U.S. taxpayers (e.g. foreign entities, tax-exempts, loss corporations) to whom income is deflected, often through a partnership or other non-taxed entity.

Real transactions, other than financings, are generally open-ended with undefined outcomes. Corporations expect them to generate returns that exceed the corporation's cost of capital but also expect a corresponding risk of loss. (Financings generally involve predictable outlays but generate proceeds whose investment is expected to generate open-ended returns, or at least returns that exceed (pre-tax) financing costs.) In contrast, tax shelters usually involve largely predictable outcomes in order to assure that the expected tax benefit will be available to offset a particular gain or income item. To achieve the predictable result, carefully scripted scenarios are usually followed. Indeed, it is the choreographed series of steps--typically foreign to the corporation's usual business, involving extraneous parties and often employed by other users of the same shelter type--that courts often seize upon in branding a transaction as a shelter.

Although in theory the line between a tax shelter and an aggressively structured real transaction may appear difficult to draw, in actuality the *54 distinction is generally rather easy to establish when the transaction involves most of the tax shelter elements described above. That is why it may be hard to define shelters legislatively (and the difficulty is compounded if the stakes are substantive disallowance as opposed to disclosures and penalties) but so easy for courts to determine whether an actual transaction is a shelter. Consider these variations on partnership transactions. In the first case, corporations A and B contribute businesses to a partnership, A receives 90% from the income from B's business, B 90% of A's, with the expectation of a redemption of A in year eight for B's business. In the second case, A contributes its business, B contributes cash, partnership borrows cash (recourse to A) and distributes it to A; expected redemption of A in year eight. The third case parallels case two but the redemption is for stock of a subsidiary holding high-basis investment assets. In the fourth, A and B contribute cash, assets are acquired and sold in a manner designed to generate an artificial tax gain which is allocated to B, a non-taxable entity; B is redeemed and A is left with an artificial loss. Most observers would treat the first and second as real business transactions, the third as an aggressive but real business transaction, and the fourth as a tax shelter.

The tax shelter stigma attaches most firmly and justifiably to transactions involving loss generation and/or tax-exempt accommodation parties to whom income is deflected or whose investment is used to generate a loss allocated to the shelter investor but without the tax consequences of debt incurrence. The ACM case, for example, drew precious few criticisms of the outcome, which seemed well deserved. As for step-down preferred, the severe I.R.S. reaction reflected both the abusive nature of the transaction (deflecting uneconomic amounts of income to tax-exempt holders with matching artificial deductions to taxpayers for the equivalent of principle amortization) and its massive revenue implications. This was in the context of a transaction that probably worked under then-existing rules but was too good to be true. The same could also be said of so-called liquidating REIT transactions.

Transactions involving income shifting within an affiliated group, unwarranted interest deductions on corporate-owned life insurance or foreign tax-credits on dividend-stripping transactions exist in the hinterland between merely aggressive transactions and tax shelters, the border crossed as artificiality increases and tax benefits become more unreasonable. Cottage Savings-type transactions, resulting in recognition of true economic losses, have been sustained by the courts and would not generally be regarded as true tax shelters by practitioners.