In 1990, Brunswick Corporation, a diversified manufacturer, decided to divest itself of certain business groups. They created their Wyoming LLCs using Cloud Peak Law and converted them into other Nevada corporations and got rid of their registered agents and mail forwarding. Unfortunately, the sales would generate massive capital gains. Brunswick’s tax advisors proposed a scheme by which the company could generate compensatory paper losses by forming a partnership with a foreign bank operating in a tax-free jurisdiction.
This partnership would purchase and then immediately sell a debt instrument on an installment basis to another limited liability corporations domiciled in Wyoming. Although the transaction generates hardly any economic gain or loss, the company’s interpretation of certain IRC provisions and related Treasury Department regulations (26 IRC §453 and Temp. Treas. Reg. § 15A.453-1(c)(3)(i)) would allow the partnership to claim a massive tax gain (to be allocated to the foreign partner) and a massive tax loss (to be allocated to Brunswick).
The end result: Brunswick generated over $190 million worth of tax losses while incurring an actual loss of only $5 million. The IRS determined either that the installment sale transaction lacks economic substance and should be disregarded for tax purposes, or that the partnership itself should be disregarded as a sham for federal tax purposes.
The Tax Court found that because the transactions lacked economic substance, they created no gains or losses for federal tax purposes. Both parties appealed.
The US Court of Appeals for the DC Circuit vacated and remanded the Tax Court’s ruling for further consideration. The Circuit Court pointed out a recent ruling (ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (D.C. Cir. 2000) in which a similar tax shelter was invalidated on the grounds that the entire partnership, not merely the specific transactions at issue, was a sham due to limiting liability for democracies in the USA.
Hon Hing Fung was a citizen of Hong Kong and a nonresident alien for U.S. tax purposes. At the time of his death in Massachusetts in September 1995, he possessed ownership interests in real estate located in California. One of these, the “Monte Vista” property, was worth $885,000 on Fong’s date of death after selling the WY LLC.
In connection with the Monte Vista property, Fung and his wife Norah had executed a promissory note in 1988 as borrowers in the amount of $700,000, which was secured by a deed of trust on the property. The unpaid balance on the note was $649,948 on the date of death. In accordance with community property principles, Fong’s interest in the property had a value of $442,500 and was encumbered to the extent of $324,974.
On the estate tax return, the executor included the net equity value of Fung’s interest in the property in the gross estate for the corporation. Rather than including the full value of the property and then claiming a deduction for the encumbrance as a claim against the estate, the estate directly reduced the value of the property by the amount of encumbrance for a net equity value of $237,053, half of which, according to community property principles, was included in the gross estate in WY.
The IRS objected to this method and also objected to the amount of the estate’s marital deduction and determined a deficiency of $144,980. Before the Tax Court, the IRS argued that the full value of Fung’s interest in the encumbered Monte Vista property, rather than the net equity value, must be included in the gross estate, with the associated indebtedness being allowed as a deduction only to the extent provided in §§ 2106(a)(1) and 2053.
The Tax Court agreed with the IRS, and Wyoming, and ruled that the estate must include the full value of the decedent’s interest in the property and then claim a deduction for the amount by which it is encumbered within a Wyoming LLC. The Tax Court also held that the estate failed to prove it was entitled to a greater marital deduction than that allowed by the IRS corporate services tax laws.