Don’t Mess with the IRS

The agency is taking companies to court more often, and winning. Is it time to rethink your tax position?

April, always the cruelest month for taxpayers, became more so this year when the Internal Revenue Service racked up yet another victory against a corporate tax shelter. At issue was a decade-old transaction between a U.S.-based financial holding company, BB&T Corp., and a Swedish wood-pulp manufacturer, Sodra Cell.

In 1997, BB&T leased a 22 percent interest in pulp-manufacturing equipment at one of Sodra’s mills and immediately subleased it back to Sodra. That brought BB&T a nice deduction. And, the IRS charged, not much else. To the agency, the deal was a prime example of an abusive tax shelter known as lease in, lease out (LILO). Although the transaction predated the 1999 tax code changes that shut down LILOs, the IRS challenged it and won in 2007 — the first time such a shelter had been tested in court.

Then, in April, a federal appeals court sided with the IRS. For BB&T, the verdicts meant an additional $1.2 billion paid in taxes and interest to clear its bill for Sodra and similar transactions.

The BB&T case is just one of several major tax-shelter cases won by the IRS in recent months. The shock waves from those victories are reverberating far and wide. Certainly, any of the hundreds of companies that have engaged in LILO or SILO (sale in, lease out) transactions, banned in 2004, will be reviewing their options. Banking giant Wachovia, for one, announced in April that as a result of the BB&T verdict it would take up to a $1 billion noncash charge to earnings related to SILO transactions. Another bank, KeyCorp, said in June that it would take a charge to earnings and capital of up to $1.2 billion, halve its dividend, and issue shares to raise another $1.5 billion — all because of a SILO strategy involving a German waste-to-energy facility that was struck down by the Northern District of Ohio court.

LILOs and SILOs haven’t been the only shelters in the IRS’s crosshairs. Last April, in a case involving a so-called intermediary transaction, a Texas federal court judge decided that Enbridge Energy was liable for more than $155 million in past and future taxes, plus penalties. Enbridge had bought stock in a pipeline company in 2001 through what was eventually deemed a sham company, thus gaining tax deductions.

Even companies that aren’t harboring any tax shelters on their books may not be safe. Experts say the IRS’s treatment of all types of tax disputes is changing as the agency applies the tough tactics it used in shelter cases to more-ordinary transactions. Gerald Kafka, global chair of Latham & Watkins LLP’s tax-controversy practice group, calls this “the trickledown effect,” which includes more national coordination on issues, a greater involvement of attorneys, and more requests for information from corporate advisers and other third parties. This new approach, coupled with an unprecedented amount of new disclosure required from companies, has made the IRS a fundamentally tougher opponent, both in court and out. “The odds are overwhelmingly in our favor,” says Donald Korb, chief counsel for the IRS since 2004.

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