n-08-34.pdf

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Part III - Administrative, Procedural, and Miscellaneous

Distressed Asset Trust (DAT) Transaction

Notice 2008-34

The Internal Revenue Service (Service) and the Treasury Department are aware
of a type of transaction, described below, in which a tax indifferent party, directly or
indirectly, contributes one or more distressed assets (for example, a creditor’s interest in
debt) with a high basis and low fair market value to a trust or series of trusts and sub-
trusts, and a U.S. taxpayer acquires an interest in the trust (and/or series of trusts
and/or sub-trusts) for the purpose of shifting a built-in loss from the tax indifferent party
to the U.S. taxpayer that has not incurred the economic loss. This notice alerts
taxpayers and their representatives that this transaction (referred to as a distressed
asset trust or DAT transaction) is a tax avoidance transaction and identifies this
transaction, and substantially similar transactions, as listed transactions for purposes of
§ 1.6011-4(b)(2) of the Income Tax Regulations and §§ 6111 and 6112 of the Internal
Revenue Code. This notice also alerts persons involved with these transactions to
certain responsibilities that may arise from their involvement with these transactions.
BACKGROUND

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The Service and Treasury Department are aware that, prior to October 23, 2004,
taxpayers used partnerships improperly to engage in variations of the distressed asset
transaction described in this notice. The Coordinated Issue Paper, “Distressed
Asset/Debt Coordinated Issue Paper,” LMSB-04-0407-031 (Apr. 18, 2007) describes
the variation of the distressed asset transaction involving partnerships (DAD). The
American Jobs Creation Act of 2004, Public Law 108-357 (118 Stat. 1418) (AJCA),
amended §§ 704, 734 and 743 effective after October 22, 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 substantial
built-in loss. The revisions to §§ 704, 734 and 743 generally (1) require that a built-in
loss may be taken into account only by the contributing partner and not other partners,
and (2) make the basis adjustment rules mandatory in cases with a substantial basis
reduction or substantial built-in loss. Thus, the statutory changes to §§ 704, 734 and
743 under AJCA prevent taxpayers from shifting a built-in loss from a tax indifferent
party to a U.S. taxpayer through the use of a partnership. The Service and Treasury
Department have learned that a variation of the distressed asset transaction using a
trust is being promoted in an attempt to avoid these revisions made by AJCA.
Consequently, this notices identifies the DAT variation of the transaction as a listed
transaction under § 1.6011-4(b)(2) for transactions that are entered into after October
22, 2004.
FACTS

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In a DAT transaction, a tax indifferent party creates a trust (Main-Trust) with X as
trustee. The tax indifferent party contributes distressed assets directly or indirectly
(through a partnership or otherwise) to Main-Trust, and is described as the grantor and
beneficiary of Main-Trust.
A U.S. taxpayer (Taxpayer) transfers cash or a note to Main-Trust in exchange
for certificates evidencing units of beneficial interest in Main-Trust. The cash or note
approximately equals the fair market value of the distressed assets. Under the terms of
the Main-Trust agreement, Taxpayer thereby becomes a beneficiary of Main-Trust.
The parties contend that Main-Trust is a trust for tax purposes with the stated
purpose of preserving and protecting assets. Thus, the parties contend that Main-Trust
is to be taxed as a trust under the Internal Revenue Code, and not as a business entity
described in § 301.7701-2 of the Procedure and Administration Regulations. As a
result, the parties contend that under § 1015(b), Main-Trust’s basis in the distressed
assets is the same as the grantor’s basis in the distressed assets (in this case, the tax
indifferent party’s basis).
Under the Main-Trust agreement, X, the trustee, is permitted to establish one or
more sub-trusts of Main-Trust, each for a separate beneficiary of Main-Trust who will
then be the sole beneficiary of that sub-trust. The Main-Trust agreement further
provides that each sub-trust for a beneficiary constitutes a separate and distinct sub-
trust of Main-Trust with beneficial interest certificates issued and separate records
maintained for each sub-trust.
As permitted under the Main-Trust agreement, the trustee creates a separate
sub-trust (Sub-Trust), transfers certificates evidencing units of beneficial interest in Sub-

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Trust (Sub-Trust Certificates) to Taxpayer, and allocates the distressed assets to Sub-
Trust for the sole benefit of the beneficiary of the Sub-Trust. The Main-Trust agreement
entitles the holder of Sub-Trust Certificates to various rights including the right to direct
the trustee to vest the holder’s ratable share of the corpus or the income of Sub-Trust in
the holder. The Taxpayer contends that the existence of these rights causes the
Taxpayer to be considered the owner of Sub-Trust under § 678, and that Sub-Trust is a
grantor trust. As a result of being treated as the owner of Sub-Trust, the Taxpayer
takes into account those items of income, deductions, and credits against tax, which are
attributable to Sub-Trust, to the extent that such items would be taken into account in
computing taxable income or credits against the tax of an individual. Section 671. The
Taxpayer contends that Sub-Trust’s basis in the distressed assets is the same as the
grantor’s basis in the distressed assets (in this case Main-Trust’s basis). Section
1015(b). Within a short period of time, the distressed assets held by the Sub-Trust are
written off as wholly worthless under § 166. Alternatively, the distressed assets are
sold, and Taxpayer claims a deduction under § 165.
DISCUSSION
The transaction described in this notice attempts to shift built-in losses from a tax
indifferent party to a U.S. taxpayer who has not incurred an economic loss so that the
U.S. taxpayer may claim a deduction of the built-in losses from the distressed assets.
The built-in loss purportedly transferred to Main-Trust and Sub-Trust and improperly
shifted to the Taxpayer is not an allowable loss for the Taxpayer. The Service may
assert one or more arguments that may include, but are not limited to, asserting that the
Taxpayer’s transfer of cash or a note to Main-Trust in exchange for certificates of

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beneficial interest is a transfer of the distressed assets under § 1001; asserting that
Main-Trust does not meet the trust requirements of § 301.7701-4; asserting that Main-
Trust is not a taxable trust; asserting that one or more of the entities is properly
classified for Federal tax purposes as a partnership subject to §§ 704(c)(1)(C), 734(b)
and 743; asserting that the claimed loss deduction under § 165 was not incurred in a
transaction undertaken for profit; asserting the judicial doctrines, including substance
over form, lack of economic substance, and step transaction; and asserting that, in the
case of distressed debt, the distressed debt was worthless under § 166 at the time of
contribution to Main-Trust and Sub-Trust.
Transactions that are the same as, or substantially similar to, the transaction
described in this notice that are entered into after October 22, 2004, are identified as
“listed transactions” for purposes of § 1.6011-4(b)(2) and §§ 6111 and 6112 effective
February 27, 2008, the date this notice was released to the public. Independent of their
classification as listed transactions, transactions that are the same as, or substantially
similar to, the transaction described in this notice may already be subject to the
requirements of § 6011, § 6111, § 6112, or the regulations thereunder. However, the
variations of this transaction described in the Coordinated Issue Paper, “Distressed
Asset/Debt Coordinated Issue Paper,” LMSB-04-0407-031 (Apr. 18, 2007), that are
subject to the AJCA changes to §§ 704, 734 and 743 are not being identified as “listed
transactions” for purposes of this notice, § 1.6011-4(b)(2), § 6111 and § 6112.
Persons required to disclose these transactions under § 1.6011-4 who fail to do
so may be subject to the penalty under § 6707A, which applies to returns and
statements due after October 22, 2004. Persons required to disclose these transactions

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under § 1.6011-4 who fail to do so may be subject to an extended period of limitations
under § 6501(c)(10). Persons required to disclose these transactions under § 6111 who
fail to do so may be subject to the penalty under § 6707(a). Persons required to
maintain lists of investors under § 6112 who fail to do so (or who fail to provide such
lists when requested by the Service) may be subject to the penalty under § 6708(a). In
addition, the Service may impose other penalties on persons involved in these
transactions or substantially similar transactions, including the accuracy-related penalty
under § 6662 or § 6662A.
A person that is a tax-exempt entity within the meaning of § 4965(c), or an entity
manager within the meaning of § 4965(d), may be subject to excise tax, disclosure,
filing or payment obligations under § 4965, § 6033(a)(2), § 6011, and § 6071. Some
taxable entities may be subject to disclosure obligations under § 6011(g), that apply to
“prohibited tax shelter transactions” as defined by § 4965(e) (including listed
transactions).
The Service and Treasury recognize that some taxpayers may have filed tax
returns taking the position that they were entitled to the purported tax benefits of the
type of transaction described in this notice. These taxpayers should take appropriate
corrective action and ensure that their transactions are disclosed properly.
DRAFTING INFORMATION
The principal author of this notice is Eric Ingala of the Office of Associate Chief
Counsel (Passthroughs and Special Industries). For further information regarding this
notice, contact Mr. Ingala at (202) 622-3070 (not a toll-free call).