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banker recommended the leveraged
partnership structure and identified the
other suitable partner. The company's
board agreed to a lower valuation for
its contributed assets, provided forma-
tion of the joint venture did not create a
significant tax liability for the company.
The accounting firm believed a trans-
action could be structured that would
be treated as a sale for financial
accounting purposes, yet would not
result in current taxation. To achieve
the desired results, the accounting
firm assisted the investment banker
in negotiating and structuring the
joint venture.
Finally, the accounting firm agreed to
a fixed fee arrangement for rendering
an opinion that the transaction would
not result in current recognition of a
tax gain.
Subsequent Events
In the original transaction, the compa-
ny deferred tax on a $524 million gain.
While the gain was expected to remain
deferred for a substantial period of
time, the joint venture only operated for
one full year (two tax years). To comply
with an antitrust mandate issued by the
Department of Justice in connection
with another acquisition, the other part-
ner had to dispose of his or her interest
in the partnership. The new buyer was
only interested in purchasing the entire
operation, so the company sold its
partnership interest and recognized all
of the deferred gain.
By the time the IRS challenged the
original transaction as a disguised
asset sale, presumably the company
had already paid tax on the deferred
gain. The amount at stake must have
been the interest on the tax liability for
the two-year deferral period.
Unable to successfully settle with the
IRS, the company decided to take the
case to the Tax Court. The IRS
responded with the assertion of a
$36.7 million accuracy-related penalty
for a substantial understatement of tax.
Tax Court's Opinion
On the income tax issue, the court
sided with the IRS. To the court, the
key tax question was whether the com-
pany's indemnification of the other
partner's guarantee truly made the
company liable for the partnership's
debt. In essence, the court determined
that the company had too many other
liabilities and too few assets to be able
to fulfill its obligations under the indem-
nity agreement.
Of greater interest for purposes of this
analysis is how the court dealt with the
accuracy-related penalty. The compa-
ny asserted that by relying on the
advice of a competent tax adviser, it
was entitled to avoid the penalty by
invoking the reasonable cause excep-
tion under IRC 6664(c) and Reg.
1.6664-4(b)(1). The court disagreed.
Tax Opinion Letter
To avoid the penalty, the company had
to show that there was reasonable
cause for the understatement of tax
and that the company acted in good
faith in relying on the advice of the
accounting firm.
The court clearly did not want to allow
the company to use the accounting
firm's opinion letter to meet the reason-
able cause exception. Unfortunately, in
decimating the accounting firm's
opinion, the court may have made it
more difficult for any client to rely on
tax advice rendered by his or her
One wonders whether the court expects an
opinion letter to be free of any expressed opinions.
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