ďCargo CultĒ Tax Opinions Wonít Stop IRS Push for International Penalties
(October 28, 2004)

A ďcargo cultĒ is a belief that if one goes through the proper rituals Ė building a runway and control tower on a remote South Sea island, for instance Ė that the results one wants (e.g., planes full of cargo) are destined to occur. Some taxpayers have followed their own cargo cult, believing that a taxpayer could shield itself from IRS penalties merely by getting a tax opinion from a law or accounting firm.

In a devastating district court decision (Long Term Capital Holdings v. United States), two opinions from established law firms were excoriated as empty rituals designed to make an otherwise ridiculous tax shelter look respectable. The opinions blessed a transaction that resulted in a partnership receiving contributions of preferred stock with a tax basis about 100 times fair market value. The partnership later sold the contributed stock and purported to realize losses in excess of $100 million.

The courtís opinion reads like a do and donít list:
  • Donít rely on an informal, cursory or oral opinion before entering into a transaction or reporting it on your tax return.
  • Donít play privilege games. An opinion that asserts work-product doctrine protection will not be viewed as objective.
  • Donít try to hide the transaction by reporting it on a questionable line or schedule of the return.
  • Donít accept a conclusory opinion at face value. Insist on seeing the full legal analysis and how it applies to your facts.
  • Most importantly, donít ask your adviser to rely on unrealistic assumptions, and donít rely on an adviser who is willing to swallow (or invent) them.

The IRS has tightened its rules for negotiating settlements of transactions similar to Long Term Capital Holdings, demanding that the taxpayer concede 100% of the tax benefit and 50% of the penalties. In the transfer pricing area, revenue agents are now required to explain why the taxpayerís documentation is sufficient to avoid a penalty. Taxpayers should expect that the Service will extend this skeptical attitude to other international issues, particularly where treaty abuse is evident.

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