Tax Court’s Ruling in Canal Corp. v. Commissioner calls into question the ability to rely on formal tax opinions

Mar 14, 2011   

In CANAL CORPORATION AND SUBSIDIARIES, FORMERLY CHESAPEAKE CORPORATION AND SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent, 135 T.C. 9 (2010), the Tax Court ruled against the taxpayer in a leverage partnership distribution. Judge Kroupa’s blistering decision railed against the taxpayer who, in part, relied on a tax opinion from a national accounting firm.

The Tax Court’s official holdings were as follows:

1. Held: Wholly owned subsidiary’s asset transfer to a newly formed LLC was a disguised sale under IRC sec. 707(a)(2)(B). Petitioner/taxpayer must include gain from the sale on its consolidated Federal income tax return for 1999.

2. Held, further, Petitioner/taxpayer is liable for an accuracy related penalty for a substantial understatement of income tax under IRC sec. 6662(a).

The facts of the case are somewhat complicated and involve the wholly owned subsidiary of the corporate parent transferring its assets and liabilities to an newly formed LLC. The newly formed LLC had two members – the wholly owned subsidiary and an unrelated third party. The corporate parent hired an investment bank and national accounting firm to structure the transaction. The national accounting firm also issued a “should” opinion that the transaction would be tax free as a contribution to a partnership and not a taxable sale.

Ultimately, the Tax Court held that it was a disguised sale and not a tax free contribution to a partnership. After determining that the transaction was a disguised sale the Court turned its attention to the taxpayer’s reliance on the “should” tax opinion.

First the Court noted that the accounting firm had a conflict in interest in structuring the transaction and then giving an opinion on the transaction. Second, the Court noted that the $800,000 price tag on the opinion amounted to, in essence, the taxpayer buying a “should” opinion in order to protect itself from penalties.

Specifically the Court stated:

Considering all the facts and circumstances, [the accounting firm’s] opinion looks more like a quid pro quo arrangement than a true tax advisory opinion. If we were to bless the closeness of the relationship, we would be providing carte blanche to promoters to provide a tax opinion as part and parcel of a promotion. Independence of advisers is sacrosanct to good faith reliance. We find that [the accounting firm] lacked the independence necessary for [the taxpayer] to establish good faith reliance.

The entire opinion can be found here.

The take-away from the opinion is that notwithstanding a “should” tax opinion from a competent tax advisor, the Court will look to the totality of the circumstances surrounding the delivery of the tax opinion to determine if the taxpayer reasonably relied on the opinion. In other words, an opinion is not per se penalty protection. Unfortunately, many taxpayers have relied on opinion(s) from tax advisors on transactions that are now under attack by the IRS. The attorneys at Fuerst Ittleman regularly assist taxpayers where advice from tax advisors is being questioned by the IRS. Please feel free to contact Fuerst Ittleman at