In Canal Corp, supra, the Tax Court recently held that a corporation's 1999 transfer of a wholly owned subsidiary to a joint venture was a disguised sale that required the company to include in capital gain the amount realized in the year of sale on its consolidated federal income tax return. An accuracy related penalty under §6662 for a substantial understatement of income tax was imposed notwithstanding the fact the PricewaterhouseCoopers (PwC) had issued a favorable opinion letter on the transaction. The Court, per the majority opinion written by Judge Kroupa, held that the “should” level of comfort opinion was nothing more than a “quid pro quo” between the taxpayer and the accounting firm which its board of directors insisted upon in order to engage in the tax motivated transaction.


In 1985, the taxpayer, Chesapeake Corp. (Chesapeake), the predecessor to Canal Corp. (and subsidiaries), acquired Wisconsin Tissue Mills, Inc., (WISCO) its largest subsidiary. Chesapeake restructured 12 years later focusing on specialty packaging but WISCO did not fall within the new strategy. Chesapeake’s basis in WISCO was small relative to its value and therefore Chesapeake preferred to not engage in a direct taxable sale to an interested buyer, Georgia-Pacific (GP).

An investment banking firm selected to advise Chesapeake recommended a leveraged partnership structure. The leveraged partnership involved WISCO and Georgia-Pacific contributing their respective tissue-business assets to a joint venture. The joint venture would borrow money from a third party and distribute it to Chesapeake, which would guarantee the debt, resulting in WISCO having a minority interest in the joint venture and Georgia-Pacific having the majority interest. The intended result would be that Chesapeake would receive a large sum of cash but would not recognize gain for tax purposes under the disguised sales rules under §707(a)(2)(B). It would still book the transaction as a sale for financial accounting purposes.

PwC, the outside auditor and tax return preparer for Chesapeake, assisted in structuring the transaction and helped in the drafting of an indemnity agreement whereby WISCO served as the indemnitor of the joint venture's debt. In its opinion letter, PwC expressed its highest level of comfort that the company would succeed on the merits and would avoid gain treatment on the distribution of the cash. Chesapeake's board, in approving the transaction, made clear to PWC and its investment banker that the asset transfer and special distribution had to be nontaxable for it to approve the transaction. The planned tax deferral enabled Chesapeake to accept a lower price for WISCO.

The planned joint venture was effectuated, i.e., formation of Georgia-Pacific Tissue LLC, and a subsidiary of Georgia-Pacific loaned money to the LLC to help repay the original return. Chesapeake did not report any gain on the transaction although, as mentioned, the transaction was treated as a sale for accounting purposes. The companies carried out the transaction, creating Georgia-Pacific/WISCO LLC. The joint venture operated for a year, with WISCO selling its minority interest to Georgia-Pacific in 2001.

Notice of Deficiency Issued by IRS

The IRS issued Chesapeake a notice of deficiency, attributing $524 million in capital gains to the company from the transaction, finding that it was a disguised sale, and imposing a $36 million accuracy-related penalty.

In its opinion, the Tax Court stressed that when a partner receives a distribution shortly after making a contribution of property, the transaction may be deemed a sale. Under Treas. Reg. §1.707-3(c)(1), “contributions and distribution transactions” within 2 years are presumed to effect a sale unless the facts and circumstances clearly establish otherwise. The court concluded that a disguised sale occurred under the rules.

The taxpayer’s reliance on Treas. Reg. §1.707-5(b), the so-called “debt-financed transfer” exception was rejected. It found instead that WISCO's indemnity agreement should be disregarded under the partnership anti-abuse regulation pertaining to the allocation of partnership debt. Treas. Reg. §1.752-2(j)(4).

Tax Court's Decision In Favor of Respondent-Commissioner

The court found that the agreement was designed to limit the risk to WISCO's assets. The court also found that an intercompany note between WISCO and Chesapeake only served the purpose of giving the appearance of economic risk, and it said the indemnity agreement lacked economic substance.

The court also rejected Chesapeake's argument that the 10% net worth requirement in Rev. Proc. 89-12 was also inapplicable. The court found that the indemnity agreement should be disregarded and further found that WISCO sold its business assets to Georgia-Pacific in 1999 in accordance with §707(a)(2)(B), the year it contributed the assets to the LLC, not the year it liquidated its LLC interest.

Finally, the court sustained the IRS's determination that Chesapeake was liable for a §6662(a) accuracy-related penalty for 1999. It found that PwC lacked the independence necessary for Chesapeake to establish good-faith reliance and that Chesapeake did not act with reasonable cause or in good faith in relying on PwC's opinion.

The mathematics to the disguised sale resulted in a $755M recharacterization of the distribution as a receipt from the disguised sale resulting in a realized gain of approximately $524M. The deficiency in tax was approximately $183.5M and the penalty was 20% of such amount or approximately $36.7M.

Reliance on PwC Opinion Did Not Result in Abatement of Accuracy Related Penalty

Chesapeake’s Board not only accepted a lower price for WISCO based on the tax deferral but further conditioned entering into the transaction in exchange for PwC’s issuance of a “should” (approximately 70-75% favorable) tax opinion. The fee for the opinion was for an agreed price of $800,000.

PwC knew that the transaction’s favorable treatment depended on whether the leveraged debt would, under the indemnity agreement, be allocated solely to WISCO. While there was no direct authority on point, the PwC favorable opinion was based on the indemnification by WISCO of Georgia-Pacific’s guaranty be given substance for federal income tax purposes. PwC advised Chesapeake, therefore, that WISCO could defer gain until it sold its remaining assets, paid off the debt, or sold its partnership interest. Mr. Miller advised that WISCO maintain assets of at least 20% of its maximum exposure under the indemnity. Although there was no direct authority requiring this percentage such standard was sourced from Rev. Proc. 89-12, 1989-1 C.B. 798, obsoleted by Rev. Rul. 2003-99, 2003-2 C.B. 388. Moreover, Rev. Proc. 89-12, supra, made no reference to allocation of partnership liabilities.

The parties effected the transaction on the same day PWC issued the "should" opinion.

Termination of the Georgia-Pacific Joint Venture

One year after the establishment of the joint venture, the deal ended in 2001 when Georgia-Pacific set out to acquire the Fort James Corporation. The Department of Justice in order to approve of the acquisition, required Georgia Pacific to sell its LLC interest for antitrust purposes. As part of a sale to a Swedish concern, Georgia-Pacific first offered to purchase and WISCO agreed to sell its minority interest in the LLC to Georgia-Pacific for $41 million, a gain of $21.2M from its initial valuation of $19.8M. Georgia-Pacific further agreed to pay Chesapeake $196M to compensate Chesapeake for any loss of tax deferral. Chesapeake reported a $524M capital gain on its consolidated Federal tax return for 2001. Chesapeake determined that the termination of the indemnity resulted in WISCO receiving a deemed distribution under §752. Chesapeake also reported the $196M tax cost make-up payment from GP as ordinary income on its consolidated Federal tax return for 2001.

Respondent issued Chesapeake a notice of deficiency for 1999 claiming that the alleged joint venture was instead a disguised sale that produced $524 million of capital gain includable in Chesapeake's consolidated income for 1999. Chesapeake timely filed a petition to the Tax Court. Respondent asserted in an amended answer a $36,691,796 accuracy-related penalty under section 6662 for substantial understatement of income tax.

Analysis of Accuracy Related Penalty

Most tax advisors are quite familiar with the particular rules surrounding the imposition of an accuracy related penalty under §6662(a) and §6662(b)(2) for a substantial understatement of income tax . The mathematical threshold was easily reached in this case, i.e., the greater of10% of the tax required to be shown on the return or $10,000. §6662(d)(1); Treas. Reg. §1.6662-4(b)(1). However the penalty does not apply with respect to any portion of an underpayment if a taxpayer shows that there was reasonable cause for, and that the taxpayer acted in good faith with respect to that portion. §6664(c)(1); Treas. Reg. §1.6664-4(a), Income Tax Regs. Among the relevant factors are the taxpayer’s efforts to determine its proper amount of taxes owed, its knowledge and experience and the reliance on the advice of a competent tax adviser. Treas. Reg. §1.6664-4(b)(1). See §6664(c); U.S. v. Boyle, 469 U.S. 241, 250-251 (1985).

However, the Tax Court opinion warned that reliance on the advice of a tax professional is not unlimited. Neither reliance on the advice of a professional tax adviser nor reliance on facts that, unknown to the taxpayer, are incorrect the required reasonable cause or good faith needed to avoid imposition of the penalty. Long Term Capital Holdings v. U.S., 330 F. Supp. 2d 122, 205-206 (D. Conn. 2004), affd. 150 Fed. Appx. 40 (2d Cir. 2005). Moreover, it is unreasonable for a taxpayer to rely on a tax adviser actively involved in planning the transaction and tainted by an inherent conflict of interest. See e.g., Mortensen v. Commissioner, 440 F.3d 375, 387 (6th Cir. 2006), affg. T.C. Memo. 2004-279; Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993), affg. Donahue v. Commissioner, T.C. Memo. 1991-181; Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43 (2000), affd. 299 F.2d 221 (3d Cir. 2002). A professional tax adviser with a stake in the outcome has such a conflict of interest.

In countering the taxpayer’s arguments of proper reliance and good faith, the Service argued that the taxpayer unreasonably relied on an opinion that made improper assumptions and was written by a tax advisor which had a conflict of interest.

The Court went on to criticize the manner in which the agreed fee was determined, the sloppiness of the written opinion itself and the amount of time actually spent on it, and concluded that PwC’s time spent in analyzing and writing the opinion was not relevant to the determination of the amount of the fee which was substantial. The opinion was found to be filled with questionable conclusions and unreasonable assumptions. There was, for example, a conclusion made by PwC that WISCO’s maintaining 20% of the LLC debt was a favorable factor in reaching its “should” opinion. The Court was highly critical of the work product and effort that went into the production of the “should” tax opinion. The Court was also upset about the number of times the draft opinion used the word “it appears” in the draft opinion. This language was used to support the author’s analysis under §752 regulations adopting an “all or nothing approach” which had no basis other than the author’s interpretation. The opinion failed to consider whether the indemnity agreement had substance. Factors indicating it did not was that neither the joint venture agreement nor the indemnity agreement included provisions requiring WISCO to maintain any minimum level of capital or assets. WISCO and Chesapeake could also remove WISCO's main asset, the intercompany note, from WISCO's books at any time and for any reason. The opinion was therefore not of reasonably quality and analysis and it was unreasonable for the taxpayer to rely on such an opinion. It did not act in good faith.

Finally, the PwC opinion was inflicted or tainted with an inherent conflict of interest. The party issuing the opinion not only researched and drafted the tax opinion he also "audited" WISCO's and the LLC's assets to make the assumptions in the tax opinion. He made legal assumptions separate from the tax assumptions in the opinion. He reviewed State law to make sure the assumptions were valid regarding whether a partnership was formed. In addition, he was intricately involved in drafting the joint venture agreement, the operating agreement and the indemnity agreement.

As the court stated: “In essence, Mr. Miller issued an opinion on a transaction he helped plan without the normal give-and-take in negotiating terms with an outside party. We are aware of no terms or conditions that GP required before it would close the transaction. We are aware only of the condition that Chesapeake's board would not close unless it received the "should" opinion. Chesapeake acted unreasonably in relying on the advice of PWC given the inherent and obvious conflict of interest. See New Phoenix Sunrise Corp. & Subs. v. Commissioner, 132 T.C. 161, 192-194 (2009) (reliance on opinion by law firm actively involved in developing, structuring and promoting transaction was unreasonable in face of conflict of interest); see also CMA Consol., Inc. v. Commissioner, T.C. Memo. 2005-16 (reliance not reasonable as advice not furnished by disinterested, objective advisers); Stobie Creek Invs., LLC v. United States, 82 Fed. Cl. 636, 714-715 (2008), affd. ___ Fed. 3d ___ (June 11, 2010).”

The Court therefore held that PWC lacked the independence necessary for Chesapeake to establish good faith reliance. It further found that the taxpayer did not act with reasonable cause or in good faith in relying on PWC's opinion. The penalty was therefore properly imposed by the Service.


The Canal Corp., supra, case warns taxpayers that certain tax opinions and advise by tax advisers, including those who are highly compensated and work for high-powered accounting and law firms, will in various instances not avoid the imposition of an accuracy related penalty. For issues involving the alleged lack of economic substance, the presence of a favorable tax opinion is irrelevant. See §7701(o). See also, August, “Codification of Economic Substance Doctrine, Parts I and II”, Business Entities (Sept/Oct) and (Nov/Dec 2010).