the Black & Decker Corporation v.  United States of America

PUBLISHED
UNITED STATES COURT OF APPEALS
FOR THE FOURTH CIRCUIT
 THE BLACK & DECKER CORPORATION,
Plaintiff-Appellee,
v. No. 05-1015 
UNITED STATES OF AMERICA,
Defendant-Appellant. 
Appeal from the United States District Court
for the District of Maryland, at Baltimore.
William D. Quarles, Jr., District Judge.
(CA-02-2070-WDQ)
Argued: October 25, 2005
Decided: February 2, 2006
Before LUTTIG, WILLIAMS, and MICHAEL, Circuit Judges.
Affirmed in part, reversed in part, and remanded by published opin-
ion. Judge Michael wrote the opinion, in which Judge Luttig and
Judge Williams joined.
COUNSEL
ARGUED: Richard Farber, UNITED STATES DEPARTMENT OF
JUSTICE, Tax Division, Washington, D.C., for Appellant. Herbert
Odell, MILLER & CHEVALIER, CHARTERED, Bala Cynwyd,
Pennsylvania, for Appellee. ON BRIEF: Eileen J. O’Connor, Assis-
tant Attorney General, Richard T. Morrison, Deputy Assistant Attor-
ney General, Allen F. Loucks, United States Attorney, Gilbert S.

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Rothenberg, Bridget M. Rowan, Deborah K. Snyder, Tax Division,
UNITED STATES DEPARTMENT OF JUSTICE, Washington,
D.C., for Appellant. Philip Karter, MILLER & CHEVALIER,
CHARTERED, Bala Cynwyd, Pennsylvania; Laura G. Ferguson,
MILLER & CHEVALIER, CHARTERED, Washington, D.C.; Harry
A. Pogash, Darren G. Pratt, THE BLACK & DECKER CORPORA-
TION, Towson, Maryland; John E. McCann, Jr., MILES & STOCK-
BRIDGE, P.C., Baltimore, Maryland, for Appellee.
OPINION
MICHAEL, Circuit Judge:
A corporate taxpayer paid $561 million to a controlled subsidiary
in exchange for 10,000 shares of the subsidiary’s stock and the sub-
sidiary’s assumption of a $560 million contingent liability of the tax-
payer. The taxpayer then sold the shares for $1 million, claimed a
$560 million capital loss on its federal income tax return, and sought
a refund based on that loss. The Internal Revenue Service declined to
pay because it concluded that the capital loss stemmed from an illegal
tax shelter. After the taxpayer sued, the district court denied the IRS’s
summary judgment motion and granted the taxpayer’s summary judg-
ment motion. The IRS appeals. We conclude that neither the IRS nor
the taxpayer is entitled to summary judgment under the controlling
tax statutes. Under the sham transaction doctrine, however, the valid-
ity of the claimed loss turns on unresolved issues of material fact.
Accordingly, we affirm the denial of the IRS’s motion, reverse the
grant of the taxpayer’s motion, and remand for further proceedings.
I.
A.
The Black & Decker Corporation (BDC), its wholly-owned subsid-
iary Black & Decker Inc. (BDI), and their direct and indirect subsidia-
ries constitute a major manufacturer of power tools and home
improvement products. (The subsidiaries involved are Emhart Indus-
tries, Inc., Price Pfister, Inc., and Kwikset Corp., all of which are
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domestic corporations controlled by BDC. BDC is also owner of
Black & Decker Canada, Inc. (the "Canadian subsidiary), which does
not file a tax return in the United States. We will refer to BDC and
its domestic direct and indirect subsidiaries as, collectively, "Tax-
payer."). Taxpayer provides medical and dental insurance benefits to
its current and retired employees, who number in the thousands. The
aggregated future health benefits claims constitute a contingent liabil-
ity because their precise cost is not known in the present. Thus, Tax-
payer can estimate but cannot predict with certainty how many of its
employees or retirees will be diagnosed with particular illnesses in
future years.
In 1998 Taxpayer realized nearly $303 million in capital gains
income from the sale of three businesses. Taxpayer sought to offset
that income against a large loss to prevent the imposition of a substan-
tial federal income tax obligation. To this end Taxpayer executed a
transaction that gave rise to what it intended to be a significant capital
loss. The Deloitte & Touche accounting firm had designed the trans-
action and advised some 30 corporate clients, including Taxpayer, on
its implementation as a tax strategy. The transaction involved a sub-
sidiary called Black & Decker Healthcare Management Inc.
(BDHMI). Taxpayer owned all of BDHMI’s common stock.
BDHMI’s preferred shareholders included an affiliate of William M.
Mercer, Inc. (Taxpayer’s benefits consultant and a subsidiary of
Marsh & McLennan Companies, Inc.) and Taxpayer’s Canadian sub-
sidiary. The participation of outside investors permitted BDHMI to
file a federal income tax return separate from Taxpayer’s.
The transaction consisted of two phases. Phase One was an
exchange on November 25, 1998, between Taxpayer and its Canadian
subsidiary on the one hand and BDHMI on the other. Taxpayer and
the Canadian subsidiary paid BDHMI approximately $561 million in
cash with funds Taxpayer had borrowed from its banks for 30 days.
In return BDHMI (1) gave Taxpayer and the Canadian subsidiary
10,000 shares of BDHMI’s series C preferred stock and (2) assumed
liability for the future health benefits claims against Taxpayer and the
Canadian subsidiary from 1999 to 2007, which had an estimated net
present value of $560 million. According to the exchange agreement
the companies executed, BDHMI’s assumption of liability "[did] not
constitute either a legal defeasance of the Benefits Liabilities by [Tax-
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payer] or a novation and consequently, [Taxpayer] . . . continue[d] to
be primarily liable for the payment and performance of the Benefits
Liabilities." J.A. 217. Thus, Taxpayer remained liable on the underly-
ing obligations transferred to BDHMI.
The companies executed Phase Two on December 29, 1998. Tax-
payer and the Canadian subsidiary sold the 10,000 BDHMI shares at
a price of $1 million to an unrelated third-party trust benefitting a for-
mer BDC executive. Also that day, BDHMI promised to lend BDI
approximately $564 million, most of which was to be repaid in
monthly installments according to the terms of three lending agree-
ments. BDI’s installment payments on the loans were "designed to
provide [BDHMI] with sufficient funds to pay" the benefits liabilities
as they came due. J.A. 127. Although BDHMI continued to hold the
benefits liabilities, Taxpayer reported all of the income from the busi-
nesses and employees that gave rise to those liabilities.
As one of BDHMI’s outside investors put it, "The rationale behind
the establishment of the subsidiary [BDHMI] is that a loss equal to
the reserve for the liabilities can be recognized upfront for tax pur-
poses and the [special purpose vehicle, BDHMI] may be able to
deduct the amount of the claims a second time as they are actually
incurred." J.A. 3235. Formally, the investors in BDHMI stood to earn
a positive return on their investment in the event that Taxpayer’s
actual health care liabilities fell short of the expected cost of those lia-
bilities, so that Taxpayer’s repayment on the loan would exceed
BDHMI’s payments on the medical claims, creating net income for
BDHMI. But as a practical matter Taxpayer expected BDHMI to gen-
erate net operating losses because the health expenses were likely to
consistently exceed BDHMI’s interest income from the loan to Tax-
payer. Or, in the words of Taxpayer’s in-house accountants, "BDHMI
will generate net operating losses since the interest income on the
note receivable is not likely to exceed annual claims paid which are
recognized for tax purposes when paid." J.A. 148.
B.
In its 1998 tax return Taxpayer characterized Phase One as the pur-
chase of the BDHMI shares for $561 million and Phase Two as the
sale of those shares for $1 million, generating a $560 million capital
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loss. Taxpayer claimed that its basis in the BDHMI stock was equal
to the cash payment without reduction by the benefits liabilities
BDHMI assumed in Phase One. The large capital loss offset the capi-
tal gains from Taxpayer’s divestitures earlier in the year. Further, the
large loss had both retrospective and prospective tax-reducing effects
under the Internal Revenue Code of 1986, as amended, 26 U.S.C.
("IRC"), allowing Taxpayer to file for refunds on its returns for the
1995 through 2000 tax years. The refunds sought totaled approxi-
mately $57 million.
Because the IRS did not pay the refunds for more than six months,
Taxpayer commenced a civil action in the U.S. District Court for the
District of Maryland. 26 U.S.C. §§ 7422; 6532(a)(1). The IRS filed
a counterclaim for tax, interest, and penalties of approximately $215
million. The IRS construed the tax laws as requiring Taxpayer to state
its basis in the shares sold as $1 million, not $560 million. Taxpayer
took the opposite view. Moving for summary judgment, the IRS
argued that under IRC § 357(c)(3)(A) Taxpayer, the transferor, had to
reduce its stock basis by the amount of the contingent liability
assumed by BDHMI, the transferee. The district court denied the
motion. Taxpayer then moved for summary judgment, arguing that
the transfer of the benefits liabilities was not a sham transaction that
could be disregarded for tax purposes. The district court granted the
motion, Black & Decker Corp. v. United States, 340 F. Supp. 2d 621
(D. Md. 2004). The district court stated that because BDHMI was
constituted for a valid business purpose, BDHMI and all of its trans-
actions were "objectively reasonable" and thus could not be disre-
garded for tax purposes. Id. at 623-24. This appeal by the IRS
followed.
II.
The IRS first contends that it was entitled to summary judgment
because, on the undisputed facts, the statutes governing the transac-
tion required the basis reduction. Preliminarily, we note that if Tax-
payer were to engage in the contingent liability transfer today, it
would be required to reduce its basis by the amount of the transferred
liabilities under IRC § 358(h), which Congress enacted as part of the
Community Renewal Tax Relief Act of 2000. P.L. 106-554, § 1(a)(7),
114 Stat. 2763 (2000). That statute does not control here because it
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does not apply retroactively. In addition, in 2001 the IRS issued
Notice 2001-17 on contingent liability tax shelters, which put corpo-
rations on notice that the IRS would challenge transactions of the type
at issue here. These legal and enforcement policy developments took
place after Taxpayer engaged in the contingent liability transaction.
Consequently, the question before us is whether the law at the time
Taxpayer executed this transaction required Taxpayer to reduce its
basis in the stock by the amount of the benefits liabilities transferred.
In answering this question, we first briefly survey the pertinent stat-
utes. Then we turn to the parties’ specific statutory arguments on
whether summary judgment should have been granted in the IRS’s
favor.
A.
On appeal the parties agree that the transaction is to be analyzed
under IRC § 351. Section 351(a) provides that no gain or loss shall
be recognized—that is, the transaction is tax-free—if property (here,
the cash from Taxpayer) is transferred to a corporation (BDHMI) by
"one or more persons" (here, members of a consolidated group, Tax-
payer) solely in exchange for voting stock in BDHMI, and immedi-
ately after the exchange the transferor is in control of the transferee.
See 26 U.S.C. § 351(a). Taxpayer did not, however, transfer property
to BDHMI "solely" in exchange for BDHMI stock because BDHMI
also assumed the contingent liability. So the transfer does not fit
within the exact terms of § 351(a).
Taxpayer would nevertheless continue to enjoy the tax-free benefit
of § 351(a) if Taxpayer could successfully invoke § 357(a). Under
§ 357(a) transactions are treated as § 351(a) tax-free transactions if
they would satisfy § 351(a) were it not for the fact that the transferee,
in consideration for the transferor’s property, not only gave its stock
but also assumed the transferor’s liability. In such cases, § 357(a) pre-
vents the transferee’s assumption of liability from being treated as
taxable money or property received by the transferor. This tax-free
benefit is not available, however, when the exceptions of §§ 357(b)
and (c) apply. See 26 U.S.C. § 357(a). (Only the § 357(b) exception
is in dispute here. Infra part III.A.)
Separate from the concept of gain or loss recognition is the concept
of basis computation. The income tax consequences of selling prop-
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erty hinge on the taxpayer’s basis in that property. Except as other-
wise provided, "the basis of property shall be the cost of such
property." 26 U.S.C. § 1012. (Usually, basis is "the original cost of
property used in computing capital gains or losses for income tax pur-
poses." Lessinger v. Comm’r, 872 F.2d 519, 525 n.3 (2d Cir. 1989)
(quoting Webster’s Third New International Dictionary 182 (1963)).
In general, when a taxpayer sells an asset for more than its basis, he
records a capital gain; when he sells the asset for less than its basis,
he records a capital loss.) In the § 351 transaction at issue here, Tax-
payer’s basis in the BDHMI stock is determined under § 358. See 26
U.S.C. § 351(h)(2). Under § 358(a)(1) a § 351 transferor’s basis in the
stock received from the transferee is the same as the basis of the prop-
erty the transferor surrendered, reduced by the amount of any "money
received." 26 U.S.C. § 358(a)(1). Section 358(d)(1) further provides
that, in § 358 analysis, an assumption of liability by the transferee
shall be treated as "money received" by the transferor. A transferor
reduces its basis in the stock received from the transferee by the
amount of any liability the transferee assumed in exchange. But the
statute also provides that § 358(d)(1) does not apply if the liability
assumed is one that would be excluded under § 357(c)(3). 26 U.S.C.
§ 358(d)(2). Section 357(c)(3), in turn, excludes "liability the pay-
ment of which . . . would give rise to a deduction." 26 U.S.C.
§ 357(c)(3)(A).
B.
To prevail on summary judgment the IRS must demonstrate that as
a matter of law Taxpayer was not entitled to the § 357(c)(3) excep-
tion. This demonstration turns on statutory meaning. "It is well estab-
lished that when the statute’s language is plain, the sole function of
the courts—at least where the disposition required by the text is not
absurd—is to enforce it according to its terms." Lamie v. United
States Trustee, 540 U.S. 526, 534 (2004) (punctuation omitted); see
Coleman v. Cmty. Trust Bank (In re Coleman), 426 F.3d 719, 724-25
(4th Cir. 2005). When the language of the statute is unclear, we "may
consult its legislative history as a guide to congressional intent." Yi v.
Fed. Bureau of Prisons, 412 F.3d 526, 533 (4th Cir. 2005). The fact
that a tax statute is at issue here does not render inapplicable these
general principles of statutory interpretation.
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The benefits liabilities Taxpayer transferred to BDHMI fall within
the plain terms of the § 357(c)(3) exception if, in the event that the
claims are paid, a person would be able to deduct the amounts paid
from that person’s taxable income. The statute does not specify, how-
ever, whether the person taking the deduction would be the liability’s
transferee (BDHMI) or the transferor (Taxpayer). Because the statute
does not clearly identify the person who would take the hypothetical
deduction the statute envisions, it is appropriate to examine the legis-
lative history so far as is necessary to identify that person.
Section 357(c) was first enacted in 1978 and rewritten into its pres-
ent form two years later by the next Congress. The Senate Report that
presaged the 1980 revision explained:
In general, liabilities the payment of which would give
rise to a deduction include trade accounts payable and other
liabilities (e.g., interest and taxes) which relate to the trans-
ferred trade or business. However, such liabilities may be
excluded under this provision only to the extent payment
thereof by the transferor would have given rise to a deduc-
tion.
S. Rep. No. 96-498, at 62 (1979), reprinted in 1980 U.S.C.C.A.N.
316, 372. The second sentence quoted resolves the uncertainty in
§ 357(c)(3)’s "would give rise to a deduction" phrase by clarifying
that Congress had in mind the deductibility by the transferor. A liabil-
ity falls within the § 357(c)(3) exception so long as, if the transfer had
not taken place and the transferor had paid the liability, the transferor
could have taken a deduction. To see why this condition is satisfied
here, let us suppose that the health care claims had remained with
Taxpayer. In that case, when Taxpayer incurred medical expenses as
its employees and retirees received health care, Taxpayer could have
deducted those expenses from income.
The IRS presses two arguments for why Taxpayer cannot claim the
§ 357(c)(3) exception. The first argument relies on legislative history.
The IRS focuses on sentences such as the first of the two from the
Senate Report quoted. It contends that Congress crafted the exception
to protect a parent corporation from a tax double whammy when
transferring both assets and associated liabilities to a subsidiary in
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exchange for stock. From this perspective, Congress wanted to pre-
vent such parent corporations from being twice penalized by (1)
deprivation of the right to deduct the transferred liabilities as they
accrued and (2) mandatory reduction of the stock basis by the amount
of the liabilities transferred. Since Taxpayer only transferred the
health claims but not the assets generating those claims, the IRS
argues that Congress did not intend for Taxpayer to benefit from
§ 357(c)(3). Further, the IRS reads the quoted phrase "would have
given rise to a deduction," S. Rep. No. 96-498, at 62, to mean a
deduction unavailable to the transferor once the liability has been
transferred.
The legislative history argument does not persuade us. The proto-
typical transaction Congress had in mind in drafting § 357(c)(3) may
well have been one in which a corporation exchanged liabilities as
part of a transfer of an entire trade or business to a controlled subsid-
iary, but nothing in the section’s plain language embraces such a limi-
tation. As a result we find no ambiguity in the statute that requires us
to parse the congressional record and discern what type of business
transactions Congress originally envisioned in enacting the section.
The Senate Report’s use of the phrase "would have given rise" also
does not go as far as the IRS would have us take it. On the contrary,
we agree with one commentator’s observation that this language
"does not imply . . . that Congress silently contemplated a case in
which liabilities are transferred but the deduction is retained by the
transferor and [then] concluded that § 357(c)(3) should not apply."
Ethan Yale, Reexamining Black & Decker’s Contingent Liability Tax
Shelter, 108 Tax Notes 223, 234 (July 11, 2005).
The IRS’s second argument is based on sound administration of the
tax laws, because the Taxpayer should not be allowed to take the
"functional equivalent of a double deduction." Appellant’s Br. at 59.
Although Taxpayer has not claimed the employee health expenses as
a deduction (BDHMI, not a party to this suit, claims them instead),
the IRS argues that Taxpayer has the legal right to seek these deduc-
tions as health care costs accrue. In the IRS’s view, the $560 million
loss that Taxpayer reported effectively accelerates deductions for
uncertain future health care costs through the year 2007. Such accel-
eration would contravene the prohibition against claiming a deduction
in a given tax year for an estimate of liabilities that have not become
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fixed by the end of that year. Here, receipt of medical care and filing
of proper claims forms would fix the annual health care liability.
United States v. Gen. Dynamics Corp., 481 U.S. 239, 242-45 (1987).
Again, we are not convinced that the language of § 357(c)(3) is so
unclear as to permit us to rely on this policy argument and adopt the
IRS’s reading. In addition, because BDHMI files a tax return separate
from Taxpayer’s and has been taking the deductions for the health
care expenses as the expenses are incurred, the "double deduction"
argument would only work if we were to treat BDHMI and Taxpayer
as a single entity. We see no justification on the present record for
disregarding the distinct corporate taxpayer identities of BDHMI and
Taxpayer. Rather, we agree with Taxpayer: "BDHMI pays the claims;
BDHMI takes the deductions—not Taxpayer." Appellee’s Br. at 27.
We conclude that the contingent liability Taxpayer transferred to
BDHMI falls within the § 357(c)(3) exception for "liability the pay-
ment of which . . . would give rise to a deduction." Therefore, under
§ 358(d)(2)’s exception to the general rule of § 358(d)(1), the liability
need not be treated as "money received" by Taxpayer for basis reduc-
tion purposes. For this reason the district court’s denial of the IRS’s
summary judgment motion was correct.
III.
The IRS next advances two arguments for why the district court
erred in granting summary judgment in Taxpayer’s favor. The first
argument is based on the IRC and the second on the judge-made sham
transaction doctrine.
A.
Section 357(b) of the IRC is an anti-abuse rule. It provides that if
a taxpayer’s principal purpose in transferring liability was to avoid
federal income tax on the § 351 exchange, or was otherwise not a
bona fide business purpose, then the assumption of liability shall, for
§ 351 analysis, be considered "money received" by the taxpayer on
the exchange. 26 U.S.C. § 357(b)(1). In this refund suit the burden is
on the taxpayer to prove that the assumption of liability "is not to be
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treated as money received by the taxpayer." 26 U.S.C. § 357(b)(2).
Thus, if § 357(b)(1) applied, Taxpayer would be required to prove "by
the clear preponderance of the evidence" that it had a bona fide busi-
ness purpose for transferring the benefits liabilities to BDHMI. Id.
The IRS argues that Taxpayer’s business purpose was a disputed
fact requiring trial. Next the IRS contends that this issue is material
because if Taxpayer could not meet this burden at trial, then Taxpayer
would be obligated to treat the benefits liabilities assumed by BDHMI
as money Taxpayer received for § 351 purposes. The purposes of
§ 351, in the IRS’s view, include the basis computation rules of § 358.
In particular, the IRS endeavors to connect the anti-abuse rule of
§ 357(b) to the basis-computation rule of § 358. The IRS would have
us travel along one of two routes between these sections.
The first route is linguistic. The IRS concentrates on the phrase
"money received," which appears in both § 357(b)(1) and in
§ 358(a)(1). From the IRS’s perspective, if Taxpayer lacked a bona
fide business purpose in the exchange, then BDHMI’s assumption of
liability would be "money received" by Taxpayer under § 357(b)(1)
and also under § 358(a)(1)(A)(ii), so that Taxpayer’s basis in the
BDHMI shares would be "decreased" by the amount of the liability
BDHMI assumed. See § 358(a)(1) ("The basis of the property permit-
ted to be received . . . without the recognition of gain or loss shall be
the same as that of the property exchanged decreased by . . . the
amount of any money received by the taxpayer"). This argument is
plausible but ultimately unavailing. It cannot overcome the absence
of any reference to § 358 on the face of § 357(b). Rather, § 357(b)(1)
refers (as pertinent here) only to the "purposes" of § 351, which are
the purposes of gain or loss recognition, as indicated by the opening
words of § 351(a) ("No gain or loss shall be recognized . . ."). Those
purposes are distinct from the purposes of § 358, which concerns the
computation of basis. Section 351(h) certainly refers to § 358, but this
reference has no substantive content; rather, it simply guides the
reader of § 351 to the basis computation rule for exchanges that qual-
ify for § 351’s tax-free treatment.
The Treasury regulation interpreting § 357 also undercuts the IRS’s
argument. The regulation explains that when a taxpayer lacks a bona
fide business purpose in transferring liabilities through a § 351
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exchange, "the total amount of liabilities assumed . . . shall, for the
purpose of determining the amount of gain to be recognized upon the
exchange in which the liabilities are assumed or acquired, be treated
as money received by the taxpayer upon the exchange." Treas. Reg.
§ 1.357-1(c) (emphasis added). The emphasized language clarifies
that the focus of § 357(b) analysis is gain recognition only. The regu-
lation’s complete silence on basis assessment indicates that § 357(b)
is not concerned with such assessment.
By declining to endorse the IRS’s view that "money received"
means the same thing in the two different sections, we adhere to the
teaching that "[a] word is not a crystal, transparent and unchanged, it
is the skin of a living thought and may vary greatly in color and con-
tent according to the circumstances and the time in which it is used."
Towne v. Eisner, 245 U.S. 418, 425 (1918) (Holmes, J.). Only by
masking the conceptual difference between gain or loss recognition
and basis computation could we treat the phrase "money received" as
having a single meaning, irrespective of "the circumstances . . . in
which it is used." The IRS has not provided compelling reasons to do
that.
The second route the IRS identifies between § 357(b) and § 358 is
structural. Here, the IRS argues that if Taxpayer could not meet
§ 357(b)’s business purpose test, Taxpayer could not use § 358(d)(2)
to invoke § 357(c)(3)’s exclusion of deduction-generating liabilities.
See supra Part II.B. That is because in the IRS’s view, to be deduct-
ible under § 357(c)(3) a liability must fall within § 357(c)(1), but
§ 357(c)(1) does not apply to any liability that falls within
§ 357(b)(1). See 26 U.S.C. § 357(c)(2) (§ 357(c)(1) "shall not apply
to any exchange to which subsection (b)(1) of this section applies.").
The IRS’s argument falters in taking this last step. We read the
statute to mean that as a general matter liability need not exceed basis
—thereby falling within § 357(c)(1)—in order to qualify for the
§ 358(d)(2) exception. Again, § 358(d)(2) provides that the ordinary
basis reduction rule of § 358(d)(1), under which assumed liabilities
are treated as money received by the transferor, does "not apply to the
amount of any liability excluded under section 357(c)(3)." 26 U.S.C.
§ 358(d)(2). Section 357(c)(3)’s exclusion, as relevant here, covers "a
liability the payment of which . . . would give rise to a deduction."
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Supra part II.B. In referring to § 357(c)(3), § 358(d)(2) does not by
implication refer to § 357(c)(1) or (2). If Congress intended such a
broader reference, it could have built one into § 358(d)(2) by, for
example, providing that § 358(d)(1) does "not apply to the amount of
any liability excluded under § 357(c)." But that is not what the statute
says.
The central difficulty with the IRS’s reasoning is that it would limit
liabilities eligible for the § 358(d)(2) exclusion to those that exceed
basis under § 357(c)(1), even in transactions that have a perfectly
legitimate business purpose and thus do not transgress the § 357(b)
anti-abuse provision. Under § 357(c)(1) "if the amount of the liability
transferred [in a § 351 exchange] is greater than the basis of the prop-
erty transferred, then, in general, the transferor-taxpayer recognizes a
capital gain on the amount by which the liability exceeds the basis of
the transferred property." Estate of Kanter v. Comm’r, 337 F.3d 833,
865 (7th Cir. 2003), rev’d on other grounds sub nom Ballard v.
Comm’r, 125 S. Ct. 1270 (2005). While § 357(c)(1) is concerned with
assumed liabilities that exceed the basis in the property transferred,
§ 358(d)(2) has no such concern; its only concern is the liabilities that
"would give rise to a deduction" as described in § 357(c)(3). We agree
with the IRS that under § 357(c)(2), when a transaction lacks a bona
fide business purpose under § 357(b)(1), § 357(c)(1) is not applied.
But accepting this much of the argument does not compel the conclu-
sion that, when § 357(b)(1) applies, it also knocks out the § 357(c)(3)
exception for basis computation purposes under § 358(d)(2). Or, as
the IRS put it in a concededly non-precedential advisory memoran-
dum to its field agents, even if a taxpayer has "abused the rules" in
violation of § 357(b), § 358, which "does not inquire into taxpayer
intent, is not the means of correcting that." Field Service Advice
199905008 (Feb. 5, 1999), at J.A. 644.
Taxpayer points to a published revenue ruling that supports this
analysis. The ruling views § 358(d)(2) as providing "that section
358(d)(1) does not apply to the amount of any liabilities defined in
section 357(c)(3)." Rev. Rul. 80-198, 1980-2 C.B. 113 (emphasis
added). There is no language in the ruling that ties § 358(d)(2) either
to § 357(c)(1)’s command regarding liabilities that exceed basis or to
§ 357(c)(2)’s displacement of § 357(c)(1) altogether when § 357(b)(1)
applies. Of course, the revenue ruling does not control our analysis
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for at least two reasons. First, while such rulings constitute "prece-
dents to be used in the disposition of other cases," Aeroquip-Vickers,
Inc. v. Comm’r, 347 F.3d 173, 181 (6th Cir. 2003) (quoting Rev. Proc.
89-14, 1989-1 C.B. 815), the precise degree of deference owed to
these rulings—particularly in the face of the IRS’s decision to inter-
pret the statute differently in litigation—is unclear. See id. at 181
(concluding that "some deference" was owed to a revenue ruling). Cf.
Dominion Res., Inc. v. United States, 219 F.3d 359, 366 (4th Cir.
2000) ("[R]evenue rulings are entitled to considerably less deference
than an agency’s properly promulgated regulations."). Second, the
hypothetical § 351 exchange analyzed in the ruling is a transfer of
assets and liabilities undertaken for a bona fide business purpose,
which is factually distinguishable from the unusual transfer of liabili-
ties alone in Taxpayer’s case. With these caveats in mind we never-
theless take the revenue ruling to be fully consistent with our reading
of the statute’s plain language. That plain language is our most impor-
tant guide to resolve the competing claims.
It is of no importance that the district court never evaluated the
IRS’s argument under § 357(b). For the reasons identified we do not
find the argument convincing. Accordingly, we cannot reverse the
summary judgment in Taxpayer’s favor on this basis.
B.
The sham transaction doctrine permits the IRS to disregard a trans-
action that literally complies with the terms of the IRC but that is
devoid of any legitimate business purpose. In Frank Lyon Co. v.
United States, 435 U.S. 561 (1978), the Supreme Court described
when, under this doctrine, a transaction should be recognized as valid
for tax purposes:
[W]here . . . there is a genuine multiple-party transaction
with economic substance which is compelled or encouraged
by business or regulatory realities, is imbued with tax-
independent considerations, and is not shaped solely by tax-
avoidance features that have meaningless labels attached,
the Government should honor the allocation of rights and
duties effectuated by the parties.
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Id. at 583-84. Our court distilled from this guidance a two-part test:
"To treat a transaction as a sham, the court must find [(1)] that the
taxpayer was motivated by no business purposes other than obtaining
tax benefits in entering the transaction, and [(2)] that the transaction
has no economic substance because no reasonable possibility of a
profit exists." Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89, 91
(4th Cir. 1985). "Whether under this test a particular transaction is a
sham is an issue of fact." Id. at 92. We applied this test in several sub-
sequent cases. Hunt v. Comm’r, 938 F.2d 466, 472 (4th Cir. 1991);
Hines v. United States, 912 F.2d 736, 739 (4th Cir. 1990); Friedman
v. Comm’r, 869 F.2d 785, 792 (4th Cir. 1989). As we clarified in
Hines, the first prong of the test is subjective, while the second is
objective. Nevertheless, "[w]hile it is important to examine both the
subjective motivations of the taxpayer and the objective reasonable-
ness of the investment, in both instances our inquiry is directed to the
same question: whether the transaction contained economic substance
aside from the tax consequences." Hines, 912 F.2d at 739.
In replying to the IRS’s arguments opposing Taxpayer’s motion for
summary judgment, Taxpayer conceded for purposes of deciding the
motion that "tax avoidance was the sole motivation underlying Black
& Decker’s decision to outsource its healthcare management function
to BDHMI." J.A. 3363. Taxpayer thus effectively conceded that the
test’s subjective prong was satisfied. To defeat Taxpayer’s summary
judgment motion, all that remained was for the IRS to show that there
were genuine issues of material fact concerning the test’s objective
prong.
The district court’s approach to the objective prong strayed from
our precedents. Although the district court quoted the pertinent lan-
guage from Rice’s Toyota, see 340 F. Supp. 2d at 623, it went on to
assert: "A corporation and its transactions are objectively reasonable,
despite any tax-avoidance motive, so long as the corporation engages
in bona fide economically-based business transactions." Id. at 623-24.
In so reasoning, the district court mischaracterized the Rice’s Toyota
test, which focuses not on the general business activities of a corpora-
tion, but on the specific transaction whose tax consequences are in
dispute. "The second prong of the sham inquiry, the economic sub-
stance inquiry, requires an objective determination of whether a rea-
sonable possibility of profit from the transaction existed apart from
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tax benefits." Rice’s Toyota, 752 F.2d at 94 (emphasis added). Thus,
many of the undisputed facts upon which the district court relied in
concluding that Taxpayer was entitled to summary judgment—
including the facts that BDHMI "maintained salaried employees" and
paid health claims as they came due with BDHMI assets, 340 F.
Supp. 2d at 624—were simply not germane to the proper inquiry
under the second prong of our circuit’s sham transaction test.
We do not agree with Taxpayer’s contention that the Supreme
Court’s decision in Moline Properties, Inc. v. Commissioner, 319
U.S. 436 (1943), supports the district court’s analysis of the objective
prong under Rice’s Toyota. The Court in Moline held that a corporate
taxpayer, the petitioner, "had a tax identity distinct from its stock-
holder," an individual, such that gain realized on sales in two tax
years were to be treated as income taxable to the corporation, not to
the individual. 319 U.S. at 440. To reach this conclusion, the Court
examined the purposes for the individual’s establishment of the cor-
poration. Id. at 439-40. The Court recognized that in some tax cases
"the corporate form may be disregarded where it is a sham or unreal."
Id. at 439. Moline is not implicated, however, by the IRS’s allegation
that under the objective prong of the sham transaction test there was
no reasonable profit opportunity in the two-phase transaction Tax-
payer executed with BDHMI in November and December 1998. The
IRS is not arguing at this point that BDHMI’s corporate identity sepa-
rate from Taxpayer must be disregarded for tax purposes, such that
income earned by one is to be attributed to the other. Shams under
Rice’s Toyota are distinct from shams under Moline. In particular, a
shareholder’s transaction with a controlled corporation may be a sham
under Rice’s Toyota even if the corporation is entitled to regard its
income as distinct from its shareholder’s because the corporation is
not itself a sham under Moline.
Hines illustrates the proper analysis under the objective prong of
the Rice’s Toyota. Hines involved an IRS challenge to investment
interest and depreciation deductions stemming from a taxpayer’s pur-
chase and lease back to the seller of used computer equipment. We
first noted that the payments on the transaction would leave the tax-
payer "with a loss of $127,324 over the eight years of the lease" to
the seller. 912 F.2d at 739. We next identified all of the possible
sources of revenue on the transaction and weighed them against this
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loss. See id. at 739-40. Viewing the evidence in the light most favor-
able to the taxpayer, which had won at trial, we nevertheless con-
cluded that the transaction "fail[ed] to yield any reasonable
expectation of a profit." Id. at 739. Hines clarifies that under this cir-
cuit’s firmly established Rice’s Toyota standard, the objective prong
of the sham transaction test focuses on reasonable expected profits
from a transaction. There is no basis here for abandoning our standard
by scrutinizing the transaction for its "real economic effects," despite
Taxpayer’s argument that we should do so based on the law of
another circuit. See United Parcel Serv. of Am., Inc. v. Comm’r, 254
F.3d 1014, 1019 (11th Cir. 2001).
In evaluating Taxpayer’s motion for summary judgment, the evi-
dence must be viewed in the light most favorable to the IRS, the non-
moving party. Consistent with Hines, the essential question posed in
Taxpayer’s motion is whether the IRS adduced sufficient facts to go
to trial on its argument that Taxpayer lacked "any reasonable expecta-
tion of a profit" from the transaction that generated the claimed $560
million capital loss reported on the 1998 return. We conclude that the
IRS offered ample evidence to permit a reasonable trier of fact to find
in the IRS’s favor. Four expert witnesses retained by the IRS
explained in their expert reports why the only economically substan-
tial value to Taxpayer in transferring its contingent liability to
BDHMI was in tax savings. These experts were (1) University of
Kansas economist Mark Hirschey, (2) Harvard economist Oliver D.
Hart, (3) Ohio State University health economist John A. Rizzo, and
(4) benefits consultant John G. Kontner. Taxpayer in turn pointed to
a countervailing expert of its own, Harvard business professor
Michael C. Jensen. The district court did not cite any of this evidence,
let alone evaluate it. Weighing all of this expert testimony should
have been left for trial because witness credibility cannot be assessed
on summary judgment. The IRS’s evidence, in sum, was sufficient to
create a triable issue on the reasonable profit expectations attaching
to Taxpayer’s transaction.
The trial to resolve whether Taxpayer’s transaction was a sham
must determine whether both prongs of the Rice’s Toyota test are sat-
isfied, since the Taxpayer’s concession that the subjective prong was
met applied only for purposes of deciding the summary judgment
motion. Regarding the subjective prong, it bears repeating that a tax-
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payer’s "mere assertion" of subjective belief in the profit opportunity
from a transaction "particularly in the face of strong objective evi-
dence that the taxpayer would incur a loss, cannot by itself establish
that the transaction was not a sham." Hines, 912 F.2d at 740. The "ul-
timate determination of whether an activity is engaged in for profit is
to be made . . . by reference to objective standards." Id.
For these reasons, proper analysis of our well-established test under
Rice’s Toyota hinged on genuine issues of material fact that remained
very much in dispute when the district court granted summary judg-
ment in Taxpayer’s favor. Accordingly, we reverse and remand for a
trial to resolve the sham transaction question.
IV.
We conclude that IRC §§ 357 and 358 do not require Taxpayer to
reduce its basis in the BDHMI stock by the amount of the liabilities
transferred to BDHMI; we therefore affirm the district court’s denial
of the IRS’s motion for summary judgment. Because the district court
erred in granting summary judgment in favor of Taxpayer under the
sham transaction doctrine, we reverse that judgment and remand for
further proceedings.
AFFIRMED IN PART, REVERSED IN PART,
AND REMANDED
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