Hercules Settles IRS Tax Dispute

The Internal Revenue Service had suffered lower-court losses in several recent similar cases.
Stephen TaubDecember 21, 2004

Chemical company Hercules Inc. has agreed to pay at least $36 million to settle a tax-shelter dispute with the Internal Revenue Service.

The dispute stemmed from a contingent liability transaction designed to shelter capital gains. The IRS, which acknowledged that it has suffered lower-court losses in similar cases involving Black & Decker and Coltec, asserted that Hercules’s tax strategy failed to comply with statutory requirements and lacked economic substance or effect.

In a typical contingent liability transaction, explained the IRS, a taxpayer that has or anticipates a substantial capital gain transfers intercompany notes to a subsidiary in exchange for stock and the subsidiary’s assumption of a contingent liability. The taxpayer claims that the basis in the stock that it receives is equal to the value of the notes without reduction for the liability that it transfers.

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When it sells the stock, often to an accommodating party, the taxpayer claims a substantial loss that offsets unrelated capital gains. The taxpayer also claims deductions in later years when the liabilities are paid or incurred.

In 1999, Hercules engaged in a contingent liability transaction and claimed a $154 million capital loss, stated the IRS. The agency added that Hercules had received an opinion from its outside tax advisor that it was more likely than not to prevail if the issue were challenged. After auditing the transaction, however, the IRS disallowed the claimed capital loss and assessed penalties; Hercules challenged both findings.

Under the terms of the settlement, the IRS stated that Hercules agreed to concede the entire capital loss claimed from the stock sale, resulting in a tax liability of about $30 million — approximately $32 million, according to a Hercules regulatory filing — and to pay a 20 percent penalty, or about $6 million.

“The resolution of the dispute with Hercules is part of the IRS’s ongoing enforcement efforts and continuing commitment to aggressively resolve tax shelter transactions through responsible settlements, or litigation when necessary,” added the IRS, in a statement.

“Recent taxpayer victories at the trial court level have not deterred the IRS from taking a tough stance on listed transactions, both inside and outside of the courthouse,” said chief counsel Don Korb, in a statement. “We are pleased that this taxpayer has chosen to put this shelter controversy behind it.”