One might expect that, when the Treasury enacts a regulation whose explicit purpose is to provide that taxpayers do not recognize gain under specified conditions, a taxpayer that complies with the conditions would in fact not recognize gain. One might also expect that, at the very least, this taxpayer would not be subject to a penalty after receiving a tax opinion endorsing the tax-free nature of the transaction. However, the Tax Court’s recent decision in Canal Corporation v. Commissioner seems to indicate that one might be wrong on both counts—at least on the facts in that case.
The taxpayer in Canal Corporation contributed property to a joint venture and received a cash distribution from the joint venture that appeared to satisfy the regulations’ criteria for a tax-free “debt-financed distribution.” Yet, the Tax Court held that the taxpayer was not entitled to receive these funds tax-free and upheld the IRS’s substantial understatement penalty, notwithstanding the fact that the taxpayer had relied on a tax opinion. What happened?
Background
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