Many taxpayers mistakenly believe that by creating and transferring assets to an entity
(such as a corporation, family partnership or trust) on paper, their transactions will
suffice for tax purposes. Belief in this false proposition lies at the very heart of the
trust scam promotions. (see sidebar).
Mere technical compliance with a state's corporate, partnership or trust law, however,
may be ineffective under the tax law: When challenging these arrangements, the IRS and
courts scrutinize the substance, not merely the form, of such transactions.
The following judicial doctrines help both to analyze the economic substance of a transaction and determine its tax consequences.
In applying income tax laws, the substance of the transaction, rather than its form,
determines the tax consequences, with few exceptions. The "form" of a
transaction is only the label the interested parties attach to their arrangement. For
instance, an arrangement might be called a compensation agreement, loan, lease or sale.
Documents may support the form, but the courts are not concerned with these labels or
papers that purport to govern the transaction -- they focus on its substance.
The "substance over form" analysis is used to dissect self-serving
transactions between parties, including loans and payments to family members; transactions
between related corporations and their shareholders, partnerships and their partners; and
between trusts and their beneficiaries. For instance, sale of a home by a parent to a
child may be recharacterized by the court as a gift, if the child never pays for it.
Related-party transactions provide fertile territory for self-dealing, with the tax
benefit as the real motivating purpose, disguised by the form of the transaction. In
contrast, arm's-length transactions with independent third parties are far less
The sham transaction embodies two separate theories:
A sham in substance occurs when the taxpayer draws up papers to characterize a
transaction contrary to objective economic realities and which has no economic
significance beyond the expected tax benefits. For instance, a gift from father to son
which is routed through the father's corporation and labeled as salary (thus deductible by
the corporation), would be a sham in substance.
In deciding if transactions lack economic substance, courts consider such factors as
arm's-length negotiations, inflated purchase prices, financial structure of the deal, and
degree of adherence to contractual terms.
Courts will not recognize a transaction lacking any business or corporate purpose, but
serves merely for dodging taxes. When interpreting a tax statute which describes
commercial transactions, courts must determine if the arrangement was entered upon for
business purposes or solely to escape taxation. Deals which comply literally with a tax
provision, yet serve no commercial purpose other than to prevent taxation, will not
receive favorable tax treatment.
For instance, there is a lack of business purpose when a taxpayer borrows money at 10%
(usually from a related party) to obtain an interest deduction and then invests those
proceeds in a savings account earning 3%. In the final analysis, the taxpayer is
generating a self-serving tax loss of 7%.
The "step transaction" doctrine requires that interrelated steps of a
transaction may be analyzed as a whole if they, in substance, are interdependent and
focused on a particular end result. The Supreme Court has stated that a result at the end
of a straight path is not made different when reached by following a devious path. For
example: Suppose a parent must pay for his child's college tuition and could sell as asset
for that payment. Instead, the parent transfers the asset to the child (who enjoys a lower
tax bracket), who immediately sells the asset to pay tuition. The transaction would be
recharacterized as a sale by the parent, not the child, and taxed to the parent.
The "assignment of income" doctrine states that income is taxed to the one
who earns it -- a taxpayer cannot avoid tax by assigning his income to another party or
entity. Gross income derived from property must be included in the income of the person
who beneficially owns it. Assignment of income adds to the "gross income"
definition -- there is an implicit requirement that gross income be included in the tax
return of the appropriate taxpayer. This applies when a taxpayer tries to deflect income
to another entity, such as by assigning an installment obligation or compensation earned
to his corporation, a family trust or partnership.
Courts have often found a constructive dividend when a closely-held "C"
corporation (a separate taxpaying entity) transfers money or other property, without
expectation of reimbursement, for the benefit of shareholders, and the transaction is not
shown as a dividend.
The question is whether or not there is an actual loan, payment of reasonable
compensation, business expense or asset purchase to support this transfer to the
shareholder. Any transfer to a shareholder from a "C" corporation except to
satisfy its corporate obligation or acquire an asset is usually a dividend.
Under Internal Revenue Code Section 482 (a statutory provision rather than judicial
doctrine), the IRS may reallocate income, deductions, allowances or credits among two or
more U.S. or foreign businesses controlled by the same interests. The term
"controlled" includes direct or indirect control, whether or not legally
enforceable and however exercisable. Commonly controlled taxpayers include parent
corporations and their subsidiaries that are ultimately controlled by the same interests.
For example, control may exist in the family setting when a child appears to run a
company, but his parent is in actual control, since Section 482's definition is not
limited to legally enforceable control.
Section 482 places a controlled taxpayer on equal footing with an uncontrolled taxpayer
by using an arm's-length standard (the price that would be paid by two independent parties
dealing with each other at arm's length). In other words, the IRS determines what the
unbiased market price or value would have been between two unrelated parties and then
adjusts the price accordingly between the controlled parties.
The IRS's authority to determine taxable income extends to any case in which the
taxable income of a controlled taxpayer is different than it would have been if the
taxpayer had been dealing at arm's length with an uncontrolled taxpayer. The IRS need not
show an intent to evade or avoid taxes.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**