Substance, Not Form, Important to IRS and the Courts

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, July 6, 1997

Copyright 1997 Robert L. Sommers, all rights reserved.

Substance, Not Form Important to the IRS and Courts

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.


Substance Over Form

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 vulnerable.


Sham Transactions

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.


Business Purpose

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%.


Step Transactions

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.


Assignment of Income Doctrine

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.


Constructive Dividends

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.


Section 482 - Allocations Between Related Parties

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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