Step Transaction Or Substance Over Form? Loss Disallowance In Any Case

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The Dog Days[i]

I’ve never much cared for the month of August. In New York, at least for me, the eighth month of the year – named by the Roman Emperor, Augustus, to honor himself[ii] – evokes memories of very warm, very humid days, and anxious thoughts about the upcoming school year.[iii]

Although I no longer stress over returning to class, August has continued to be my least favorite month and, by the look of things, this year will be no different.

We begin the month with the Senate having finally agreed to take up debate of the $1.2 trillion bipartisan infrastructure package backed by the White House.[iv]

Of course, this debate is only a prelude to a second, anything-but-bipartisan, $3.5 trillion package – which includes the President’s proposed tax increases – that may only pass the Senate under the budget reconciliation package. According to the Majority Leader, Senator Schumer, the budget resolution that must be passed to initiate the reconciliation process, together with the infrastructure bill, will be voted upon by the Senate within the next one-to-two weeks.[v]

Meanwhile, in yet another sign of the distrust that has permeated the halls of Congress, Speaker Pelosi last week reaffirmed her position that the House of Representatives will not consider the Senate’s infrastructure package until the Senate has also passed the second, much larger, legislative package referenced above.

What’s a Taxpayer or Their Adviser to Do?

As our elected representatives in Washington huff and puff over the Administration’s legislative proposals,[vi] the latest data on State revenues indicates they have almost returned to pre-pandemic levels.[vii] There is very little chance, however, that the State and local tax increases enacted to address the shortfalls projected during the pandemic will be scaled back. And don’t hold your breath waiting for the States to return any of the pandemic-related emergency funds provided by Congress.

Most business owners have begrudgingly accepted the likelihood of Federal income tax increases, though they remain unsure of the magnitude and the effective dates of these increases. For many, the timing couldn’t be worse because the generation of baby boomers[viii] has begun the process of disposing of trillions of dollars’ worth of assets.[ix]

Those owners who have already consulted their advisers know that the most prudent approach toward disposing of their business requires a long-term view, one that is focused on the net economic outcome of a transaction, including the impact of taxes. These folks will be attuned to any changes in the tax proposals being considered by Congress and will prepare as best they can to respond thereto.

Does this mean tax advisers will remain glued to their favorite electronic devices, waiting for the latest developments from Washington? To some extent, yes, but there are many other tax-related “events” of which these advisers must also keep abreast. Life will go on, after all, with or without the enactment of the Administration’s tax plan,[x] and there are certain, more enduring concepts the application of which will always be of interest to the tax practitioner.

For example, a recent decision[xi] of the Court of Federal Claims considered an interesting application of two of these concepts: the step transaction doctrine and the related party rules.

The Transactions

Taxpayer was a corporation and the sole legal owner of Sub. For tax purposes, however, Sub was treated as a “partnership” in which Taxpayer, together with a creditor bank (“Bank-Sub”), was a partner.[xii]

Sub was a so-called “commercial paper conduit” – a financial vehicle that made investments funded by the issuance of short-term, unsecured notes (commercial paper). It reinvested the loan proceeds in longer term investments. Sub would profit from the spread, or the rate of return on its investments over the interest rate paid on the commercial paper that it issued.

The Put

Sub exercised a put right that required Bank – the parent of Bank-Sub – to purchase certain distressed financial assets (the “Investment”) from Sub at a preset value equal to Sub’s tax basis in the assets, regardless of their market value (the “Put Right”).[xiii] Bank was also the administrator of Sub,[xiv] and in that role managed Sub, as well as absorbed most of the benefit and risk of the operation. Pursuant to applicable banking regulations, Sub was consolidated on Bank’s balance sheet.

The Payment

In conjunction with the sale of the Investment to Bank pursuant to the Put Right, Sub was required, under the terms of a separately executed arrangement, to transfer a large sum of money to Bank.

The payment made by Sub in conjunction with the sale to Bank was from a Sub account (the “Account” or “Loan Account”), the funds of which originated from a loan to Sub (the “Loan”), which were held for the benefit of, and were to be paid to, the first party (Sub or Bank) to suffer a loss upon the exercise of the Put Right. The creditor on the Loan was Bank’s subsidiary, Bank-Sub, which was also Taxpayer’s partner for Federal tax purposes.

Sub exercised the Put Right and, because there was a substantial loss on the sale, triggered the transfer of the balance in the Account to Bank. Sub simultaneously received certain insurance proceeds from this event which, when netted against the amount paid to Bank, resulted in the reported loss that was disputed by the IRS.

The Tax Return

For the taxable year in question, Sub filed an IRS Form 1065, Partnership Tax Return, that reported the loss stemming from the payment made to Bank out of Sub’s Account in conjunction with Sub’s above-described sale to Bank. The loss was allocated to Taxpayer.[xv]

The IRS treated the sale by Sub to Bank as a sale to a related party, and disallowed the deduction claimed by Sub for the loss realized on the overall transaction.[xvi]

Taxpayer asserted that the loss was an ordinary business loss and that the related party sale rule (with its disallowance of the loss deduction) should not apply. Taxpayer filed an amended U.S. Corporation Income Tax Return for an earlier tax year to which it tried to carry back its allocable share of Sub’s loss for the purpose of claiming a tax refund.

On the amended return, Taxpayer characterized the transaction differently than Sub had.[xvii] Taxpayer presented the transfer from the Account to Bank as a separate event from the sale of the Investment by Sub to Bank pursuant to the Put Right. Thus, Taxpayer claimed an ordinary loss[xviii] for the amount transferred from the Account, minus the insurance proceeds, rather than as a loss on the sale of an asset to which the prohibition on deducting loses from the sale or exchange of property with a related party would apply.

Taxpayer claimed that Sub’s partnership tax return was incorrect in consolidating the transfer from the Account into the sale of the Investment on Sub’s return. Taxpayer’s amended corporate tax return netted the payment from the Account with the insurance payment, resulting in the claimed ordinary loss.[xix]

The IRS disallowed Taxpayer’s claimed loss deduction. Taxpayer disagreed and submitted a Protest to the IRS Office of Appeals, but IRS Appeals issued a Notice of Disallowance to Taxpayer with respect to the claimed loss. Taxpayer disagreed with that disallowance and filed a complaint with the Court of Claims.[xx]

The Court’s Analysis

Taxpayer asked the Court to find that the step transaction doctrine was inappropriately applied by the IRS to collapse the disputed events – the sale of the Investment pursuant to the Put Right plus the transfer from the Account – into a single sale transaction and, instead, that these events should be viewed separately so that the transfer from the Account was viewed in isolation as a deductible ordinary loss.

The IRS argued that Taxpayer should be precluded from altering the form in which the partnership (Sub) originally chose to report the transaction on its tax return.

The central question before the Court, therefore, was the relation of the Account payment to the sale of the Investment. If the payment was part of the sale – in essence, an offset to the price paid by Bank – then the Code disallowed the loss because it was part of a related party transaction. If the payment was an ordinary business loss, it was irrelevant that the parties were related, and the loss was an allowable deduction.

The IRS argued that the Account payment was inextricably linked to the sale of the Investment and, as such, these two events had to be viewed collectively, with the result that the payment was collapsed into a capital sale under the step transaction doctrine.

The IRS also argued that Sub originally reported the payment netted together with the sale of the Investment (thus giving it a capital character) and, as such, the Danielson rule precluded Taxpayer from later recharacterizing the transactions.

Taxpayer’s position was that it was improper to consolidate the two events because, at the time of the creation of the Put Right, the parties could not have intended that the transaction would occur for the simple reason that the Loan was not yet in place. Taxpayer also argued that the Danielson Rule was inapplicable because it only applied to bind parties to reflect the same characterization for tax purposes as the parties agreed upon in associated contractual obligations. The characterization on the partnership tax return was thus irrelevant, according to Taxpayer.

The Danielson Rule

The Danielson rule binds a taxpayer to the original form chosen for a transaction if the taxpayer later tries to recharacterize part of that transaction for tax purposes.[xxi]  In Danielson, the taxpayer was not permitted to recharacterize the allocation of consideration in a contract from payment for items that resulted in ordinary income tax to items that would result in capital gains tax, even when the original contractual allocation was likely incorrect. The taxpayer was forced to live with the tax consequences of its initial contractual allocation.

Taxpayer argued that Danielson was inapplicable to its case because Sub never explicitly contracted or agreed to any allocation or characterization of the Account payment in the disputed transactions. Rather, Sub merely incorrectly netted the two separate events as a single sale of business assets (the Investment). Taxpayer argued it would be an impermissible extension of the rule to bind a taxpayer to an allegedly erroneous characterization reported on a tax return. Taxpayer claimed that the original reporting on the return was filed in error, and that error was the result of the complicated circumstances surrounding the transactions.

The Court observed that the Danielson rule has only been used to bind taxpayers to certain characterizations agreed upon by contract. Those contractual allocations bind taxpayers to report transactions consistent with their business arrangements.

The Court explained it was confronted with a characterization on a tax return by the partnership that the IRS sought to deem irrevocable. Sub’s partnership return was only informational, the Court pointed out, not an allocation of consideration in a contractual agreement. It was not binding as an allocation for tax purposes.

Thus, the Court declined to expand the reach of the Danielson rule.

Substance Over Form

The Court then considered the IRS’s argument that the sale and Account payment were, in substance, a single transaction. The IRS described this as an application of the “step transaction doctrine.” The Court, however, viewed the question under the concept of “substance over form.”

The Court explained that interrelated, yet formally distinct, steps in an integrated transaction may not be considered independently of the overall transaction. The purpose of the step transaction doctrine, the Court continued, is to “give tax effect to the substance, as opposed to the form of a transaction, by ignoring for tax purposes, steps of an integrated transaction that separately are without substance.”

According to the Court, the taxpayer bears the burden of proving that a transaction has economic substance and, so, should not be ignored.  The measure of economic substance is objective, the Court stated, not subjective.

The IRS took no issue with either of the transactional steps here – both had economic substance. Instead, the IRS argued that the linked character of the two transactions became clear when the effect of the Account payment was considered. The payment was made only in only tandem with a sale of the Investment pursuant to the Put Right – the two were inextricably linked.

The Court stated that, in a typical substance over form case, the courts consider several factors. The transaction that is to be analyzed, the Court stated, is “the one that gave rise to the alleged tax benefit.” The focus of analysis thus needs to be on the sale in question, not the underlying, otherwise legitimate, business purposes that created the framework that enabled the transaction. The Court observed that “arrangements with subsidiaries that do not affect the economic interest of independent third parties deserve particularly close scrutiny.”[xxii]

Although the transaction at issue was not between a parent and subsidiary, the Court found that the substance over form analysis was apposite to Taxpayer’s case due to the “tight web of contractual and legal relationships” among the parties.

For the step transaction doctrine, the Court continued, there are no universal tests, but there are three typical methods of inquiry to determine the interrelatedness of separate steps. These methods include the “interdependence test,” the “binding commitment test,” and the “end result test.” The disputed events need only satisfy one of the tests to apply the step transaction doctrine.[xxiii] The end result test, the Court stated, is used to determine if a series of transactions are independent, or if they are, in fact, components of a single transaction that was intended from the outset with the purpose of reaching an ultimate result.

The intent of the taxpayer is especially relevant for an “end results” analysis. The intent question is “not whether the taxpayer intended to avoid taxes.”[xxiv] The inquiry is whether the taxpayer intended to reach a particular result through a series of transactions. “[I]f a taxpayer engages in a series of steps that achieve a particular result, he cannot request independent tax recognition of the individual steps unless he shows that at the time he engaged in the individual step, its result was the intended end result in and of itself.”

In the case before the Court, there was no disagreement that Bank and Sub were related parties for tax purposes because of the investment by Bank-Sub in the Loan. The fact that the sale was executed and resulted in the sale of Investment to Bank was also not disputed, nor was the characterization of this event as a sale of capital asset. Finally, it was undisputed that the function of the Loan was to compensate the first party to experience losses from the sale of the Investment pursuant to the Put Right. A payment from the Account was always anticipated to be at least a partial offset of losses resulting from the sale of a distressed asset.

Taxpayer argued that independent business purposes precluded application of the step transaction doctrine. It focused on the Loan. Taxpayer asserted that regulatory and accounting changes drove the creation of the Loan, not tax avoidance.

Taxpayer insisted that the step-transaction doctrine could not be applied because there were legitimate business reasons for the Loan and that, under the “end results” test, Sub could never have intended to make the payment because Sub never intended to invest in declining assets.

The Court responded that Taxpayer was focused on the wrong transaction. The relevant event, the Court stated, was not the creation of the Loan Account; it was the payment from the Account to Bank. That payment had no purpose other than to offset some of the loss built into the Investment purchase price. When that narrower focus was applied, the Court explained, the answer was clear – the payment was part of the sale transaction. There was no question that the “taxpayer intended to reach a particular result,” namely, to use the payment to offset some of the Bank’s losses. The Account payment was intended to be made in conjunction with a capital sale. A sale was a condition precedent to an Account payment. Although Sub could have entered a sale with Bank without the Loan, the Court stated it could not ignore the fact that, at the time the Loan came into existence, the Investment sale was already in place. Thus, the two were inextricably linked. The payment from Sub’s Account to Bank was unquestionably part of the sale; the former was triggered by the latter.

Whether the two transactions were “stepped together” or the substance (purpose) of the transactions was analyzed as a unified whole, the result was the same – the Account payment was part of a capital sale. “It is [Taxpayer’s] misfortune,” the Court stated, “that, at the time the particular sale was initiated, [Bank-Sub] had become a partner in [Sub].” Because the Account payment was properly treated as part of the Investment sale, the Code’s related party sale rule properly disallowed Taxpayer’s deduction of the loss from Sub’s sale to Bank.

Be Alert

How often have you wondered why a “single” transaction was being undertaken using two or more steps, each of which seemed to have a legitimate business purpose, especially where the tax result arising from a single step would not be the same as the result following the multi-step approach?

Were the parties to the transaction somehow related to one another?

Were more than two parties involved notwithstanding your client’s transaction could have been effectuated with only one other party?

Suffice it to say that the foregoing circumstances should be considered carefully. In particular, it would behoove you to analyze the proposed structure under the step transaction and substance over form doctrines to determine its true character and, thereby, protect your client.


[i] Associated by the Ancients with the positioning in the night sky of Sirius, the “dog star.”

[ii] In the movie, Gladiator, remember what Maximus said to Commodus, “The time for honoring yourself will soon be at an end.” The line evokes a time in Roman history before the deification of emperors. For me, it recalls the “triumph,” which may only be granted by the Senate to celebrate a general’s military victory. The individual to be honored rode in a chariot, accompanied by a slave whose job was to hold a crown over the celebrant’s head and continuously whisper to him that he was only mortal.

[iii] Think of it as the “Sunday” of the months.

[iv] The 2,702-page bill was presented to the full Senate last night and is expected to be voted upon later this week.

[v] Before the Senate takes its lengthy August recess, which runs well into September.

[vi] No, I am not referring to the calls from many corners for the Federal legalization of cannabis. Mr. Biden has not yet endorsed such a move.

See my article, “The Biden Presidency: How Will Cannabis Business Be Taxed?” on the internet, at https://www.taxlawforchb.com/2021/02/the-biden-presidency-how-will-cannabis-business-be-taxed/ .

[vii] https://www.pewtrusts.org/en/research-and-analysis/data-visualizations/2014/fiscal-50?utm_campaign=2021-07-27+Squeeze&utm_medium=email&utm_source=Pew&subscriberkey=00Q0P00000soY4EUAU#ind0 .

[viii] Representing more than 40% of small businesses. https://www.guidantfinancial.com/small-business-trends/ .

[ix] https://taxwealth.com/the-great-sale-of-baby-boomer-businesses-has-begun/ .

[x] Part of Mr. Biden’s American Families Plan. https://www.whitehouse.gov/briefing-room/statements-releases/2021/04/28/fact-sheet-the-american-families-plan/ .

[xi] GSS Holdings (Liberty) Inc. v. the U.S., U.S. Court of Federal Claims, No. 19-728T (July 26, 2021).

[xii] Taxpayer was the legal owner of Sub, but its equity was “nominal” so it required additional financial support to operate. The “legal shareholder does not have any decision-making ability, nor is it required to absorb any expected losses or receive any expected residual returns.” Bank, as administrator, controlled Sub’s operations.

[xiii] To mitigate or hedge against liquidity risk, Sub created put rights for every package of longer-term investments it purchased. The put ensured liquidity by giving Sub the ability to sell the investment package to Bank at a preset price, regardless of the investments’ market value. In exchange for this protection, Sub paid a liquidity fee to Bank. Thus, for example, if Sub purchased an investment for $100, and subsequently the market value of the investment declined to $80, the put allowed Sub to force Bank to pay a preset value for the investment. If Bank had agreed to be the counterparty to the put, and the preset price was $100, Bank would be required to pay $100 to Sub for the investment assets. This essentially shifted the risk of investment decline to Bank.

[xiv] Clearly, Sub had a history of financial difficulties.

[xv] Sub recorded the purchase by Bank on its tax returns, listed the basis of the Investment at $244,648,409, which included the par value of the assets as well as the $24,000,000 in funds from the Account transferred to Bank. Sub reported a sales price of $222,098,797 which included $220,648,409 (the par value of the investment) and $1,450,388 in insurance. Sub netted these sums together, resulting in a claimed net loss of $22,549,612, which was allocated to Taxpayer.

[xvi] See IRC Sec. 707(b)(1), which generally provides that no deduction will be allowed in respect of losses from sales of property between a partnership (Sub) and a person (Bank) owning, directly or indirectly, more than 50% of the capital interest, or the profits interest, in the partnership.

There are many other “related party rules” in the Code. See my article, “Related Party Sales” on the internet: https://www.taxlawforchb.com/2013/12/related-party-sales/ .

[xvii] Interestingly, there was no discussion in the opinion regarding IRC Sec. 6222 (as in effect before 2018) which requires a partner to treat any partnership-related item on the partner’s tax return in a manner that is consistent with the partnership’s treatment of such item on the partnership’s tax return. A partner who takes such a position must disclose it on IRS Form 8082, Notice of Inconsistent Treatment.

[xviii] Under IRC Sec. 165.

[xix] Taxpayer’s position was consistent with the tax treatment of similar transactions prior to Bank-Sub becoming the tax partner in Sub.

[xx] Rather than Federal District Court. IRC Sec. 7422 and Sec. 6532.

[xxi] See Comm’r v. Danielson, 378 F.2d 771 (3d Cir. 1967). A taxpayer is generally bound to the characterization of a transaction originally chosen by the taxpayer.

[xxii] As always, related party transactions attract special scrutiny.

[xxiii] The interdependence test is an inquiry “into whether the individual transactions in the series would be ‘fruitless’ without completion of the series.” The binding commitment test analyzes whether the taxpayer, when entering the first transaction, is obligated to pursue successive steps in a series of later transactions.

[xxiv] Tax avoidance is a legitimate motive when structuring business deals, but where parties are interrelated, the court may exercise “a heighted level of skepticism and scrutiny in th[e] matter.”

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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