Recent Tax Court Decision: Economic Substance and the Step Transaction Doctrine
A recent Tax Court case illustrates the reach of the economic substance doctrine and the step transaction doctrine. For the benefit of our readers, we have briefed the case below:
Complex Media, Inc. v. Comm’r, T.C. Memo. 2021-14 | February 10, 2021 | Halpern, J. | Dkt. Nos. 13368-15 and 19898-17
Short Summary: Taxpayer-corporation (Corp.) acquired the assets of a business from a third-party partnership (P’ship). In exchange for the transferred assets, Corp. issued approximately 5 million shares of common stock. Immediately thereafter, Corp. redeemed 1.875 million of the common shares held by P’ship in exchange for $2.7 million in cash and Corp’s obligation to make an additional payment of $300,000 a year later. P’ship paid the cash and assigned its right to the additional payment to one of its partners in redemption of that partner’s interest in P’ship. Corp. claimed an increased basis of $3 million in intangible assets it acquired from P’ship and amortized that additional basis under I.R.C. § 197(a). The IRS disallowed the deductions under I.R.C. § 197(a).
Key Issues: Whether Corp. is entitled to the amortization deductions under I.R.C. § 197(a)?
Primary Holdings: Yes, in part, because: (1) Corp’s issuance and immediate redemption of 1,875,000 common shares had no economic substance and should be disregarded under the step transaction doctrine, with the cash and the deferred payment right treated as additional consideration for the assets Corp. acquired from P’ship; (2) the parties agree that I.R.C. § 351 governs the tax consequences of the transactions at issue and accordingly, P’ship recognized gain in the transaction to the extent of the $2.7 million cash it received and the fair market value of its right to the additional $300,000 payment; this increases the basis of the assets transferred to Corp.; and (3) when assets transferred in an I.R.C. § 351 exchange with taxable boot constitute a trade or business, the residual method of allocation prescribed by I.R.C. § 1060 can appropriately be used to allocate the boot among the transferred assets; consequently, P’ship’s gain in amortizable I.R.C. 197 intangibles, and the corresponding increase in asset bases allowed to Corp., is determined by subtracting from the agreed total asset value the estimated values of those assets other than amortizable I.R.C. § 197 intangibles.
Key Points of Law:
- Section 197(a) allows taxpayers amortization deductions in respect of intangible assets that qualify as “amortizable section 197 intangible[s].” A taxpayer can recover its adjusted basis in an amortizable section 197 intangible over 15 years beginning with the month of acquisition. 197(a).
- Section 197(d) identifies a broad range of assets as “section 197 intangible[s]”, including goodwill, going-concern value, workforce-in-place, business books and records, patents, copyrights, know-how, government licenses and permits, customer and supplier relationships, covenants not to compete, franchises, trademarks, and trade names. To qualify as “amortizable section 197 intangibles,” most section 197 intangibles have to meet three conditions. First, the taxpayer must have acquired the asset after August 10, 1993. 197(c)(1)(A). Second, the taxpayer has to hold the asset in connection with the conduct of a trade or business or other income-producing activity. Sec. 197(c)(1)(B). And third, subject to enumerated exceptions, the asset cannot have been created by the taxpayer. Sec. 197(c)(2). The exclusion for self-created intangibles does not apply to governmental licenses or permits, covenants not to compete, franchises, trademarks, or trade names. Id.
- Section 351 generally provides nonrecognition treatment to incorporations and other transactions in which the controlling shareholders of a corporation transfer property to it in exchange for its stock. In particular, section 351(a) provides as a general rule: “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control * * * of the corporation.” Section 368(c) defines “control,” for purposes of section 351 and other specified sections, to mean “the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.” If a shareholder receives nonstock consideration in an exchange that would otherwise qualify for nonrecognition treatment under section 351(a), the shareholder cannot recognize any loss but has to recognize any realized gain in an amount not in excess of the sum of the money and the fair market value of any other nonstock property (collectively, boot) the shareholder receives. 351(b). The transferee corporation’s basis in property received in a section 351 exchange is “the same as it would be in the hands of the transferor, increased in the amount of gain recognized to the transferor on such transfer.” Sec. 362(a).
- If a section 351 exchange includes a section 197 intangible, the transferee corporation is treated as the transferor shareholder “with respect to so much of the adjusted basis in the hands of the * * * [corporation] as does not exceed the adjusted basis in the hands of the transferor.” 197(f)(2)(A). The corporation, in effect, steps into the transferor’s shoes and can “continue to amortize its adjusted basis, to the extent it does not exceed the transferor’s adjusted basis, ratably over the remainder of the transferor’s 15-year amortization period.” Treas. Reg. § 1.197-2(g)(2)(ii)(B). Any increase in the basis of the section 197 intangible allowed by section 362(a) as a result of gain recognized by the shareholder is treated as though the corporation acquired the assets other than in a section 351 exchange (i.e., by the purchase). Treas. Reg. § 1.197-2(g)(2)(ii)(B).
- For Section 351 purposes, and in applying the “control-immediatley-after” requirement of Section 351(a), Tax Court jurisprudence requires us to take the effects of the redemption into account—even if, as respondent would have us do, we were to treat the redemption as separate from the asset transfer. As explained in Intermountain Lumber Co., 65 T.C. 1025 (1976), a determination of “ownership” as that term is used in Section 368(c) and for purposes of control under section 351 depends upon the obligation and freedom of action of the transferee with respect to the stock when he acquired it from the corporation. Such traditional ownership attributes as legal title, voting rights, and possession of stock certificates are not conclusive.
- A taxpayer owes the Commissioner the duty to be consistent in the tax treatment of items and will not be permitted to benefit from the taxpayer’s own prior error or omission. Cluck v. Comm’r, 105 T.C. 324, 331 (1995). This duty applies when, after the expiration of the period of limitations on assessing tax for an earlier year, the taxpayer, for the purpose of determining its tax liability for a later year, seeks to take a position on an issue of fact contrary to reporting or representations on which the Commissioner relied, or to which he acquiesced, in regard to the earlier year. See LeFever v. Comm’r, 103 T.C. 523, 543-44 (1994), supplemented by C. Memo. 1995-321, aff’d, 100 F.3d 778 (10th Cir. 1988). The duty of consistency is usually understood to encompass both the taxpayer and parties with sufficient identical economic interests. LeFever v. Comm’r, 100 F.3d at 788.
- While a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not. Comm’r v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. at 149. Thus, a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof in which an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc. Comm’r v. Danielson, 378 F.2d at 775. Although Danielson itself did not involve a choice between the form of a transaction and its alleged substance, the Tax court and others have extended the Danielson rule to limit a taxpayer’s eligibility to challenge not only the terms of the contracts governing a transaction but also the form of the transactions as established by those contractual terms. And the Tax Court has long accepted that both the Danielson rule and Ullman’s “strong proof” test “apply beyond the confines of allocating payments to a convenant not to compete.” Coleman v. Comm’r, 87 T.C. 178, 202 (1986), aff’d without published opinion, 833 F.2d 303 (3d Cir. 1987).
- But to the extent the Danielson rule limits a taxpayer’s eligibility to disavow the form of its transactions as well as the terms of the contracts that govern those transactions, the rule has no application to these cases because the Tax Court has never accepted the Danielson See Schmitz v. Comm’r, 51 T.C. 306, 316 (1968), aff’d sub nom. Throndson v. Comm’r, 457 F.2d 10122 (9th Cir. 1972).
- As the Tax Court’s caselaw has evolved, it has become more hospitable to taxpayers seeking to disavow the form of their transactions. But, the taxpayer has to meet an additional burden in attempting to disavow transactional form, and such burden relates not to how much evidence but what that evidence must show. In these cases, the Commissioner can succeed in disregarding the form of a transaction by showing that the form in which the taxpayer cast the transaction does not reflect its economic substance. For the taxpayer to disavow the form it chose (or at least acquiesced to), it must make that showing and more. In particular, the taxpayer must establish that the form of the transaction was not chosen for the purpose of obtaining tax benefits (to etierh the taxpayer itself or a counterparty) that are inconsistent with those the taxpayer seeks through disregarding that form. When the form that the taxpayer seeks to disavow was chosen for reasons other than providing tax benefits inconsistent with those the taxpayer seeks, the policy concerns articulated in Danielson will not be present.
- Much ink has been spilled on the question of how proximate various steps must be, in time or intention, for them to be combined under the step transaction doctrine. See, e.g., Andantech, LLC v. Comm’r, T.C. Memo. 2002-97. If the step transaction doctrine has any potency, it necessarily applies to combine a first step that occurs when a preexisting obligation requires the immediate execution of a second step that undoes the first.
- Because the character of any gain recognized in a Section 351 exchange may differ depending on the nature of the transferred assets, a transferor who receives taxable boot in addition to stock of the transferee corporation must determine gain on an asset-by-asset basis. See Easson v. Comm’r, 33 T.C. 963, 975 (1960); see also Rul. 68-55, 1968-1 C.B. 140. The transferee corporation’s basis in each asset equals the transferor’s basis in the asset increased by the gain recognized by the transferor in the exchange of that asset for stok and boot. Easson v. Comm’r, 33 T.C. at 975.
- The Tax Court looks with disavor on any effort by the IRS to take a position contrary to one of its reveue rulings. See, e.g., Rauenhorst v. Comm’r, 119 T.C. 157, 171 (2002) (rejecting the proposition that the Commissioner is not bound to follow his revenue rulings in Tax Court proceedings).
- The Cohan rule allows the Tax Court to estimate the amounts of allowable deductions when there is evidence that the taxpayer incurred deductible expenditures. Ashkouri v. Comm’r, T.C. Memo. 2019-95. To do so, however, the Tax Court must have some basis on which to make an estimate. The Tax Court has relied on Cohan to estimate a taxpayer’s basis in property. See, e.g., Huzella v. Comm’r, T.C. Memo. 2017-210.
- Under the residual method of Section 1060, the assets in each of seven classes are assigned, in succession, a portion of the purchase price equal to their fair market value. Reg. § 1.1060-1(a)(1). Any value not attributable to assets in the first five classes is assigned to Section 197 intangibles. Treas. Reg. § 1.338-6(b).
- By its terms, Section 1060 applies to “applicable asset acquisitions.” Section 1060(c) defines “applicable asset acquisition” to mean “any transfer (1) of assets which constitute a trade or business, and (2) with respect to which the transferee’s basis in such assets is determined wholly by reference to the consideration paid for such assets.” Despite the statutory definition, Treas. Reg. § 1.1060-1(b)(8) provides: “A transfer may constitute an applicable asset acquisition notwithstanding the fact that no gain or loss is recognized with respect to a portion of the group of assets transferred.”
Insight: Complex Media is a 103 page reminder of the potential federal income tax complexities inherent in certain taxable or tax-free transactions. As discussed in the opinion, in many cases, taxpayers are bound to the transactional form they choose, even to their peril. This can lead to surprising tax results, particularly if not vetted by tax counsel.