Business Purpose: The Assault Upon the Citadel
Robert Thornton Smith*
* Partner, Linklaters, New York, New York. Princeton University, A.B. 1965; Harvard Law School, J.D., 1968.
The Status of the business purpose, or economic substance, doctrine (the "Economic Substance Doctrine") is solidly entrenched, without the slightest suggestion in judicial opinions that it is ill-founded. This doctrine plays a central role in the recent heightened focus on corporate tax shelters and under President Clinton's tax reform proposals.
In contrast to the uniform acceptance by the courts, the Service, and the Treasury of this hoary doctrine, commentators have taken a critical view and offer intellectual challenges that need to be answered.
The Economic Substance Doctrine, as it has evolved to date, may be summarized as providing that an arrangement will be recognized for tax purposes only if it "appreciably" affects the taxpayer's beneficial interest such that it can be said "with reason… to have purposes, substance or utility apart from [its] anticipated tax consequences." In applying this standard, both subjective motivations and objective economic substance are taken into account.
This simple formulation obscures a variety of issues. Several articles provide a good summary and discussion of the existing case law and of various issues that have arisen under Economic Substance Doctrine.
This Article is differently focused, and no effort here is made to provide a general summary of the law. Instead, this Article provides an underlying justification for the Economic Substance Doctrine and defends this tax principle against the criticisms charged. In so doing, this Article concentrates on the deeper questions of statutory interpretation that lie at the heart of the criticisms and issues surrounding the Economic Substance Doctrine.
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Rethinking Differential Review of Tax Court Decisions
David F. Shores
*Sullivan & Cromwell, New York, New York. An earlier version of this Article was presented at the Tax Forum in New York on December 7, 1998.
I wrote an article in 1996 proposing that the circuit courts of appeals deferentially review Tax Court decisions on questions of law. The main theme of the article was that, while circuit courts generally review Tax Court decisions on questions of law de novo, they are free to adopt a standard of deferential review should they decide to do so. That conclusion was drawn from the language of section 7482(a)(1), and in conjunction with section 7482(c)(1), and from its legislative history. A second theme was that courts of appeals ought to adopt a standard of deferential review, mainly but not exclusively, in the interest of uniformity. Tax simplification, especially the avoidance of undue complexity in decisional law, could be viewed as a third theme. However, complexity and nonuniformity are opposite sides of the same coin. Decisional law becomes unduly complex because different courts adopt inconsistent rules in construing the code.
The idea of the second theme was that much of the nonuniformity in decisional law arises from disagreements between Tax Court and the courts of appeals on questions of law. As noted above, nearly every reversal of a Tax Court decision on a question of law creates a nonuniformity problem in a very profound sense . Under Golsen v. Commissioner, the Tax Court follows court of appeals decisions with which it disagrees in cases appealable to that court of appeals, but it has traditionally adhered to its original position in cases appealable to other courts of appeals. While Golsen is supported by powerful reasoning, it means that a single court will apply a different rule of law to different taxpayers depending upon where they reside. The resulting nonuniformity is more serious than that which typically arises from a split among the circuits on a question of law. If federal district courts in California and Maine apply conflicting rules of law because they (or the Courts of Appeals for the Ninth and First Circuits) disagree, lack of uniformity results. That is unfortunate. However, one of the major functions of the Supreme Court is to resolve conflicts between circuits. So, at least in theory and to a large degree in a practical sense as well, the lack of uniformity is temporary. Nonuniformity in this context can be justified as an unavoidable, but temporary, consequence of the federal system.
No mechanism exists for resolving conflicts created by Tax Court reversals, and they are likely to persist indefinitely. Only if such a conflict generates a split among the circuits is it likely to be resolved by the Supreme Court. Furthermore, the application of different rules by different courts in different regions of the country is one thing- unpleasant, but perhaps viewed by most as an unavoidable risk of life. The application of different rules by the same court depending upon where one resides is another thing. It is a more direct affront to fair treatment and thus more difficult to accept than is different treatment by different courts. It is especially disconcerting when under Golsen, the Tax Court applies different rules to different taxpayers in the same case, or different rules to the same taxpayer in different years due to a change of residence.
I recognized in my earlier article that a deferential review would be no panacea. Courts of appeals would continue to reverse tax court decisions, and splits among the circuits would still occur. However, I argued that with deferential review such reversals and splits would be less frequent and involve weightier issues than is presently the case. In short, I envisioned deferential review as having a unifying effect. Courts of appeals would slower to reverse Tax Court decisions, and since all courts of appeals would be more inclined to agree with the Tax Court, they would be less inclined to disagree with each other.
I also recognized that deferential review of Tax Court decisions potentially would create a new problem in the form of intracircuit conflicts. Courts of appeals hear cases originating in the Tax Court as well as the district courts, and district court decisions on questions of law are reviewed de novo. If different standards of review apply depending on where these cases originated, it is entirely possible that a given court of appeals would resolve a legal question differently depending on whether it was appealed from the Tax Court or the district court. The result would be nonuniformity of a type similar to that created by Golsen. As noted, under Golsen, the Tax Court sometimes applies different rules, depending on which circuit court of appeals has appellate jurisdiction. If Tax Court decisions on questions of law were subject to deferential review, while district court decisions were reviewed de novo, a court of appeals might apply different rules depending upon which court tried the case.
Despite these shortcomings, I argued that "since most tax litigation occurs in the Tax Court, deferential review would advance system-wide uniformity even if it created some intracircuit conflicts, and the interest in national uniformity ought to trump intracircuit uniformity. " Furthermore, deferential review is a flexible concept. Courts of appeals would naturally resist intracircuit conflicts. So, it is unlikely that deferential review would lead a court of appeals to create such a conflict. On balance, I concluded that the benefits of deferential review would outweigh the costs.
In a thoughtful critique of my article, Professor Steve Johnson agreed with its main theme. However, Professor Johnson disagreed with the second theme. Indeed he argued that deferential review "without any structural change in the tax litigation process would make a flawed system even worse." Professor Johnson cogently argued that some of the disadvantages of deferential review discussed in my article are more serious than I had anticipated and pointed out some additional disadvantages. In light of his criticism, this article undertakes a deeper and more comprehensive examination of the second theme. It is now apparent that the analysis of deferential review in my earlier article was not as penetrating as it should have been, and my conclusions have been revised in significant ways. However, in the end I am not persuaded, as is Professor Johnson, that deferential review would "lead to a worse situation than doing nothing."
Part II of this Article focuses on Professor Johnson's critique. It explains why I continue to believe that deferential review would improve the tax litigation system. Part III considers deferential review of agency decisions and what the judicial experience in that context suggests concerning review of Tax Court decisions. Part IV draws upon the administrative law experience in proposing a model for deferential review of Tax Court decisions. Part V considers the proposed model as a compliment to a broader policy of uniformity in federal law. Finally, Part VI reviews some recent tax cases that demonstrate the need for change and suggests how deferential review under the proposed model would improve the tax litigation process.
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Why Can't We All Just Get Along: Finding Consistent Solutions to the Treatment of Derivatives and Other Problems
William B. Taylor*
Diana L. Wollman*
* Sullivan & Cromwell, New York, New York. An earlier version of this Article was presented at the Tax Forum in New York on December 7, 1998.
Some of the day-to-day complexity in the tax law results from the accretion over a Period of years of different answers to essentially similar problems. In part this may simply be the product of a compartmentalized Service in which different people deal with aspects of the same issue, depending on whether the aspect is "foreign" or "domestic" or otherwise pigeon-holed, and in which similar issues are addressed under different Code provisions at different times. Whatever the cause, much of the complexity seems unnecessary and avoidable. This Article suggests that using the same definition or characterization for multiple Code provisions would be better. Such general rules would be set out in one place and incorporated elsewhere by reference. Revisions ordinarily would need to be made in only one place. The use of general rules might sometimes gloss over differences between the contexts in which similar problems are raised, but this price is, in our judgment, modest (and can, in any case, be addressed by modifying the general concepts when necessary).
The examples set out below deal with aspects of derivative financial instruments. The examples lead to certain specific conclusions—for example, that a single definition of "good" investment income and activities could general be used under section 512(b), 7704(c), 864(b)(2), 851(b)(2), 856(c), and 892; that there could be a single rule for "sourcing" gains and losses from derivative financial instruments; and that uniform rules should also be developed for determining when gain or loss from derivative financial instruments is recognized and when two transactions are subject to special rules because one is a hedge of the other.
Our main point, which should not be obscured by the examples, is that the approach of looking for single definitions and rules to address substantially similar issues under different Code provisions would be a step towards simplification and could be applied throughout the code.
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Publicly-Traded Partnerships and Unrelated Business Taxable Income
Johnny Rex Buckles*
* Of Counsel, Thompson & Knight, LLP; Oklahoma State University, BS, 1989; Harvard University, JD, 1992; Dallas Theological Seminary, M.A.B.S., 1999.
Publicly-traded partnerships ("PTPs") have become common vehicle for attracting a variety of investors, large and small. Interests in PTPs offer many of the same benefits to investors as shares in corporations, including liquidity, the benefit of expert management, and ease of valuation. Not surprisingly, large organizations exempt from federal income taxation under section 501(a) of the Code, such as pension funds described in section 401(a) and private foundations described in section 501(c)(3), have invested (or contemplated investing) in PTPs as part of sophisticated investment programs designed to diversify portfolios, reduce aggregate risks, and maximize returns on investments.
The taxation of PTPs is governed primarily by section 7704 and the regulations issued thereunder. PTPs are generally treated as corporations for federal income tax purposes. As such, a PTP's partners, including tax-exempt entities, would reasonably expect their partnership interests to be treated as the shares in a corporation for federal income tax purposes. However, one puzzling sentence buried in a report of the Budget Committee of the House of Representatives ("Budget Committee"), which purports to explain the effect of the Omnibus Budget Reconciliation Act of 1993 ("OBRA 1993") on PTPs, has left a nagging issue that remains unresolved. The perplexing statement is that "investments in publicly-traded partnerships are treated the same as investments in other partnerships for purposes of the unrelated business taxable income ("UBTI") rules. The issues raised by this language is whether Congress intended a tax-exempt partner's interest in a PTP taxed as a corporation under section 704(a) to be treated in the same manner as an interest in a partnership taxed as such for purposes of determining the partner's unrelated business taxable income ("UBTI"). The Tax Court explicitly declined to express a view of this issue in dicta when it had an opportunity to do so.
Earlier this year, the Service revised the Internal Revenue Manual's discussion of the taxation of PTPs to reflect the Service's current understanding of OBRA 1993. The relevant provision of the Internal Revenue Manual correctly notes that OBRA 1993 modified section 512(c) to facilitate the investment by tax-exempt organizations in PTPs. Then, in apparent reliance upon the cryptic statement of the report of the Budget Committee, the Internal Revenue Manual states that, with the repeal of then-existing section 512(c) by OBRA 1993, "exempt organizations' investments in publicly-traded partnerships will be treated the same as income from other partnerships for purposes of determining unrelated business taxable income." Even more recently, in its twenty-second edition of the Exempt Organizations Continuing Professional Education Program (Aug. 30, 1999), the Service repeated its assertion that investments in PTPs are now treated the same as investments in other partnerships for purposes of the unrelated business income tax rules.
The thesis of this article is that, contrary to the Service's apparent understanding of OBRA 1993 and the quoted language in the report of the Budget Committee, a tax-exempt partner's investment in a PTP is not necessarily "treated the same as" investments in other partnerships for purposes of determining the organization's UBTI. Rather, the proper analysis begins with the inquiry of whether the PTP is treated as a corporation under 7704(a). If the PTP is so treated, a tax-exempt partner's interest in the PTP is treated precisely as a share of stock in a corporation subject to Subchapter C. Thus, the PTP's distributions will be treated as distributions from a corporation ( i.e., generally dividends), and such distributions will not consist in part of UBTI even if the PTP finances its operations with debt. However, if the PTP is treated as a partnership under special exceptions set forth in section 7704, the investment will be treated as an investment in any other partnership for purposes of computing the partner's UBTI.
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It’s a Wonderful Life Insurance Policy: Determining the Correct Theory to Tax the Employee in Employer-Pay-All Equity Split-Dollar Life Insurance Arrangements
* Associate Professor of Law, Widener University School of Law; University of Tennessee College of Law, J.D., 1982; New York University School of Law, LL.M, in Taxation, 1983; University of Florida, College of Law, LL.M. in Taxation, 1991. The author wishes to thank Michael J. Donnelly, an ex-law student at Widener University School of Law for his diligent and tireless service as the author’s research assistant. The author also thanks Kimberly Collins, a law student at Widener University School of Law, for her service as the author’s research assistant. Finally the author also acknowledges the assistance of Professor Jeff L. Lewin for his insightful comments in earlier drafts. Any deficiencies in this article are the sole responsibility of the author.
You see, George, you really had a wonderful life. Don’t you see what a mistake it would be to throw it away?
For years, the media, tax commentators, and the insurance industry have universally lauded all types of split-dollar life insurance arrangements as a low cost, tax effective way to provide a taxpayer with tax-favored retirement benefits, charitable giving opportunities, beneficiary survivor income, and estate liquidity. Yet if the Service ever formalizes its position taken in a recent technical advice memorandum (the "TAM"), the adverse tax consequences may cause a certain type of employment split-dollar arrangement to disappear.
An employment split-dollar arrangement ("ESDA") involves the acquisition by an employer and employee of some variation of a whole life or universal life insurance policy on the employee’s life. Such a policy has two basic economic components relevant to tan ESDA: the term life insurance component of the policy (the "Term Component") is funded by the smaller portion of the premium (the "Term Component Premiums"). The other component is a cash value investment (the "Cash Value Account"), which is funded by the most substantial portion of the premium payments (the "Cash Value Premiums"). The Cash Value Premiums are invested and generate earnings accumulated in the Cash Value Account. The accumulated earnings in excess of the premiums invested in the policy less any amounts applied to pay insurance-related costs are present the "Equity Growth" of the policy. The "Mortality Gain" is the difference between the face amount of the policy and the Cash Value account. Because the parties design ESDAs to be compensatory, the employer always pays the larger Cash Value Premium, with the employee paying the smaller Term Component Premium. In some arrangements, known in the insurance industry as employer-pay-all ("EPA") arrangements, the employer pays the entire premium. EPA arrangements are the focus of the Article.
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Tax Evidence: A Primer on the Federal Rules of Evidence as Applied by the Tax Court
* Tax attorney at the Office of Chief Council for the Internal Revenue Service. University of Montana, B.A., J.D.; University of Florida, LL.M. in Taxation. Member of the Washington, Montana and Washington D.C. bars. The views or opinions expressed in this Article are solely those of the author and do not reflect the views or opinions of the Internal Revenue Service. The author would like to express appreciation for invaluable suggestions and helpful criticisms given on previous drafts by Patricia Heatherman, an associate with Merrill O’Sullivan LLP in Bend, Oregon, and Loretta Kneupper.
The United States Tax Court applies Federal Rules of Evidence (the "Rules") during its proceedings. These rules establish the guidelines the judge will use to determine what testimony and documents will be admissible in evidence.
We follow the Federal Rule of Evidence in our proceedings. This provides all Parties with ground rules for presenting their cases. To depart from these rules not only would contradict our mandated authority but also would prejudice the parties by removing the certainty of what the Court may consider in finding facts. A party could not adequately prepare or defend a case if it were uncertain what standards would be applied to judge the admissibility of evidence. While it is generally accepted that a relaxed application of the rules of evidence during a bench trial results in less prejudice to the fact finder because of a judge’s legal training and experience, the uncertainty of what will be used to find facts is highly prejudicial to a party whether the fact finder is a judge or a jury. Incompetent evidence should not be admitted to proof. We, therefore, believe that adhering to the Federal Rules of Evidence is a sound way to protect the integrity of our proceedings.
In order to present the best case possible, it is imperative for a party litigating in the Tax Court to understand the Federal Rules of Evidence and how they have been interpreted and applied by the Tax Court.
This article surveys the Tax Court’s interpretation and application of the Federal Rules of Evidence. Appendix A sets forth those Federal Rules of Evidence which have not been addressed or interpreted by the Tax Court in its opinions. The Article does not discuss the application of the Federal Rules of Evidence by District Courts, the Court of Federal Claims, or the Circuit Courts of Appeal or Tax Court opinions which do not specifically rely on the Federal Rules of Evidence. Appendix B provides a summary of the Federal Rules of Evidence most commonly used in the Tax Court and the various foundational requirements.
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