November 03, 2011 The Tax Lawyer

Circular Cash Flows and the Federal Income Tax

Vol. 64, No. 3 - Spring 2011

Jasper L. Cummings, Jr.

Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.


    This Article investigates the suspicion exhibited by the federal judiciary and the Service toward circular flows of cash and other property. The courts and Service suspect that nothing happened for tax purposes and tend to conclude that because the cash wound up where it started, its passage should be ignored. Ignoring cash flows is an application of step transaction analysis for determining facts by focusing on the two ends of a transaction and ignoring the intervening steps. In turn, step transaction analysis is a method within the substance over form approach to fact-finding, which is not peculiar to tax, although the terminology is somewhat peculiar to tax. However, substance does not always control form, substance is not always obvious, step transaction analysis does not always apply, and circular flows of cash are not and should not always be ignored. Therefore, the ability of a step transaction analysis to disregard circular cash flows is an observation, not a reason to disregard the circular flows.

    A reason to apply step transaction analysis to a circular cash flow must be found in each case. For example, the Supreme Court determined in Lazarus that a sale and leaseback were not two transactions but one (a secured loan), and so ignored the circular flow of the property, leaving the circular flow of cash to be a loan; therefore, the original owner had owned the property all along and could depreciate it. Normally, the finding of a single transaction or a single relationship between the parties to a circular flow should be required to ignore the circular flow. Unfortunately, courts and the Service typically think that discerning a circular flow by itself justifies ignoring the circular flow.

    The factual issue of whether there are two transactions and two relationships between the parties, or simply one, can usually be determined in tax cases the same way it is determined in nontax cases. Most of the circular flow cases involve businesses, and most business transactions involve contracts. In contract litigation the common law courts normally seek to find what the parties to a transaction intended as between  themselves, based on all of the facts and circumstances. Contract interpretation can result in ignoring a circular flow of cash, and so should the tax law.

    This Article deduces from the federal income tax case law four broad types, or clusters, of circular cash flows that tend to be disregarded for the common reason that somehow the cash repayment is generated by the original cash payment and within a single relationship: (1) transactions between a taxpayer and itself in the form of an agent or disregarded entity; (2) two offsetting payments that occur in a single exchange with a separate taxpayer that are netted to produce a lower or zero net payment as one leg of the exchange; (3) a pair of nominally separate exchanges that are treated as one because in substance they are not generated by two separate relationships, and the parties intended one exchange; and (4) seemingly circular corporation–shareholder transfers that are peculiar to the corporate regime but whose tax treatment has had an unfortunately broad impact on the entire field of circular flows. These four categories may seem simplistic, but differentiating among them can substantially clarify the confusion that surrounds most circular cash flow cases. The following are examples of the second and third types of cases:

  1. Netting. A pays B $100 for a truck and B refunds $10 because A qualified for reduced pricing. A has paid $90 for the truck for tax purposes and for most other legal purposes. The parties engaged in a single exchange as to which one side should be netted due to a circular cash flow; netting occurs because the repayment is generated by the original payment.
  2. Paired Exchanges—Single Relationship. A sells three used trucks to B, a vehicle dealer, for $100, and simultaneously B sells a new truck to A for $100. A and B intend to swap old trucks for a new truck and so have only one relationship, that of exchanging trucks. A’s receipt of the new truck is generated by A’s exchange of the old trucks. Therefore, the cash leg of each of the two formal exchanges make up a circular cash flow that should be disregarded for purposes of characterizing the transaction.
  3. Paired Exchanges—Dual Relationship. Conversely, if A is a dealer who sells a truck to B for $100 and B is a lawyer to whom A happens to pay $100 for services at about the same time, the cash flow that could be called circular is generated by separate relationships and the parties probably did not intend to swap a truck for services, and so the two transactions should be respected in form.

    Determining when netting in a single exchange should occur can be factually difficult. Determining when pairs of exchanges reflect a single relationship or two relationships can also be factually difficult. But knowing what type of facts can justify applying step transaction analysis to an apparently circular cash flow leads to more logical conclusions than simply disregarding all flows that seem to be circular.

    The corporation–shareholder category bridges netting and paired exchanges. It has influenced the entire subject of circular cash flows because its occurrences are so common and were among the first recognized and decided circular flow cases. And yet the pervasive influence can be misleading and has contributed to the confusion in the area because the corporation–shareholder cases are sui generis in two ways: (1) the inherent commonality of interest of corporations and shareholders forces the tax law to rely more on form than substance in taxing their transactions, and such forms can properly place a shareholder in two or more distinct relationships with its corporation; and (2) in contrast to most other circular flow cases, and also due to the commonality of interest between corporations and their shareholders, many corporation–shareholder transactions are unilateral (e.g., capital contributions, distributions), which tends to place the emphasis on netting. Therefore, this category of cases receives special handling insofar as circular cash flows are concerned, just as it does for other purposes of the income tax law.

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