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March 08, 2018 The Tax Lawyer

Do Tax-Motivated Wash Gain Sales Pass Economic Substance Muster?

Volume 71, No. 2 - Winter 2018

Stanley Veliotis


For nearly a century, the Code has disallowed wash losses, which are losses from the sale of a share of stock or other security for which the taxpayer within 30 days before or after the sale repurchases the asset. In contrast, the Code does not forbid wash gains. Taking advantage of this, many textbooks, academics, practitioners, and business journalists recommend that taxpayers pursue a wash gain strategy, including even repurchasing immediately. These authors suggest two settings in which the wash gain saves the seller taxes. The first setting is when the taxpayer expects future tax rate increases and thus sells appreciated stock now for a gain taxed at the lower rate, and buys it back so that the future tax rate would be applied to a lower gain. This strategy makes the most sense when the current rate is zero, but can even make sense if the current rate is not zero (assuming a low enough time value of money cost of prepaying the tax). The second setting involves taxpayers who have carryovers (especially if they are soon to expire), in which case the taxpayer can realize wash gains to use up carryover and effectively write up the basis so that future sales will have a smaller taxable gain.

    After detailing these recommendations, this Article explains why many wash gain transactions are vulnerable to attack by the Service and the courts. After showing how the economic substance doctrine and its many—sometimes overlapping—doctrines could apply to the wash gain, this Article then focuses on two strands of the substance-related doctrines: substantive sham and step transaction. The Article also fits its wash gain analysis into jurisprudence addressing whether a sale is a bona fide sale. Finally, the Article explains how the recent codification of the economic substance doctrine in section 7701(o), including related underpayment penalties, raises the stakes for wash gain sellers who lose the battle with the Service or the court.

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Stanley Veliotis