From this substance-over-form concept emerged at least two different but related doctrines: the economic substance doctrine and the step transaction doctrine. The economic substance doctrine allows the IRS to deny tax benefits if the purported pretax economic profit is significantly less than the value of the expected tax benefits from the transaction. Likewise, the step transaction doctrine permits the IRS to disregard steps in a transaction when those steps lack independent significance and to assess the results instead of the integrated transaction. Both doctrines are based on the idea that if two transactions have the same economic outcome, they should have the same tax outcome.
The requirement that a transaction have economic substance originated from Gregory’s substance-over-form language. In Gregory, the taxpayer had an independent business purpose for conducting the transaction (she wanted to sell her stock); thus, only the form of the transaction (a reorganization) was tax-motivated.
In contrast, in Knetsch v. United States, the taxpayer did not have an independent business purpose for conducting the transaction: the taxpayer was only seeking tax benefits. Knetsch involved tax arbitrage—“whereby [a taxpayer] profit[s] after-tax from both paying and receiving a dollar because the dollar … pa[id] is treated more favorably than the dollar … receive[d].” In Knetsch, the taxpayer paid $91,570 to reduce its tax obligation by $233,297.68. The taxpayer was able to reduce the tax obligation by accelerating deductions, postponing income, and converting ordinary income into capital gain. Had the tax benefits been allowed, the taxpayer would have profited by $141,727.68. Referencing Gregory, and again acknowledging that tax avoidance was indeed legitimate, the Supreme Court nevertheless called the taxpayer’s transaction a “fiction,” a “sham,” and a “facade.” The Court noted that the transaction did “‘not appreciably affect [the taxpayer’s] beneficial interest except to reduce his tax.’ For it is patent that there was nothing of substance to be realized by [the taxpayer] from this transaction beyond a tax deduction.” Accordingly, the Court denied the tax benefits. Thus, unlike in Gregory, in Knetsch, both the purpose for the transaction (its existence) and the form of the transaction (tax arbitrage) were tax motivated. Hence, the Court’s analysis focused on the economic effect of the transaction (the form) rather than the taxpayer’s motivation for the transaction. I will call this the economic substance principle to distinguish it from the economic substance doctrine described below. Pursuant to the economic substance principle, a court examines whether the purported economic activity would have occurred absent any tax benefits the taxpayer is now claiming: stated differently, the court asks whether there was a prospect of profit before taxes (pretax-profit prospect). A transaction must have a meaningful economic purpose or investor risk to be legitimate: the IRS can invalidate a transaction if it lacks economic substance independent of tax considerations. Simply put, “the transaction [must have] practical economic effects other than the creation of income tax losses.”
Subsequently, the Supreme Court combined the business purpose doctrine and the economic substance principle into one test in Frank Lyon Co. v. United States. Frank Lyon involved a sale/lease-back transaction of a building. The issue for the Court was whether the taxpayer, Frank Lyon, was entitled to claim depreciation and other deductions on a building when it acted more like a lender than a lessor. Frank Lyon had entered into an arrangement at below market value to finance a building. While it faced possible financial loss if its business partner went bankrupt, Frank Lyon could realize up to $1.5 million in tax benefits if all went well. The transaction in its essence was simple: the business partner effectively sold nontransferable depreciation deductions to the highest bidder, which in this case was Frank Lyon.
Like the taxpayer in Knetsch, the taxpayer in Frank Lyon did not have a business purpose for the transaction; thus, both the existence and the form of the transaction were entirely tax-motivated. For this reason, both business purpose and economic substance were at issue. Unlike the taxpayer in Knetsch, however, Frank Lyon had a business partner, and that partner had a legitimate business reason for entering into and structuring the transaction as the parties did. Although Frank Lyon had neither a business purpose nor the possibility of economic gain absent tax considerations, the Court nevertheless concluded that because the taxpayer had undertaken a transaction with a “genuine economic risk,” the deductions were allowable. In crafting this new doctrine, the Court stated:
[W]here, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties.
Thus was born the economic substance doctrine. The economic substance doctrine combines the business purpose doctrine and the economic substance principle into a single two-pronged test. Under the business purpose prong, a court assesses the underlying motivation for the transaction. Under the economic substance prong, a court determines whether the purported economic activity would have occurred absent the tax benefits. While the business purpose prong focuses on the taxpayer’s intent, the economic substance prong focuses on the transaction’s effect.
Another substance-over-form doctrine, the step transaction doctrine, allows the IRS to treat “a series of formally independent steps … as a single, integrated transaction” for tax purposes: the result is to assess the tax effects of the integrated transaction and ignore the tax effects of the transaction’s intermediate steps. The step transaction doctrine first came into play in Minnesota Tea Co. v. Helvering when the taxpayer sold some of its assets for stock in another company and the remainder of its assets for cash in pursuance of a plan of reorganization. Under the relevant statute at the time, the sale of the assets would result in a taxable gain unless the proceeds were “distributed” to the taxpayer’s shareholders. Instead of using the cash to directly pay creditors, the taxpayer disseminated the cash to its shareholders in return for their agreement to assume the taxpayer’s debts. The Court ignored the steps of the transaction and held that there was no distribution within the meaning of the statute, finding that the dissemination was, instead, the taxpayer’s payment to its creditors. The Court allowed the IRS to tax the gain from the sale of the assets.
A given result at the end of a straight path is not made a different result because reached by following a devious path. The preliminary distribution … was a meaningless and unnecessary incident in the transmission of the fund to the creditors, all along intended to come to their hands.
Later, in Commissioner v. Court Holding Co., two shareholders orally agreed to sell an apartment building to a third party. Following the advice of legal counsel, the taxpayer-corporation first liquidated the property to its shareholders, who subsequently sold the building to the true buyer. Affirming the Tax Court’s finding against the taxpayer-corporation, the Supreme Court ignored the shareholders’ participation in the transaction, stating that a “transaction must be viewed as a whole, and each step, from the commencement of negotiations to the consummation of the sale, is relevant [to the whole].”
In sum, the step transaction doctrine allows the IRS to eviscerate meaningless steps in a multi-step transaction. “Under the step-transaction doctrine, a particular step in a transaction is disregarded for tax purposes if the taxpayer could have achieved its objective more directly, but instead included the step for no other purpose than to avoid U.S. taxes.”
Returning to the case that started this discussion, GSS Holdings (Liberty) Inc. v. United States, I believe the majority correctly understood that the economic substance doctrine and the step transaction doctrine are related but separate doctrines that fall within the substance-over-form umbrella. The Claims Court wrongly conflated them, and the dissent wrongly concluded that substance over form replaced them.