Sham Transactions
When a business transaction or plan does not have as its objective earning a profit, but is performed merely for tax motives, the business faces a potential tax issue with the IRS. The IRS may regard the transaction as a sham transaction - which is a transaction without economic substance. Sham transactions may result in civil and criminal tax penalties.
An example of a sham transaction is an artificial loss on a business transaction created for tax purposes. Our principal Ted Craft is an expert in analyzing business transactions to determine whether or not they are sham transactions.
Depending on the motive, the IRS may view sham transactions as a civil matter and simply adjust the amount of individual taxes due, or seek a criminal prosecution.
Substance Over Form
In applying income tax laws, the substance of the transaction, rather than its form, determines the tax consequences. In reviewing a transaction, if the IRS finds the economic substance of the transaction is not reflected in the form, it may adjust the corporate taxes to reflect the substance. Depending on the motive, the taxpayer may also face criminal charges.
The "substance over form" analysis is used to dissect self-serving transactions between parties, such as transactions between corporations and their shareholders and partners. Here is an example of a substance-over-form transaction:
- A corporation sells assets in the corporation to a shareholder in return for a note payable by the shareholder to the corporation.
- The shareholder does not pay the corporation the note.
- The corporation declares the note uncollectible and writes it off as a receivable it will never receive.
This is an example of a criminal substance-over-form case. The substance of the case is that the shareholder took the assets form the company without any intention of paying the note.
Our principal Ted Craft is an expert in analyzing "substance over form" transactions for clients in the Boston area.
To qualify your tax case, call Theodore Craft at 888-TAX-RISK.
Economic Substance Doctrine Information
Congress codified the common law doctrine of "economic substance" as a mandatory two-prong test in the Health Care and Education Affordability Reconciliation Act of 2010 (H.R. 4872, P.L. 11-152, the "Act"), signed into law by the president on March 30, 2010. The "economic substance" doctrine [otherwise stated as the doctrine of substance over form] has historically denied federal income tax benefits to transactions that do not have "economic substance." A transaction or series of transactions entered into solely or predominantly for tax considerations normally, that is with very few if any exceptions, lack economic substance if profit [in the sense of a reasonable inference of "business purpose" from all the facts] is not likely without regard to the tax considerations. Thus, even though a transaction or series of transactions may literally comply with provisions of the Internal Revenue Code and its interpretations [the usual "hook" for the "sale" of a transaction scheme or package of planned transactions], the literal compliance, or "form" in which the transaction or series of transactions is "clothed," may not comport with the "substance," or economic reality of the whole. The Act imposes a strict liability penalty standard, and possibly also increased penalties, for federal income tax benefits disallowed because a transaction fails to qualify under the newly codified test.
The Act (§1409) adds §7701(0) to the Internal Revenue Code to provide that a transaction would only have economic substance if (1) the transaction changes the taxpayer's economic position in a meaningful way (considered apart from federal income tax effects) and (2) the taxpayer has a substantial purpose (again, apart from federal income tax effects) for entering into the transaction. This is referred to as a "conjunctive test." It applies to transactions entered into after March 30, 2010. According to the Joint Committee on Taxation ("JCT"), enforcement of the new provision would raise $4.5 billion through 2019.
Comment: Case law interpreting the economic substance doctrine has developed since the Nixon administration. I expect that the application of the fundamental tests contained in the new Act to facts presented in cases selected for examination will result in new difficulties of interpretation which will be carried on in litigation for years to come. Undoubtedly codification of the test will be interpreted in one way or another to supply the appearance of loopholes in transactions structured in a certain way. It must be understood that the bricks and mortar metaphor for the economic substance test is the only true touchstone for guidance. If a transaction is held together by the mortar of tax considerations and the bricks are the business considerations, the transaction will usually be sound for tax purposes. On the other hand, if the bricks of the transaction or model of the business plan are purely driven tax considerations the hoped for tax result will inevitably fail. The new Act adds considerable wrinkles to figuring out pre-tax and post-tax economic profit (with fees and other transaction expenses taken into account as expenses) in the "weighting" of "profit potential."
The Act amends §6664(c) of the Code to prohibit application of the "reasonable cause exception" to a substantial understatement penalty attributable to any transaction that fails the economic substance test. Thus, a "more likely than not" tax opinion may not be enough to shield a taxpayer from penalties. In a further amendment to §6662 of the Code, the understatement penalty increases from 20% to 40% to the extent that an understatement is attributable to any portion of a transaction that lacks economic substance and is not adequately disclosed in a return or statement attached to the return. A non-disclosure cannot be cured by amendment or supplemental disclosure after notice of examination of the relevant return has been made. Finally, §6676 of the Code completes the circle of pain stating that a claim for refund for any amount attributable to a transaction lacking economic substance will not be considered to have a reasonable basis and, accordingly, will subject the amount of the claim to a 20% penalty.
- Codification of Economic Substance Doctrine and Imposition of Penalties
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To learn more about this topic, please visit pages 142-157 of the Technical Explanation of the Revenue Provisions of the "Reconciliation Act of 2010", as amended, in Combination with the "Patient Protection and Affordable Care Act"
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See revenue proceedure 2012-15 Re: Substantial underpayment aspects of the accuracy related penalty beginning in 2011.
