Attacking Tax Shelters: Galloping Toward a Better Step Transaction Doctrine

• Author: Jonathan D. Grossberg
• Position: Practitioner-in-Residence, Janet R. Spragens Federal Tax Clinic, American University, Washington College of Law. LL.M. (Taxation), New York University School of Law; J.D., Cornell Law School; B.A., Cornell University.
• Pages: 369-436

Attacking Tax Shelters: Galloping Toward a Better Step Transaction Doctrine Jonathan D. Grossberg * Since the beginning of the Internal Revenue Code, taxpayers have sought to lower their tax bills through creative tax planning. The step transaction doctrine is one of several tools used by the Internal Revenue Service and courts to challenge tax shelters and tax evasion. The step transaction doctrine provides that the courts may combine two or more allegedly separate steps in a multi-step transaction into a single step to better reflect the economic reality of the taxpayer’s actions. Derived from Supreme Court decisions in the 1930s, the doctrine deserves renewed scrutiny today because serious conceptual issues exist regarding the three current tests that courts use to determine when to combine various steps in a tax-motivated multiple-step transaction. This Article addresses two perennial themes in tax law: the role of judicial doctrines in a statutory system and the difficulty of taxing related-party transactions. This Article argues that courts should reformulate the binding commitment, interdependence, and end result tests as two objective tests: an objective test based on the law of offer and acceptance for arms-length transactions and an economic reality test for transactions between related parties. These new tests provide conceptual clarity and promote predictability while protecting the public treasury. The new tests borrow underlying concepts from contract and commercial law. The new tests demonstrate the fruitful possibilities of borrowing across areas of law. They also demonstrate that tax law shares similar concerns Copyright 2017, by JONATHAN D. GROSSBERG. * Practitioner-in-Residence, Janet R. Spragens Federal Tax Clinic, American University, Washington College of Law. LL.M. (Taxation), New York University School of Law; J.D., Cornell Law School; B.A., Cornell University. I am grateful for helpful comments and suggestions from Daniel Shaviro, Robert Green, Robert Hillman, David Shipley, Patricia Lee, Nancy Abramowitz, Benjamin Leff, Kenneth Anderson, Heather Hughes, Susan Carle, David Shechtman, Kathleen Gordon, Diane Weinroth, David Grossberg, Robyn Grossberg, Nina Goldman Grossberg, and two anonymous readers, and from the participants in the American University, Washington College of Law Business Faculty Workshop, the Mid-Atlantic Clinical Writers’ Workshop, and the Sharing Scholarship Building Teachers Conference at Albany Law School. I am also thankful for Margaret Hobbs’ excellent research assistance, Kevin Gustafson’s editorial assistance, and additional research assistance from Sonja Balic and Matthew Abbott. I am also grateful to the staff of the Pence Law Library at American University Washington College of Law, especially Khelani Clay, for finding sources and providing other research and reference assistance. 370 LOUISIANA LAW REVIEW [Vol. 78 with other areas of law—a proposition that is sometimes doubted. This Article further contends that the step transaction doctrine, as reformulated, should be available for assertion by taxpayers in transactions between unrelated parties. Acknowledging the availability of the test for assertion by taxpayers will have the salutary effect of aligning the letter of the doctrine with its application. TABLE OF CONTENTS Introduction .................................................................................. 370 I. Background on Judicial Doctrines ............................................... 377 A. Common Roots of the Judicial Doctrines .............................. 378 B. The Step Transaction Doctrine .............................................. 381 1. The Binding Commitment Test ....................................... 382 2. The Interdependence Test ............................................... 383 3. The End Result Test ........................................................ 386 4. The Relationship Between the Three Tests ..................... 390 5. Recent Cases Applying the Doctrine .............................. 395 C. Critical Responses to the Step Transaction Doctrine ............. 397 1. Test Application Criticisms ............................................. 398 2. Criticism of the Existence of Specific Tests ................... 401 3. Critics Favoring an Entirely New Test ............................ 404 D. Recent Scholarship ................................................................ 408 II. A New Vision of the Step Transaction Doctrine .......................... 409 A. Objective Test ........................................................................ 412 B. Economic Reality Test ........................................................... 417 C. Why Two Tests? .................................................................... 423 D. Offensive Use of Judicial Doctrines ...................................... 424 E. Different Tests, Different Results .......................................... 431 III. Broader Themes and Open Questions: Borrowing Across Areas of Law and Aligning Theory with Practice ........................ 433 Conclusion .................................................................................... 436 INTRODUCTION The Internal Revenue Code (“IRC” or “Code”) and the Treasury Regulations (“Regulations”) consume volumes and volumes of provisions. These provisions are worded carefully and often reflect competing policies 2018] ATTACKING TAX SHELTERS 371 beyond raising revenue, such as favoring or disfavoring certain taxpayer behavior and advancing social policies. Since the beginning of the Code, taxpayers have sought to lower their tax bills through creative tax planning. This behavior often has been met with judicial approval. 1 Congress, by enacting the anti-abuse provisions of the Code, and the Internal Revenue Service (“IRS”), by promulgating anti-abuse regulations, have sought to combat this behavior. 2 This Article addresses two of the perennial themes of tax law: the role of judicial doctrines in a statutory system and the difficulty of taxing transactions between related parties. These concerns link this Article to broader themes in the law. Tax law is governed primarily by code and regulation, as are intellectual property law, immigration law, criminal law, and many other areas of law. In each of these primarily statutory systems of law, when the courts perceive a gap or deficiency in the statutory system, they augment the system with judge-made common law. 3 1. See infra notes 35–39 and accompanying text. 2. In one recent case, the court noted that much of the caselaw using the economic substance, sham transaction, and other judicial doctrines in interpreting and applying tax statutes, represents an effort to reconcile two competing policy goals. On one hand, having clear, concrete rules embodied in a written Code and regulations that exclusively define a taxpayer’s obligations (1) facilitates smooth operation of our voluntary compliance system, (2) helps to render that system transparent and administrable, and (3) furthers the free market economy by permitting taxpayers to know in advance the tax consequences of their transactions. On the other side of the scales, the Code’s and the regulations’ fiendish complexity necessarily creates space for attempts to achieve tax results that Congress and the Treasury plainly never contemplated, while nevertheless complying strictly with the letter of the rules, at the expense of the fisc (and other taxpayers). CNT Inv’rs, L.L.C. v. Comm’r, 144 T.C. 161, 198 (2015). 3. See generally Brett Fischman & Dan Moylan, The Evolving Common Law Doctrine of Copyright Misuse: A Unified Theory and its Application to Software, 15 BERK. TECH. L.J. 865 (2000) (discussing the emerging common law doctrine of misuse in copyright law as a judicial attempt to prevent statutory protection from being abused as an anticompetitive tactic); Alan Scott Rau, Intellectual Property, 16 TEX. TECH L. REV. 355 (1985) (discussing how and to what extent the Fifth Circuit incorporated the common law doctrine of functionality into its reading of the Lanham Act in Sicilia Di R. Biebow & Co. v. Cox, 732 F.2d 417 (5th Cir. 1984)); Kiran H. Griffith, Comment, Fugitives in Immigration: A Call for Legislative Guidelines on Disentitlement, 36 SEATTLE U. L. REV. 209 (2012) (discussing the use of the common law doctrine of fugitive disentitlement in immigration law); John M. Mulcahey, Recent Decision, Res 372 LOUISIANA LAW REVIEW [Vol. 78 In tax law, courts have created doctrines to prevent perceived taxpayer abuse. In certain circumstances, some of these doctrines have been available to taxpayers to characterize their own transactions in a more tax-favorable manner. 4 These doctrines include substance over form, economic substance, business purpose, sham transaction, and step transaction. 5 The courts and Congress have struggled with related-party transactions 6 since the earliest days of the Internal Revenue Code. The assignment of income doctrine, as embodied in the classic case of Lucas v. Earl, 7 was an early effort to address this issue. Specific Code sections, such as §§ 267 and 1239, also address the issues caused by related-party transactions. The Treasury often issues regulations specifically addressing the special difficulties of taxing related-party transactions in a variety of contexts. 8 Among these various efforts, the judicial doctrines mentioned above— substance over form, economic substance, business purpose, sham transaction, and step transaction—all of which have their genesis in Gregory v. Helvering, 9 have played a prominent role in regulating transactions between related parties. Although scholars recently have paid significant attention to the economic substance doctrine, owing in part to its codification, substantially less scholarly attention has been paid in recent years to the step transaction doctrine. 10 This Article contends that the step transaction doctrine is...