SHAM on You: Too GOOD TO BE TRUE.
|Engler, Mitchell L.
INTRODIJCTION 315 I. THE PROBLEM 317 A. The Current State and Local Tax Manifestation 317 B. Extension to Non-Tax Areas 319 1. Marriage and Divorce 319 2. Property Law Strawman Transfer 321 3. Contract Law 322 4. Copyright Law 325 5. Usurious Interest Limitations 326 6. Low-Income Buyer Protections 328 II. THE RESPONSE 330 A. Endorsed Workarounds 330 1. Stare Decisis 331 2. Form as a Desired Proxy 336 B. Unsanctioned Shams 339 1. Explanations 339 a. Lack of Full Appreciation 340 b. Indefinite Borders Difficulties 343 c. Special Issues Where Legislation 344 2. The Judicial Response 345 a. Baseline Protection: Pure Sham 346 b. Balanced Summary Judgment Expansion 350 3. Anticipate the Workaround: Legislative Protection 356 CONCLUSION 359 "Show, is not Substance: Realities Govern Wise Men." (1) INTRODUCTION
Despite their ongoing commitment, Angela and David Boyter undertook a seemingly bizarre annual ritual. They would divorce late each year only to remarry early the following year. (2) What motivated these annual two-step reversals? Marriage increases the taxes of certain couples under our tax system, with marital status determined as of December 31 each year. (3) The Boyters thus wanted to maintain their marital status but without the marriage tax penalty. In that spirit, they used their claimed tax savings to fund an annual vacation together.
The December 2017 federal tax bill (4) generated a similar response this year, with a surprising twist as to the identity of the manipulators. The tax bill imposed a new $10,000 limit on most state and local tax deductions. (5) In response, New York Governor Andrew Cuomo and other state government officials endorsed the following scheme to avoid these new limits. Since the new $10,000 limit does not apply to charitable contributions, certain high-tax states like New York would grant their citizens state tax credits for "voluntary" charitable payments to state funds. (6) Treasury Secretary Steven Mnuchin called this a "ridiculous" attempt to dress up non-deductible state tax payments as deductible charitable contributions. (7) Section I.A provides more detail on this most current manifestation of the legal sham problem.
As well documented elsewhere, these two instances present just the tip of the iceberg for the tax system. (8) But the problem of legal shams extends well beyond taxes. The flip side to the Boyter case provides one such illustration. Some individuals formally marry without the Boyters' genuine commitment in order to obtain immigration or other legal benefits. (9)
The first year law school curriculum further evidences the pervasiveness of legal machinations. Property law teaches the strawman technique under which a temporary transfer to a third party can facilitate an otherwise unobtainable legal result. (10) Contract law presents two formalistic ways to possibly evade the consideration requirement for a contract modification: (1) a two-step rescission and re-formation, or (2) the inclusion of a nominal "peppercorn." Section I.B provides a more expansive discussion of how the sham problem permeates these and other non-tax areas as well. (11)
Ample commentary focuses on the appropriate tax law response to such machinations. The non-tax areas have generated some commentary as well, albeit typically focused just on the one particular legal area under consideration. The pervasiveness of the problem in so many diverse areas, however, evidences the need for a more coordinated response. This Article fills that gap, developing broader responses for application across the board to engender more respect for legal requirements. In particular, Section II explores why courts sometimes grant legal effect to formalistic machinations, which then leads to appropriate responses.
Section II.A first considers two reasons why courts sometimes actually endorse the legal workaround. Stare decisis provides the first explanation: courts want to reach a desired result but are reluctant to discard long-standing precedent. Second, courts sometimes sanction formal workarounds as proxies for an indirect goal. While perhaps seemingly innocuous at first, this Section highlights the unwitting danger of these approaches. As evidenced by much tax literature and two intriguing anecdotes, these permissible workarounds can encourage unintended legal disregard elsewhere. For instance, this Section shares a classroom exchange where one of my insightful students suggested use of the property law strawman to navigate around an adverse tax Code provision. Given this pernicious carryover impact, Section II instructs that judges should opt instead for more direct solutions to the stare decisis or proxy scenarios.
Section II.B then shifts to areas where courts tolerate, but do not endorse, the formalistic result. Section II.B.1 explains how vagueness and overbreadth concerns underlie such judicial inaction, partly attributable to the lack of a concrete sham definition. Section II.B.2 therefore crafts a precise, but limited, sham definition sensitive to overbreadth concerns. Given the limited scope, the Section suggests providing additional protection through the summary judgment screening mechanism. Finally, Section II.B.3 highlights how legislatures can better insulate vulnerable provisions against shams with built-in protective clauses.
While workarounds are endemic to the tax area, the problem permeates many non-t ax areas. After Section A recaps the current tax scenario, Section B presents six different other areas to highlight the pervasive nature of the challenge for the legal system.
The Current State and Local Tax Manifestation
Prior to 2018, state income and real estate taxes were freely deductible for regular federal tax purposes. (12) With such deductibility, citizens in high-tax states did not bear the full brunt of heavy state taxes. Rather, a significant portion shifted over to citizens in low-tax states. (13) The recent tax bill, however, capped the deduction of most state taxes at $10,000. (14) Citizens in high-tax states now bear the full cost of state tax charges which exceed the $10,000 cap. (15)
Many high-tax states understandably resisted this real cost increase of their taxes to their citizens. In response, several such states (including New York, California, New Jersey, Illinois, and Connecticut) have sought loopholes around the new $10,000 limit. (16) Drawing upon the lack of a comparable cap on charitable contributions, (17) these workarounds endeavor to convert excess state tax payments into charitable contributions. (18)
The Illinois approach provides a useful representative example. As originated in the Illinois House, the bill initially provided a new 100% state tax credit for contributions to a new Illinois Education Excellence Fund. (19) For example, a $10,000 contribution would generate a $10,000 credit (i.e., a dollar for dollar credit). The Illinois Senate later modified the House bill to reduce the credit percentage to 90% (e.g., a $9,000 credit for a $10,000 contribution). (20) As analyzed in Section II.B.2, such reduction to a 90% credit appears to improve the optics but does not alter the sham nature of the arrangement.
Extension to Non-Tax Areas
As discussed below, the sham problem permeates many diverse areas of law.
Marriage and Divorce
Sham marriage and divorce neatly demonstrates both tax and non-tax exposure. As noted in the Introduction, the Boyters attempted to avoid the marital tax penalty through an annual two-step divorce and remarriage. (21) The Fourth Circuit remanded the case to the Tax Court "to determine whether the divorces, even if valid under [state] law, are nonetheless shams and should be disregarded for federal income tax purposes for the years in question." (22)
The non-tax issues generally flow from the inverse of the Boyter's sham divorce: sham marriages to achieve some non-tax marital benefit. Such non-tax benefits can include health benefits, immigration or naturalization purposes, or spousal immunity. (23) And so the non-tax law must grapple with when to ignore the marriage and negate the desired marital benefits. Interestingly, the flip side sham marriage also could provide tax benefits as sometimes two individuals pay less aggregate tax if married (a so-called "marital bonus" couple). (24) The tax law thus could induce a reverse Boyter annual marriage late each year, followed by a quick divorce early the following year.
Property Law Strawman Transfer
Black's Law Dictionary definition of strawman neatly presents the legal challenge: "a third party used in some transactions as a temporary transferee to allow the principal parties to accomplish something that is otherwise impermissible" (25) This well-accepted definition might seem innocuous enough on a first read. On further reflection, though, it seems antithetical to the Fourth Circuit's potential sham disregard of the Boyter's temporary divorce and Mnuchin's fair rebuke of the current state tax dodge.
Lawyers typically receive their first exposure to the strawman technique in their Property Law class. A joint tenancy traditionally required the "four unities of title" under common law. This required the creation of each person's ownership interests at the same time (unity of time) and through the same conveying instrument (unity of interest). (26) This prevented an existing owner (Ellie) from establishing a joint tenancy with a new owner (Nellie). The strawman technique developed as a way around the problem. (27) Ellie would transfer the property to a temporary strawman (say Ellie's lawyer) who would then convey the property back to Ellie and Nellie as joint tenants. In form, Ellie and Nellie established their ownership interests at the same time and through the same instrument. Consistent with the Black's definition above, property law generally respected this formal workaround of the unities of time and interest.
Most jurisdictions relaxed the...
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