A walk through the step-transaction doctrine.

• Author: Knight, Ray A.

The economics surrounding the COVID-19 pandemic maybe causing many taxpayers to enter into transactions to preserve capital and reduce financial risk. The IRS may challenge the validity of transactions that appear primarily motivated by tax considerations. To best defend a taxpayer's reported tax treatment of a series of transactions, taxpayers and their advisers should understand the possible grounds for a challenge of that treatment. The IRS frequently attempts to recharacterize a series of separate transactions as a single transaction for tax purposes based on the step-transaction doctrine. An overview and analysis of the step-transaction doctrine's application should enable more secure and efficient tax planning and aid an informed judgment of the strength of the IRS's position if it invokes the doctrine in a challenge to the taxpayers treatment of a series of transactions.

The step-transaction doctrine is a rule of substance over form. It "treats a series of formally separate 'steps' as a single transaction if such steps are in substance integrated, interdependent, and focused toward a particular result." (1) Whether the doctrine applies is a question of fact. (2)

Impact of application

If taxpayers arrange to meet all the statutory requirements for each of a series of transactions but manipulate either the economics or the timing of the transactions to obtain favorable tax treatment, the IRS may be able to apply the step-transaction doctrine to deny the taxpayer the favorable tax benefits Examples where the IRS has successfully used the doctrine include:

* Loan and option transactions under the guise of a reorganization and financing arrangement constituted the sale of a partnership interest (from nontaxable to a taxable transaction). (3)

* Impermissible attempts to create amortizable term interests out of nondepreciable property (amortization deduction was disallowed). (4)

* A parent's sale of its 80% owned subsidiary to another company, which was followed by the parent corporation's repurchase of all of the subsidiary's assets except the assets of a single grocery store (loss was disallowed). (5)

* Advance royalty payments under nonoperating coal leases were allowed as deductions from ordinary income only if the taxpayer's intent was to mine coal at the time that he entered into the leases (deductions under Sec. 631(c) disallowed). (6)

* Lease-stripping transactions as multiple-party transactions intended to allow one party to realize rental income and to allow another party to report deductions (improperly separated income from related deductions, and, thus, the tax consequences of the deductions were disallowed). (7)

* Transfers of a corporation's stock by stockholders to a second corporation in exchange for stock of the second corporation, cash, and notes, followed by the merger of the first corporation into the second corporation, were a tax-free reorganization under Sec. 368(a)(1)(A). Thus, the transfer of the stock, cash, and notes was found to be a distribution of a dividend (in the amount of the cash and notes) rather than a sale of the stock, cash, and notes. (8)

Three tests for determining if the doctrine applies

As the Tax Court stated:

The step transaction doctrine generally applies in cases where a taxpayer seeks to get from point A to point D and does so stopping in between at points B and C. The whole purpose of the unnecessary stops is to achieve tax consequences differing from those which a direct path from A to D would have produced. In such a situation, courts are not bound by the twisted path taken by the taxpayer, and the intervening stops may be disregarded or rearranged. (9) The courts generally have used one of three tests to determine whether the step-transaction doctrine should be applied to a series of transactions: the end-result test, the interdependence test, and the binding-commitment test. However, courts have seldom applied the binding-commitment test, which requires that there be a binding commitment at the time the first step was entered into to take the later steps claimed to be part of a single transaction. (10)

End-result test

Under the end-result test, "purportedly separate transactions will be amalgamated into a single transaction when it appears that they were really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result." (11) "A prerequisite to application of the end result test is proof of an agreement or understanding between the transacting parties to bring about the ultimate result." (12) Thus, to avoid the application of the...