Today we welcome to Procedurally Taxing Professor Emily Cauble from the Depaul University College of Law. Professor Cauble is a prolific and eclectic author, with articles in the past few years discussing safe harbors in the tax system, the taxation of publicly traded entities and detrimental reliance on IRS guidance, to name just a few. In this post, Professor Cauble discusses points from her forthcoming article in the Virginia Tax Review, where she explores the doctrine that generally has prevented taxpayers from arguing that the substance of the transaction rather than the form should dictate tax results. The article reveals inconsistencies in the way the IRS and courts have approached the issue and offers a solution that could help provide some needed guidance. Les
In tax cases, it is often true that the genuine substance of a transaction will triumph over the transaction’s mere form for purposes of determining the transaction’s tax consequences. Despite the generally prominent role played by substance in tax law, a taxpayer often will be bound to the transactional form that he or she selects. I will refer to courts’ resistance to taxpayers’ attempts to invoke substance-over-form as the “Non-Disavowal Doctrine.”
The Non-Disavowal Doctrine is aimed at penalizing taxpayers for engaging in Post-Transactional Tax Planning. A taxpayer who engages in Post-Transactional Tax Planning designs a transaction with a form that differs from its substance in order to preserve the option of reporting tax consequences based on either form or substance, whichever is more favorable given the transaction’s economic outcome.read more...
The Non-Disavowal Doctrine: Examples
Maletis v. U.S. 200 F.2d 97 (9th Cir. 1952) provides a useful example of the doctrine’s role in discouraging Post-Transactional Tax Planning. In Maletis, the taxpayer established an entity to operate a wine making business. In form, the entity was owned by the taxpayer and his two sons. In substance, the entity was owned only by the taxpayer. In years when the business was profitable, the taxpayer filed tax returns in accordance with the form of the arrangement. As a result, in years in which the business generated taxable income, that income was reported in part by the taxpayer and in part by his sons. Presumably because the sons were subject to lower effective tax rates than the taxpayer, this reporting led to less total tax liability than what would have been the case had all taxable income been reported by the taxpayer.
In a subsequent year in which the business generated a loss, the taxpayer claimed that, in substance, the business was owned entirely by him and not by a partnership in which his sons were partners. As a result, the taxpayer asserted the right to deduct the entire tax loss, leading to lower tax liability given his sons’ lower effective tax rates than what would have resulted had the tax loss been shared among the taxpayer and his sons. The IRS challenged this treatment asserting that the taxpayer should be bound by the form he selected – that of a partnership. The court held in favor of the IRS. Justifying its holding, the court stated that without such a result, “the taxpayer could commence doing business as a corporation or partnership and, if everything [went] well, realize the income tax advantages therefrom; but if things [did] not turn out so well, [could] turn around and disclaim the business form he created to realize the loss as his individual loss.” In other words, without the Non-Disavowal Doctrine, taxpayers could more easily engage in Post-Transactional Tax Planning.
Taxpayer Victories Notwithstanding the Doctrine
Notwithstanding the Non-Disavowal Doctrine, taxpayers do not invariably lose when they characterize their transactions based on substance rather than form. A taxpayer who succeeds in such a case often is able to provide a non-tax explanation for the form that he or she selected. For example, in Jones Syndicate v. Comm’r, 23 F.2d 833 (7th Cir. 1927) the taxpayer labeled an instrument “preferred stock,” despite the fact that the instrument was debt in substance, in order to avoid a conflict with state usury laws. The taxpayer characterized the instrument as debt for tax purposes. The IRS challenged the taxpayer’s characterization, and the court held in favor of the taxpayer.
In some cases, the non-tax explanation offered by a taxpayer who is able to overcome the Non-Disavowal Doctrine is a non-U.S. tax explanation. In other words, the taxpayer selected a given form because it provided tax benefits in a non-U.S. jurisdiction.Private Letter Ruling 9835011 provides one example.
Brief Analysis of the Authorities Suggests Inconsistent Approaches
At first glance, it may seem counterintuitive that courts are more likely to allow a taxpayer to disavow the form he or she selected in order to obtain more beneficial tax consequences if the form produced non-tax benefits or tax benefits in a non-U.S. jurisdiction. However, this feature of law could be explained as an attempt by courts to identify taxpayers that are not engaged in Post-Transactional Tax Planning and allow those taxpayers to disavow their selected forms. If a taxpayer engages in a transaction and selects a form that differs from the transaction’s substance, the taxpayer’s choice of form might generally suggest that the taxpayer planned to leave open the option of engaging in Post-Transactional Tax Planning by reporting the tax consequences of the transaction based on either its form or substance, whichever, in hindsight, led to the most favorable tax consequences. If a given form was selected instead to produce some non-tax benefits (for instance, if an instrument was labeled “equity” to avoid violation of usury laws) that provides an alternative explanation for the taxpayer’s chosen form, and the alternative explanation might help to rebut the conclusion that the taxpayer selected a transactional form in order to facilitate Post-Transactional Tax Planning.
However, under the method currently used by many courts, the Non-Disavowal Doctrine is sometimes invoked in cases that do not involve Post-Transactional Tax Planning and is not reliably invoked in all cases that do entail Post-Transactional Tax Planning. In particular, many courts implicitly (and, in some cases, inaccurately) assume that a taxpayer is engaging in Post-Transactional Tax Planning if the taxpayer selects a form that differs from a transaction’s substance and cannot provide a non-tax explanation for the selected form. In some cases, such a taxpayer is not, in fact, engaging in Post-Transactional Tax Planning. Instead, he or she selected a given form simply because he or she was unaware of the tax consequences of doing so. At the same time, if the taxpayer can provide a non-tax explanation for his or her selected form, many courts automatically (and, sometimes, incorrectly) conclude that the taxpayer has not engaged in Post-Transactional Tax Planning. This conclusion is sometimes incorrect because a taxpayer can be driven by multiple motives – he or she could select a given form because it provides non-tax benefits and also because it facilitates Post-Transactional Tax Planning.
The Way Out: The Rebuttable Presumption Proposal
To remedy these errors, I propose that courts should reform their analytical methods. In particular, anytime a taxpayer selects a form that differs from a transaction’s substance that fact ought to establish a rebuttable presumption that the taxpayer plans to engage in Post-Transactional Tax Planning. Providing a non-tax explanation for the selected form should not be necessary or sufficient to rebut the presumption. Instead, courts should consider other facts that more reliably demonstrate a lack of Post-Transactional Tax Planning. If the taxpayer succeeds in rebutting the presumption, the taxpayer should be able to report the consequences of the transaction based on its substance. If the taxpayer cannot rebut the presumption, the Non-Disavowal Doctrine should bind the taxpayer to his or her selected form.
Below is a non-exhaustive list of examples of fact patterns under which a court could conclude that the taxpayer successfully rebutted the presumption:
- The taxpayer has consistently reported the transaction’s tax consequences based on its substance even in years in which doing so led to meaningfully higher tax liability than reporting based on the transaction’s form.
- Based on all the facts and circumstances, the taxpayer can convince a court that he or she selected a given form simply because he or she was unaware of the tax consequences of a transaction and not adequately advised and the taxpayer has always reported the transaction’s consequences based on its substance.
- The form selected by the taxpayer was such that, regardless of the economic outcome of the transaction, reporting based on the transaction’s substance would always lead to more favorable tax consequences than reporting based on the transaction’s form.
Finally, when a taxpayer engages in a transaction with a form that differs from its substance, the taxpayer ought to be given a new option to file a disclosure with the IRS, contemporaneously with the time the taxpayer initiates the transaction, indicating that the taxpayer plans to report tax consequences based on the transaction’s substance. A taxpayer who files such a document should be able to rebut the presumption that he or she was engaging in Post-Transactional Tax Planning and should be allowed (and required) to report the transaction’s consequences based on its substance. It is crucial that the filing occur contemporaneously with the time the taxpayer initiates the transaction and not at the time the taxpayer files a return reporting the transaction’s tax consequences for the first year. Filing at the time of the return would provide taxpayers with an opportunity to engage in Post-Transactional Tax Planning by awaiting receipt of information about the transaction’s economic outcome during the first year before making the decision to report based on substance.