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With the looming increase in tax rates on investment income and capital gains in particular, a large number of stock market investors have been selling long-term positions to lock in the 2012 rate, which currently tops out at 15%. Come January 1,2013, gain on the same sale could be taxed at a rate as high as 23.8%, consisting of a long-term capital gains tax rate of 20% plus a Medicare surtax of 3.8% imposed on joint filers with AGI greater than $250,000 and single filers with AGI greater than $200,000. (See Internal Revenue Code § 1411).
A question attracting attention as the year draws to a close and the pace of this activity has accelerated has been whether a stock sale undertaken solely to take advantage of the lower 2012 capital gains tax rates might fall within the scope of Code § 7701(o), the relatively new economic substance statute codified as part of the landmark Health Care and Education Reconciliation Act of 2010 (Pub. L. 111-152, 124 Stat. 1029). Concerns about coming within the scope of this statute are that it might subject the investor to a 20% penalty enacted as part of the new law. See Code § 6662(b)(6). The penalty, if applicable, is a “strict liability” one, which means that taxpayers cannot avoid it on grounds of reasonable cause, such as reliance on a tax advisor. (The penalty for a transaction determined to lack economic substance is also increased to a whopping 40% if the transaction is undisclosed. See Code § 6662(i). However, as long as a taxpayer reports the transaction on his or her tax return, the 40% penalty should not apply.)
Thankfully, the eleventh hour concerns expressed about this issue should be put to rest for stock investment gain-recognition transactions in 2012. Even assuming the economic substance statute is conceptually broad enough to ensnare stock sale transactions undertaken to lock in lower capital gains tax rates, the penalty is only applicable to “underpayments.” Because a long-term capital gain recognized in 2012 does not reduce a taxpayer’s taxable income but rather increases it (unless the gain is offset by otherwise unused capital losses), there is no underpayment against which to apply a penalty.
Now let’s vary the circumstances by introducing a simultaneous buyback of the stock at the time of sale to reestablish the same position. Does that change anything vis a vis a potential penalty risk? We still have a gain recognition transaction in 2012, so there is no tax underpayment against which a penalty could apply for this year. As for the repurchased stock, its cost basis is at the repurchase price, which means that a subsequent sale in a future year will either produce a smaller taxable gain or larger taxable loss than would have occurred had the original share lots with their lower cost basis simply been maintained. Some have speculated that this could produce a tax underpayment against which the strict liability economic substance penalty might apply in the year of sale. After all, in defining a transaction that has economic substance, § 7701(o) requires (1) that the transaction change in a “meaningful way” the taxpayer’s economic position apart from federal tax benefits, and (2) that the taxpayer have a non-tax purpose for entering into the transaction.
In theory, a sale and instantaneous repurchase might fail to satisfy both of these tests. On the other hand, a repurchase transaction that occurs sometime after the sale introduces an element of market risk from stock price fluctuation that should mitigate any penalty risk. Similarly, a repurchase in a different type of account (e.g., in a tax-deferred account where the original sale was in a taxable account or vice versa) should also put the taxpayer on firmer ground.
So what are the real risks that the IRS might choose some unfortunate taxpayers to assert a strict liability penalty? It has, after all, been less than forthcoming in providing guidance on what types of plain vanilla transactions, if any, may be viewed as falling within the scope of the new economic substance statute. Perhaps the best indicator one can draw upon is the title of § 7701(o), “Clarification of Economic Substance Doctrine.” The codified doctrine has been portrayed as merely a clarification of the economic substance law in effect for transactions entered into before March 30, 2010. Under the pre-codification doctrine, which is derived solely from the common law, there do not appear to be any reported economic substance cases involving a taxpayer’s sale and repurchase transaction that results in accelerated gain recognition. Couple this with the fact that no court has been asked to interpret the breadth of the new economic substance statute since it was passed in 2010, and it is reasonable to believe that the IRS would prefer to choose a different, and presumably more compelling battleground to make its first stand defending the application of Section 7701(o) and the strict liability penalty.
Finally, in the case of a 2012 gain-recognition stock sale and simultaneous repurchase, it cannot be entirely certain that the transaction will even produce a tax savings when all is said and done. This is because of the difference between the tax rates for long and short term capital gains (which are taxed at ordinary income rates). Because a new holding period is established for the repurchased stock, it remains possible that the stock, when sold, will produce a short-term capital gain subject to a larger tax burden than might have occurred if if the original long-term position was held into 2013 or beyond. In the end, the lack of certainty about the ultimate tax effect until the second sale occurs may be taxpayers’ best argument that the sale and repurchase transaction had economic substance after all.
Philip Karter specializes in tax controversy and tax litigation matters. In his 38-year career, Mr. Karter has litigated Federal tax cases in the United States District Courts, the United States Tax Court and the United States Court ...