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Wish you had planned your transaction differently for tax purposes? In limited circumstances, the courts may allow a taxpayer to claim tax consequences consistent with a transaction’s economic substance even if inconsistent with its form.
In tax litigation involving structured transactions, when the form of a transaction produces favorable tax results for the taxpayer, the IRS often trots out various economic substance / form over substance-type theories to ignore or recast the form a transaction. Conversely, when an alternative form of a transaction would produce more favorable results for the taxpayer, the IRS tends to fall back on a general principle that taxpayers may not disavow the form of their own transaction, preventing the taxpayer from invoking the same economic substance-type theories that the IRS regularly relies on. A Tax Court case decided this week, Complex Media v. Commissioner, describes the contours of this general principle in a manner the courts had not previously elucidated.
Complex Media involved an asset acquisition in which the parties wanted to buy-out one of the transacting entity’s owners. Because the owners of the purchasing entity lacked sufficient cash for the buy-out, they structured the transaction as a Section 351 exchange (Complex Media acquired the assets solely in exchange for stock), followed by a redemption that resulted in cash to the owner the parties sought to buy-out. Contrary to this form, Complex Media argued the cash should be treated as boot in the Section 351 step of the transaction. That’s a highly simplified version of it. Now the point.
In its decision, the Tax Court recognized that while its precedent had been more rigid than other court’s precedent in allowing taxpayers to disavow the form of their transactions, the Tax Court’s “caselaw has evolved, [and] become more hospitable to taxpayers.” Reviewing the court’s existing precedent, the Court states: “We also accepted that ‘[t]he taxpayer, as well as the Commissioner, is entitled to assert the substance-over-form argument’ but added that, ‘in such situations the taxpayer may face a higher than usual burden of proof.’” For decades, however, courts had not illuminated what exactly that burden entails. In the Glacier State Elec. Supply case, the Tax Court had suggested that the taxpayer's higher burden might be an evidentiary one.
The Complex Media decision clarifies: “we now conclude that the additional burden the taxpayer has to meet in disavowing transactional form relates not to the quantum of evidence but instead to its content--not how much evidence but what that evidence must show by the usual preponderance.” To meet this standard, the taxpayer is required to show, just as the IRS would be, that the form in which the taxpayer cast the transaction does not reflect its economic substance. The taxpayer, however, has the further burden of “establishing that the form of the transaction was not chosen for the purpose of obtaining tax benefits . . . that are inconsistent with those the taxpayer seeks through disregarding that form.”
Two additional notes about the Complex Media decision. First, to the extent there is any tension between the decision and the Third Circuit’s 1967 decision in Commissioner v. Danielson (which the IRS frequently invokes), the court points out that the underlying policies of Danielson are not violated in this case and that in any event the Tax Court “has never accepted the Danielson Rule” and because the Complex Media case is not appealable to the Third Circuit (or to any other appellate court that has accepted the Danielson rule), the Tax Court is not required to reconcile that decision. Second, Complex Media was released as a Memorandum Decision even though its content could have justified a published decision. For a discussion of the authoritative value of Memorandum Opinion, see Lowy, Legal Authorities in U.S. Federal Tax Matters– Research & Interpretation, 3rd Ed., TAX MANAGEMENT PORTFOLIO (2016), p. A-98.
If the Complex Media decision stands (the IRS may file for reconsideration and/or appeal), it may provide a valuable roadmap for taxpayers and their advisors as to the circumstances under which they may view the tax consequences of transactions according to their economic substance, rather than their form.