The so-called sham transaction doctrine is “judge made law” which will deny advantageous tax treatment where transactions are carried out primarily for tax avoidance purposes and they lack a bona fide business purpose.
This doctrine tends to be applied where a taxpayer attempts to disguise a transaction and make it appear to be something that, in reality, it is not. When it is applied, the courts will ignore the form of the transaction and declare it to be a “sham” and then proceed to ascertain the tax impact based upon the court’s view of the substantive nature of the transaction. A transaction that is labeled a sham when it is deemed to not be motivated by a legitimate business purpose other than its anticipated tax benefits (in other words, tax savings does not qualify as a legitimate tax purpose), will be deemed to lack economic substance because there is no reasonable expectation of profit and thus will be disregarded for tax purposes. As explained below, the courts consider various “factors” whether to apply the sham transaction doctrine to a transaction or series of transactions. Please see the official IRS site for more details.
a. What factors do the courts consider when they decide whether to apply the sham transaction doctrine to a transaction or series of transactions?
Transactions are at risk of being re-characterized by the taxing authorities as a sham if no (non-tax) business or investment motive can be identified, and the buyer is seen to be under the common control of the seller.
For example, the sale of an asset to a LLC at a price well in excess of the asset’s fair market value will not be respected where the seller and the LLC are under common control. Likewise when a sole shareholder or group of controlling shareholders sells an asset to their corporation at an inflated price and then retain control over the asset, the transaction is at risk of being disregarded as a sham because the service can argue the transaction is lacking in good faith or finality.
The following factors from case law are what the government and the courts will consider in deeming whether a valid sale transaction or a sham has taken place:
- Was the price associated with the transaction reasonable or overstated?
- Was there a common control over the property been retained?
- Was there a genuine intent to pay the full purchase price by the buyer?
- Was the seller receiving a real economic benefit from the sale of the property other than purely tax benefits?
Case law has shown that the IRS generally is the sole party that benefits from this substance-over-form type of analysis in deeming a transaction a sham. Taxpayers have had to bear a heavy burden in attempting to persuade a court to disregard the form of their own sham transaction and thus have, on balance, not been successful in doing so.
Another methodology the government has used successfully to set aside a transaction it deems to have been entered into for the sole purpose of creating a tax loss (i.e. a sham purpose) is where it finds the parties have sufficient influence over the transaction as to remove any substantial risk of being unable to return to their previous position. The parties involved will label the transaction an accommodation rather than an arm’s length sale. Alternatively, the same transaction may be characterized as a sale, but not between the parties involved in the taxpayer’s transaction.
b. Are these some specific examples from cases that helpfully illustrate the sham transaction doctrine in action?
Yes—the following cases illustrate the application of the sham transaction doctrine (sometimes learning by example is easier than doing so in the abstract).
In D.M. Fender v US, CA-5, 78-2 USTC 9617, 577 F2d 934, a sale of bonds to a bank where the taxpayers owned the controlling block of stock was disregarded as non bonafide because they did not in the government’s opinion suffer a genuine economic loss which is a requirement for a loss deduction.
In T.F. Abbott, Jr. v Commr, 23 TCM 445, Dec. 26,696(M), TC Memo. 1964-65, aff’d, per curiam, CA-5, 65-1 USTC 9331, 342 F2d 997, the Court of Appeals in the 5th Circuit affirmed the Tax Court in holding that a major stockholder of a corporation (and not his related corporation) in reality realized a gain from the sale of stock. The major stockholder purportedly transferred stock to the corporation as a capital contribution and then his related corporation turned around and immediately sold the stock at a gain. The Tax Court justified setting aside the form of the transaction by holding that the stockholder in substance had sold stock as an individual using the corporation as a conduit, and then contributed the proceeds to the corporation as a capital contribution.
In the Est. of S. Ravetti v Commr, 67 TCM 3064, Dec. 49,893(M), TC Memo. 1994-260, the losses flowing to a limited partner related to a purchase of a film by a partnership were disallowed because the acquisition was held to lack economic substance. Factors that the court focused on to justify the disallowance were (i) over-inflated purchase price for the film in order to support tax benefits, and (ii) the lack of personal liability of the limited partner. The transaction was held to not be the result of a true arms-length negotiation.
In H.J. Smith, Jr. v Commr, 50 TCM 1444, Dec. 42,488(M), TC Memo. 1985-567 a sale of stock at auction was held to be invalid where the seller’s son purchased the stock with money given to him by the seller (his father) because the father (in economic terms) did not receive anything for the stock.
In P.J. Batastini v Commr, 53 TCM 1500, Dec. 44,086(M), TC Memo. 1987-378; Milbrew, Inc. v Commr, 42 TCM 1467, Dec. 38,363(M), TC Memo. 1981-80, aff’d, CA-7, 83-2 USTC 9467, 710 F2d 1302; F.C. LaGrange v Commr, 26 TC 191, Dec. 21,699 (1956) a series of sale-leaseback transactions were disallowed because the court believed the transactions were entered into solely to inflate the value of the assets used in a school bus business. In reality title to the asset of the business were never transferred to the buyers and the agreed upon purchase price greatly exceeded the true value of the underlying assets. These factors along with others led to the disallowance under the transaction lacked economic substance by the court.
In W.G. Hock v Commr, 54 TCM 407, Dec. 44,167(M), TC Memo 1987-444, the limited partners in a mining operation’s expenses and losses were disallowed because the investment in the mining operation was held to not be motivated by a valid business purpose. The transactions as a whole lacked economic substance because of the relationship and lack of knowledge or experience in the mining industry of the parties and the overstated purchase price. Moreover, no ore was ever mined or sold and no payments were actually made to the seller, and factors were apparent that indicated the mine was never a profitable business venture.
