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What is the Step Transaction Doctrine?

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    The Step Transaction Doctrine: Page Contents at a Glance

    Retired high-income earners who have contributed to a Roth IRA may find calculating income taxes confusing, especially if they have not done much tax planning in the past to prepare. Eventually, they may face tax consequences from the IRS, which will cite the step transaction doctrine.

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    This doctrine combines any number of formerly separate steps in a transaction into one. Any tax consequences will apply to the entire combination, rather than be applied to each step separately. The IRS step transaction doctrine definition attempts to give the federal government and the court an understanding of how a full transaction affects the taxpayer’s situation, regardless of how many distinct steps occurred to reach the endpoint in the transaction.

    Step Transaction Doctrine: The Three-Test Rule

    Taxpayers and tax professionals alike face challenges in understanding the doctrine because the federal courts don’t have a standard that they regularly follow when determining whether the step transaction doctrine applies. However, the federal courts do have three tests they typically apply to cases like this.

    First is the binding commitment test. This test allows for collapsing several transaction steps into a single step only if a binding commitment to follow through on the subsequent steps was present at the time the taxpayer took the first step.

    As a step transaction doctrine example, the Supreme Court initially applied the binding commitment test in 1968. It determined that multiple stock distributions over a series of tax years could not be combined into a single transaction, because no binding commitment to follow through on the other stock distributions existed at the time the first stock distribution took place. This could apply to a step transaction doctrine Roth IRA situation.

    The second test is called the interdependence test. The court uses this test to determine what relationship exists, if any, between the individual steps within the transaction. It attempts to determine whether the steps are independently significant or whether they are collectively dependent on a larger planned transaction. In other words, the court tries to determine if the legal ramifications of each independent step are not relevant without the completion of the entire collection of transactions.

    The third test is called the end result test or the intent test. It focuses on the intent of the taxpayer when undertaking separate transactions. If the taxpayer intended for each step in the transaction to be part of a larger transaction, the court may apply the step transaction doctrine.

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    Step Transaction Doctrine Definition

    The step transaction doctrine dictates that a series of formally separate steps will be collapsed into one step, with the tax consequences applying to the one-step, rather than the formally separate ones.  Essentially, the IRS will collapse a series of separate “steps” into a single transaction in order for the government to obtain a clear view of what the separate steps are accomplishing. The Supreme Court in Commissioner v. Clark, 489 U.S. 726, 738 (1989), stated the doctrine thus: “interrelated yet formally distinct steps in an integrated transaction may not be considered independently of the overall transaction. By thus linking together all interdependent steps with legal or business significance, rather than taking them in isolation, federal tax liability may be based on a realistic view of the entire transaction.”

    Step Doctrine, AKA Substance Over Form Doctrine

    This doctrine is often used in conjunction with the “substance over form doctrine,” discussed below.  When the IRS collapses these steps, one of the factors considers is the time interval between them (although this factor is not determinative).

    The step transaction doctrine is a frustrating one for taxpayers and practitioners alike. In part, this is because of its seemingly amorphous nature of the rule. Regrettably, no single judicial standard has been universally accepted by the federal courts in applying the doctrine.  However, the three most commonly invoked types of “step testing” utilized by the federal courts are (a) the binding commitment test, (b) the interdependence test, and(c) the end result test. We discuss these in turn.

    A.  The Binding Commitment Test

    The Supreme Court first used the binding commitment test in Commissioner v Gordon, 391 U.S. 83 (1968),  where the Court refused to treat stock distributions taking place over several tax years as a single transaction for tax purposes. The Court held that if a transaction is to be characterized as a first step, then there must be a “binding commitment” to take the later steps.

    The binding commitment test as it is currently applied requires collapsing several transaction steps into a single transaction solely where a binding commitment existed as to the subsequent steps at the time the first step was taken. Subsequent judicial use of the binding commitment test has been sparse, and post-Gordon court decisions have tended to confine the test to the facts of that case.

    On balance, when binding commitments are present, the subsequent steps will be collapsed into a single transaction for analysis purposes.    Where they are not present courts have tended to apply the other two tests, described below.

    B.  Interdependence Test

    The interdependence test focuses on the relationship between the individual steps of a series of transactions and analyzes whether those steps have independent significance or whether their meaning is derived or dependent on a larger planned transaction.   A judgment is made as to whether the steps are so interdependent that the legal ramifications of each intermediate transaction would be nil without the completion of the entire series of transactions. When it is apparent that any single step would not have been undertaken except in contemplation of the totality of the associated transactions, the step transaction doctrine will be applied.  Conversely, if the foregoing analysis does not establish that the first step would not have been taken without contemplation of the later ones, the steps are not integrated.  The IRS discusses the interdependence test on its website here.

    C.  End Result Test

    Under the frequently applied end result test, related but separate transactions are collapsed into a single transaction (for tax purposes) when the government is of the opinion that they are really related component parts of a single overarching transaction.  The end result test is used when it is clear that a planned tax result is achieved via a series of related transactions that could not be achieved via a single transaction.   However, where a business engages in a series of related transactions that appear to be designed and executed as part of a unitary plan to achieve an intended result, the plan may be viewed in the aggregate regardless of whether the effect of doing so increases or decreases the combined tax effect.

    The end result test focuses on intent of the taxpayer (sometimes this is called the “intent test” – for example, on the Wikipedia entry). Where the separate transactions are viewed as a single, overarching scheme (and it is the taxpayer’s intent that this is so), then those separate transactions will be collapsed (ignored) and treated as a single transaction. Where this required intent is deemed absent—where the taxpayer did not so intend to create a number of steps to achieve an over-arching purpose—the steps analyzed are treated as separate.

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