Opinion ID: 2299749
Heading Depth: 2
Heading Rank: 3

Heading: The Step Transaction Doctrine

Text: The Supreme Court and the federal circuits long have recognized the principle that form will not prevail over substance in federal tax matters. That is, taxpayers cannot escape tax liability by disguising the true nature of transactions with mere formalisms. In Minnesota Tea Co. v. Helvering, 302 U.S. 609, 612, 58 S.Ct. 393, 394, 82 L.Ed. 474 (1938), the issue before the Supreme Court was whether petitioner's delivery of cash to stockholders, who thereafter paid an equal sum of cash toward petitioner's debts, constituted a distribution pursuant to the Internal Revenue Code. The Court explained that the Code established that, in respect of any cash received and not distributed, there was a taxable gain to petitioner. And, quite as plainly, payment of the debts by petitioner, if made directly by petitioner to the creditors, would not have been a distribution under the statute; for that contemplates a distribution to stockholders, and not payment to creditors. If, then, petitioner had followed the simple course of retaining in its own hands the sum here in question, and subsequently paying it directly to the creditors, it necessarily would result that liability of petitioner for a tax on the amount of gain could not be avoided. And, obviously, this is the effect of what was done, although circuitously. Id. at 612-13, 58 S.Ct. at 394, 82 L.Ed. 474. The Court went on to hold that even though petitioner took a roundabout process, it achieved the same benefit it would have received had it retained the amount of the distribution and applied that sum to reduce its indebtedness. Id. at 613, 58 S.Ct. at 395, 82 L.Ed. 474. The Court concluded that [p]ayment of indebtedness, and not distribution of dividends, was, from the beginning, the aim of the understanding with the stockholders and was the end accomplished by carrying that understanding into effect. A given result at the end of a straight path is not made a different result because reached by following a devious path.Id. (emphasis added). See also Gregory v. Helvering, 293 U.S. 465, 469, 470, 55 S.Ct. 266, 267, 268, 79 L.Ed. 596 (1935) (noting that although [t]he legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted, allowing sham transactions to escape tax liability would exalt artifice above reality.). The Court later clarified this axiom in Commissioner v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708, 89 L.Ed. 981 (1945): The incidence of taxation depends upon the substance of a transaction. The tax consequences which arise from gains from a sale of property are not finally to be determined solely by the means employed to transfer legal title. Rather, the transaction must be viewed as a whole, and each step, from the commencement of negotiations to the consummation of the sale, is relevant. A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title. To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress. [Emphasis added.] [Footnote omitted.] The step transaction doctrine, as the principle later was to become known, was specifically recognized by the Supreme Court in Commissioner v. Clark, 489 U.S. 726, 109 S.Ct. 1455, 103 L.Ed.2d 753 (1989). In that case the Court examined a substantial cash payment made in connection with a stock-for-stock exchange to determine whether it had the effect of a distribution of a dividend and was taxable as ordinary income or whether it was subject to capital gains. The Court reviewed the language and history of the Internal Revenue Code provision at issue, applied a commonsense understanding of the economic substance of the transaction, and declared that a determination whether the exchange had the effect of distributing a dividend should be resolved by examining the effect of the exchange as a whole. Id. at 738, 109 S.Ct. at 1462, 103 L.Ed.2d 753. Going on, the Court stated: Our reading of the statute as requiring that the transaction be treated as a unified whole is reinforced by the well established step-transaction doctrine, a doctrine that the Government has applied in related contexts, see, e.g., Rev. Rul. 75-447, 1975-2 Cum. Bull. 113, and that we have expressly sanctioned, see Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613, 58 S.Ct. 393, 394, 82 L.Ed. 474 (1938); Commissioner v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708, 89 L.Ed. 981 (1945). Under this doctrine, 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. 1 B. Bittker, Federal Taxation of Income, Estates and Gifts ¶ 4.3.5, p. 4-52 (1981). Id. at 738, 109 S.Ct. at 1462-63, 103 L.Ed.2d 753. The federal circuit courts of appeal have explicitly recognized and applied the step transaction doctrine, recognizing three tests used to determine whether transactions should be stepped together and considered not as isolated incidents, but as components in an overall plan. See, e.g., Kornfeld v. Commissioner, 137 F.3d 1231 (10th Cir.), cert. denied, ___ U.S. ___, 119 S.Ct. 171, 142 L.Ed.2d 139 (1998); G.M. Trading Corp. v. Commissioner, 121 F.3d 977 (5th Cir.1997); Greene v. United States, 13 F.3d 577 (2d Cir.1994); Associated Wholesale Grocers, Inc. v. United States, 927 F.2d 1517 (10th Cir.1991); Brown v. United States, 782 F.2d 559 (6th Cir.1986); Security Indus. Ins. Co. v. United States, 702 F.2d 1234 (5th Cir. 1983); McDonald's Restaurants v. Commissioner, 688 F.2d 520 (7th Cir.1982); Redwing Carriers, Inc. v. Tomlinson, 399 F.2d 652 (5th Cir.1968); Penrod v. Commissioner, 88 T.C. 1415, 1987 WL 49335 (1987); King Enters., Inc. v. United States, 189 Ct.Cl. 466, 418 F.2d 511 (1969). In Associated Wholesale Grocers, 927 F.2d at 1522, the Court of Appeals for the Tenth Circuit identified the end result, interdependence, and binding commitment tests. Although the end result and interdependence tests are the most frequently used, see id., federal courts have not required the taxpayer to meet all three nor have many courts applied all three. See Kornfeld, 137 F.3d at 1235; Greene, 13 F.3d at 583-85; Associated Wholesale Grocers, 927 F.2d at 1523. Nonetheless, although there are distinct differences between each of the step transaction tests, each is faithful to the central purpose of the step transaction doctrine; that is, to assure that tax consequences turn on the substance of a transaction rather than on its form. King Enters., 418 F.2d at 517. The narrowest and most seldom applied test, the binding commitment test, see Kornfeld, 137 F.3d at 1235; Associated Wholesale Grocers, 927 F.2d at 1522 n. 6, provides that a transaction will be stepped together if, at the first step of the transaction, a binding commitment was entered into to undertake later steps. See Penrod, 88 T.C. at 1429. The test is of limited applicability because it appears to have been formulated to address a transaction that spanned several tax years. See McDonald's Restaurants, 688 F.2d at 525. Another court has described the Supreme Court's application of this test as limited to the circumstances of that case and further noted the Court gave no indication that it intended the binding commitment test to be the touchstone of the step transaction doctrine in tax law. King Enters., 418 F.2d at 518 (discussing Commissioner v. Gordon, 391 U.S. 83, 88 S.Ct. 1517, 20 L.Ed.2d 448 (1968)). The interdependence test, a variation on the end result test, focuses on whether the steps in the transaction are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series. Greene, 13 F.3d at 584; Associated Wholesale Grocers, 927 F.2d at 1523; Penrod, 88 T.C. at 1430. The interdependence test concentrates on the relationship between all of the steps. Associated Wholesale Grocers, 927 F.2d at 1523; Penrod, 88 T.C. at 1430. In applying this test, courts must look at whether each individual step had some `independent significance or whether they had meaning only as part of the larger transaction.' Greene, 13 F.3d at 584 (quoting Penrod, 88 T.C. at 1430). The end result test amalgamates purportedly separate transactions when it appears they actually were prearranged parts of `a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result.' Associated Wholesale Grocers, 927 F.2d at 1523 (quoting King Enters., 418 F.2d at 516). This test is based upon the initial intent of the parties. Penrod, 88 T.C. at 1430. What is more, even though the initial arrangement between the parties need not be legally binding, there must be some showing of an informal agreement or understanding. Greene, 13 F.3d at 583. Several state courts have adopted the step transaction doctrine. [10] See, e.g., Penner v. County of Santa Barbara, 37 Cal. App.4th 1672, 44 Cal.Rptr.2d 606 (1995); McMillin-BCED/Miramar Ranch North v. County of San Diego, 31 Cal.App.4th 545, 37 Cal.Rptr.2d 472 (1995); Shuwa Invs. Corp. v. County of Los Angeles, 1 Cal.App.4th 1635, 2 Cal.Rptr.2d 783 (1991); Noddings Inv. Group, Inc. v. Capstar Communications, Inc., 1999 WL 182568 (Del.Ch.1999); Koch v. Commissioner, 33 Mass.App.Ct. 707, 605 N.E.2d 301 (1992), rev'd on other grounds, 416 Mass. 540, 624 N.E.2d 91 (1993); Lehmann v. Upper Cape Cod Reg'l Vocational Technical School Dist. Comm., 17 Mass.App.Ct. 283, 457 N.E.2d 666 (1983); Hutton v. Johnson, 956 S.W.2d 484 (Tenn.1997). Notably, many of these cases adopted and applied the step transaction doctrine in matters other than income tax or corporate mergers. See, e.g., Lehmann, 17 Mass.App.Ct. at 284, 457 N.E.2d at 668 (applying the step transaction doctrine to hold that a school district improperly reduced a teacher's salary); Hutton, 956 S.W.2d at 489 (evaluating whether two transactions involving the purchase of jet aircraft should be considered one stepped together transaction for purposes of personal property taxation). The California Court of Appeal in McMillin-BCED, 31 Cal.App.4th at 550, 37 Cal.Rptr.2d at 474, applied the step transaction doctrine in a property tax matter to hold a series of transactions had established that a 100% change in ownership occurred in favor of McMillin and, therefore, it was not entitled to a refund of paid property taxes. In McMillin-BCED, BCE Development Properties, Inc. (Properties), a wholly-owned subsidiary of BCE Development, Inc. (Development), agreed in May 1989 to sell to McMillin/Scipps Ranch, a limited partnership for which the sole general partner was McMillin Communities, Inc. (McMillin), the subject 1200 acres of land for $100 million. The agreement fell through, however, because McMillin/Scipps Ranch could not secure financing and did not want to incur liabilities arising from any predevelopment activities on the land. The court described the subsequent steps in the transactions: Development then decided to develop the land with the assistance of an experienced residential developer. The following transactions ensued: As of January 26, 1990, title to the land was still held by Development. On that date, Development and Properties formed (but did not fund) a general partnership called Scripps Ranch. The partnership agreement required Development to contribute 30 percent tenancy-in-common interest in the land and Properties to contribute 70 percent tenancy-in-common interest in the land to the newly formed partnership, as initial capital contributions. Profits and losses were to be shared in the same proportions. Four days later, Development conveyed a 70 percent tenancy-in-common interest in the land to Properties. For purposes of discussion, we shall refer to the tenancy-in-common transfer between Development and Properties as Step 1. On February 7, 1990, Development and Properties, as tenants-in-common, refinanced the land for $50 million. They executed a promissory note and deeds of trust in favor of their lender, Mortgage Development Corporation (MDC), which was, like Development, a wholly-owned subsidiary of BCE Canada. MDC immediately assigned the note to yet another wholly-owned subsidiary of BCE Canada, BCED Pacific, Inc. In a declaration prepared by Jeffrey H. Wagner, the director of taxation of the BCED corporations, submitted in support of the McMillin-BCED opening trial brief, the purpose for this loan was explained: (a) to strengthen and improve [Development's] interest in the Land by becoming a secured lender and (b) to reduce the amount of equity in the Land a future developer/investor would be required to `buy into.' We shall refer to this transaction, the refinancing of the land by Development and Properties as tenants-in-common, as Step 2. Step 3 also took place on February 7, 1990, when Development and Properties deeded their respective interests in the land to the Scripps Ranch partnership, as required by the partnership agreement. In other words, they exchanged their 30-70 percent interests in the land for general partnership interests which would own the land. This structure would provide flexibility to negotiate a particular financial deal with a developer. The Scripps Ranch partnership assumed the loan on a non-recourse basis. Development then carried out negotiations with McMillin, as well as a competing developer, Davidson Communities, Inc. (Davidson), to establish terms for a partnership agreement. On February 9, 1990, the Scripps Ranch partnership and McMillin entered into a contribution agreement establishing the terms and conditions for McMillin's admission as a partner and Development's withdrawal from the partnership. Development agreed to guarantee the performance of all of Properties' present and future obligations to McMillin under the partnership agreement. McMillin agreed to contribute $5 million cash to the partnership. Properties' capital account was valued at $30 million. Development assigned its 30 percent partnership interest to, and withdrew from, the partnership. The effective date of the first amended and restated agreement of general partnership was February 12, 1990. Step 4 thus took place when McMillin bought into the appellant partnership. Two days later, the partnership name was changed from Scripps Ranch to McMillin-BCED. Pursuant to this agreement, McMillin now held a 14 percent interest in the capital of the partnership, a 30 percent interest in the profits, and a 50 percent management interest. Id. at 551-52, 37 Cal.Rptr.2d at 475 (footnote omitted) (alteration in original). The county assessor later reassessed the property, claiming a 100% change in ownership had occurred on February 12, 1990. Before determining whether the four steps should have been stepped together, that is, treated as one transaction that transferred 100% ownership subject to reassessment, the court decided that only one of the three tests need be satisfied in order to apply the step transaction doctrine. The court explained that an earlier California case involving nearly the same issue and applying the step transaction doctrine, Shuwa Investments Corp., 1 Cal. App.4th 1635, 2 Cal.Rptr.2d 783, did not address whether all three tests were required or the satisfaction of only one or two of the tests was sufficient. McMillin-BCED, 31 Cal.App.4th at 555, 37 Cal.Rptr.2d at 477. The McMillin court then examined comments by the courts in King Enterprises and Associated Wholesale Grocers. In King Enterprises, as we noted above, that court stated that although there are differences in each of the step transaction tests, each test is faithful to the central purpose of the step transaction doctrine. McMillin-BCED, 31 Cal. App.4th at 555, 37 Cal.Rptr.2d at 477 (quoting King Enters., 418 F.2d at 517). The Court of Appeal for the Tenth Circuit in Associated Wholesale Grocers had found the satisfaction of only one of the tests, the interdependence test, adequate to apply the step transaction doctrine. McMillin-BCED, 31 Cal.App.4th at 555, 37 Cal.Rptr.2d at 477-78. Accordingly, the court concluded, the step transaction doctrine may be applied upon an adequate showing that one or more of the applicable tests is satisfied by the facts presented. Id. at 556, 37 Cal.Rptr.2d at 478. The court next analyzed the facts under each of the tests. The facts of that case did not satisfy either the end result and binding commitment tests. First, both the tests seemed to require the same parties to pursue the same or related intent throughout the steps of the transaction. There was no evidence that McMillin, which joined the partnership in step four, desired the same end result or had the same ultimate purpose and intent in the transaction as the partnership formed by Development and Properties. Furthermore, Development and Properties had independent, legitimate business purposes for each of the transactions in steps one through three of protecting their financial interests in the property. Finally, the transaction was not stretched out over a period of years, which seemed implicitly required by the Tenth Circuit in Associated Wholesale Grocers, 927 F.2d at 1522-23 n. 6, to apply the binding commitment test. The court then turned to the interdependence test. Applying findings made by the trial court, the court concluded that all of the steps were implemented with the goal of McMillin's development of the land: The trial court pointed out at trial that it was significant that in a series of transactions closely related in time, McMillin as an outsider came in to assume all of the entitlement of one of the partners, at specified percentages of capital and profit. The profit was directly related to the percentage of ownership of the third party's predecessor, Development. The way in which this was accomplished was that Development assigned its percentage interest to the partnership, and McMillin then made a $5 million capital contribution and obtained a 14 percent capital interest in the partnership, along with a 30 percent profit interest and a 50 percent management interest. The history of this transaction includes the failed sale to McMillin at an earlier time. A reasonable inference may be drawn that McMillin's goals would not have been accomplished as a developer without the transfer of title from Development, through Properties, to the Scripps Ranch partnership, and ultimately to the appellant McMillin-BCED partnership. Even if Development and Properties had internal corporate reasons as affiliates to transfer title among themselves, refinance the property, and create a development partnership, those steps would essentially have been fruitless had they not been able to find a developer to join in the project. These steps had the necessary interdependence such that, in substance, a change of ownership occurred. McMillin-BCED, 31 Cal.App.4th at 560-61, 37 Cal.Rptr.2d at 481. Accordingly, because of the close relationship between all of the steps and because each of the steps essentially would have been fruitless had the ultimate goal not been achieved, the court held that the interdependence test applied and the transactions were correctly stepped together for the purpose of the property tax reassessment. Id. at 562, 37 Cal.Rptr.2d at 482.