Opinion ID: 69326
Heading Depth: 3
Heading Rank: 1

Heading: Substance Over Form

Text: The Supreme Court held in Commissioner v. Court Holding Co., 324 U.S. 331 (1945), that the IRS may assess taxes based on the substance, rather than the form, of a conduit transaction. The Court explained: 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 the 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. Id. at 334. The Court reaffirmed this holding in United States v. Cumberland Public Service Co., 338 U.S. 451 (1950), and observed that in applying the substance-over-form principle, the court “can consider motives, intent, and conduct in addition to what appears in written instruments used by parties to control rights as among themselves.” See id. at 455 n.3. The Supreme Court has also cautioned, however, against disregarding legitimate transactions, stating that “where . . . there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by taxavoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties.” Frank Lyon, 435 U.S. at 583-84. We have applied the substance-over-form doctrine on numerous occasions, beginning with our decision in Davant v. Commissioner, 366 F.2d 874 (5th Cir. 1966), to conclude that the sale of a corporation’s assets through an intermediary 6 No. 08-20261 to avoid capital gains taxation could be treated as a direct sale, thus triggering a higher rate of taxation. Davant involved taxpayers who sold their stock in a corporation and attempted to claim a lower capital gains rate for the sale. To accomplish this, the taxpayers sold their stock to an intermediary who would “make a reasonable profit” for his role,1 and then the intermediary would sell the corporation’s assets to a buyer (in this case, another corporation owned by the taxpayers) and liquidate the target corporation. See id. at 878. The taxpayer argued that the transaction was a bona fide sale of his stock in the corporation, while the IRS argued that the transaction should have been treated as a corporate reorganization and taxed at a higher ordinary income rate. See id. at 879. We agreed with the IRS’s determination, stating that the “courts have never been shackled to mere paper subterfuges. It is hard to imagine a transaction more devoid of substance than the purported ‘sale’ to [the intermediary].” Id. at 880. This court specifically noted that the intermediary “served no function other than to divert our attention to avoid tax. Stated another way, his presence served no legitimate nontax-avoidance business purpose.” Id. at 881. There was thus no merit in the taxpayers’ argument that a stock sale could not be treated as a sale of assets: “[W]e see that the treatment of stocks as assets, or assets as stock, has always been utilized by the courts in harmonizing the statutory language with the single rational plane of taxation envisioned by Congress.” Id. at 887. Similarly, in Blueberry Land Co. v. Commissioner, 361 F.2d 93 (5th Cir. 1966), the taxpayers sought to sell their corporations’ assets. After finding a buyer, the taxpayers and the buyer began negotiating the sale and reached an agreement, but the deal fell apart because of the perceived adverse tax consequences. Id. at 94-96. At that time, an intermediary agreed to establish 1 The intermediary received $15,583.30 for his role in the transaction. The entire sale was for approximately $1 million in consideration. See Davant, 366 F.2d at 878. 7 No. 08-20261 a holding company that would buy the taxpayers’ stock, sell the assets to the buyer, and liquidate the corporations. Id. at 96-97. The intermediary established the holding company and accomplished the transaction, retaining a modest fee for his services. See id. The IRS sought to treat the transaction as a sham, and we agreed, specifically relying on the fact that the transaction had been negotiated by the taxpayer with the eventual buyer -- and that the intermediary “served no real or useful economic purpose apart from tax savings.” Id. at 102. “Nothing here said is intended to prevent or in any way discourage a real and bona fide sale of stock by stockholders of one corporation to a second corporation, and liquidation of the first by the acquiring corporation. . . . But missing here is that all-important element -- the transaction must be real and bona fide.” Id. We also agreed with the IRS’s substance-over-form determination in Reef Corp. v Commissioner, 368 F.2d 125 (5th Cir. 1966). The taxpayer in that case was a corporation owed by two groups of shareholders. One group sought to buy the other’s interest in the corporation. The initial plan for accomplishing this goal was rejected by the sellers because of the adverse tax consequences, so the parties developed a new plan for using a new corporate entity and an intermediary to engage in a stock/asset swap in order to obtain a more favorable tax basis for the purchased assets. Id. at 128-29. We explained: [The intermediary] was a mere conduit in a preconceived and prearranged unified plan to redeem the stock of the [sellers]. His activity was but a step in the plan. He carried out a sales contract already entered into between the corporations. He assumed no risk, incurred no personal liability, paid no expenses and obtained only bare legal title to the stock. There was an insufficient shifting of economic interests to [the intermediary]. It is settled that under such circumstances substance must be given effect over form for federal tax purposes. Id. at 130. 8 No. 08-20261 However, we have not always agreed with the IRS’s application of the substance over form doctrine. In Compaq Computer Corp. v Commissioner, 277 F.3d 778 (5th Cir. 2001), the taxpayer (Compaq) purchased shares of a foreign corporation using an intermediary. The evidence established that the intermediary approached Compaq about buying the stock and that the intermediary “[w]ithout involving Compaq . . . chose both the sizes and prices of the trades and the identity of the company that would sell the [shares] to Compaq.” Id. at 779-80. The IRS argued that the transaction should be disregarded, which would prevent Compaq from claiming favorable tax treatment on its capital losses and dividends. We disagreed, concluding that the transaction was motivated by a business purpose unrelated to obtaining tax benefits and “economic substance.” Id. at 781-82. Specifically, we noted that the transactions “had both a reasonable possibility of profit attended by a real risk of loss and an adequate non-tax business purpose. The transaction was not a mere formality or artifice but occurred in a real market subject to real risks.” Id. at 788.