Opinion ID: 515523
Heading Depth: 2
Heading Rank: 2

Heading: Sham Transaction Doctrine

Text: 17 The sham transaction doctrine requires courts and the Commissioner to look beyond the form of a transaction and to determine whether its substance is of such a nature that expenses or losses incurred in connection with it are deductible under an applicable section of the Internal Revenue Code. If a transaction's form complies with the Code's requirements for deductibility, but the transaction lacks the factual or economic substance that form represents, then expenses or losses incurred in connection with the transaction are not deductible. 18 The sham transaction doctrine emerged from the Supreme Court's decision in Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935). In Gregory, the Court affirmed the Commissioner in denying deductions claimed by taxpayers for losses and expenses incurred in a corporate reorganization. The taxpayers had followed each step required by the Code for the reorganization. Nevertheless, the Court held these losses nondeductible. The Court held that this transaction was a mere device for the consummation of a preconceived plan and not a reorganization within the intent of the Code as it then existed. Id. at 469, 55 S.Ct. at 267-268. Because the transaction lacked economic substance, as opposed to formal reality, it was not the thing which the statute intended. Id. 19 The sham transaction doctrine has become widely accepted, see generally B. Bittker, Federal Taxation of Income, Estates and Gifts p 4.3.3 (1981 and Supp.1988), as has the general notion that courts should look at the substance of a transaction rather than just its form. See generally Frank Lyon Co. v. United States, 435 U.S. 561, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978) (Court looked at economic substance or reality of sale and leaseback transactions); Knetsch v. United States, 364 U.S. 361, 81 S.Ct. 132, 5 L.Ed.2d 128 (1960) (interest expense deductions disallowed because only thing of substance to be realized in transaction was tax deduction); Commissioner v. Court Holding Co., 324 U.S. 331, 65 S.Ct. 707, 89 L.Ed. 981 (1945) (creating step transaction doctrine, whereby courts must consider all steps of transaction in light of entire transaction, so that substance of transaction will control over form of each step). While it is true that a taxpayer can structure a transaction to minimize tax liability under the Internal Revenue Code, Gregory, 293 U.S. at 469, 55 S.Ct. at 267-268, that transaction must nevertheless have economic substance in order to be the thing which the statute intended. Id. 20 Taxpayers deducted the losses in this case under I.R.C. Sec. 165. I.R.C. Sec. 165(a) allows losses in general to be deducted from a taxpayer's taxable income. 8 I.R.C. Sec. 165(c)(2) limits those deductible losses to losses incurred in transactions, not in connection with a trade or business, entered into for profit. This statute was clearly aimed at economically-motivated, or profit-motivated, transactions. Miller v. Commissioner, 836 F.2d 1274, 1278-79 (10th Cir.1988). If a transaction is not motivated by profit or economic advantage, then that transaction is a sham for purposes of analysis under I.R.C. Sec. 165(c)(2). See Boynton v. Commissioner, 649 F.2d 1168, 1172 (5th Cir. Unit B 1981), cert. denied, 454 U.S. 1146, 102 S.Ct. 1009, 71 L.Ed.2d 299 (1982); 9 cf. Gregory v. Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596 (1935). Naturally, the profit or economic motivation cannot be merely tax benefits. 21 Although Section 108 of the Deficit Reduction Act of 1984, Pub.L. No. 98-369, 98 Stat. 494, 630 (1984) (Section 108), 10 provides for deduction of losses incurred in closing one leg of a straddle transaction, in order for Section 108 to apply, the underlying transaction must not be a sham. Miller, 836 F.2d at 1278-79; see also Neely v. United States, 775 F.2d 1092, 1094 (9th Cir.1985). The Eleventh Circuit recently affirmed a tax court decision holding that Section 108 does not apply where the transactions involved are shams. Forseth v. Commissioner, 85 T.C. 127 (1985) (holding commodity straddle transactions shams because of lack of economic substance), aff'd without published opinion sub nom. Wooldridge v. Commissioner, 800 F.2d 266 (11th Cir.1986). The analysis of whether something is a sham, then, must occur before analysis of the for-profit test of I.R.C. Sec. 165(c)(2) and Section 108. See Sochin v. Commissioner, 843 F.2d 351, 353-54 n. 6 (9th Cir.1988) (Section 108 does not apply until the court determines that the transaction is not a sham); accord Enrici, 813 F.2d at 295 n. 1; Mahoney v. Commissioner, 808 F.2d 1219, 1220 (6th Cir.1987). 22 Courts have recognized two basic types of sham transactions. Shams in fact are transactions that never occur. In such shams, taxpayers claim deductions for transactions that have been created on paper but which never took place. Shams in substance are transactions that actually occurred but which lack the substance their form represents. Gregory, for example, involved a substantive sham. The issue in this case is whether, assuming the transactions actually occurred as claimed, the transactions are shams in substance. 23 Petitioners at oral argument strongly asserted that the tax court erred in failing to evaluate the subjective intent of each individual taxpayer. Petitioners argued that the tax court could not find that these transactions constituted a substantive sham without evaluating the intent or motive of each person entering into the transactions. We disagree. 24 It is true that I.R.C. Sec. 165(c)(2) and Section 108 require a transaction to be entered into for profit, and that the analysis of the for-profit test under these provisions focuses on the subjective intent of the taxpayer. See e.g., Helvering v. National Grocery Co., 304 U.S. 282, 58 S.Ct. 932, 82 L.Ed.1346 (1938); Miller v. Commissioner, 836 F.2d 1274, 1280 (10th Cir.1988) (the meaning of 'transaction entered into for profit' has been settled at least since 1938, when the Supreme Court indicated that a subjective standard is applied and the taxpayer's primary motive must be one of profit). Under I.R.C. Sec. 165(c)(2), courts evaluate whether a taxpayer entered the transactions primarily for profit, Miller, 836 F.2d at 1280, and the test under Section 108 is the same. Id.; see also Landreth v. Commissioner, 859 F.2d 643 (9th Cir.1988). Naturally, the evaluation of the level of profit motive possessed by a taxpayer in entering into a transaction involves an inquiry into the subjective motive or intent of the taxpayer. The analysis of whether a transaction is a substantive sham, however, addresses whether a transaction's substance is that which its form represents. That does not necessarily require an analysis of a taxpayer's subjective intent. Once a court determines a transaction is a sham, no further inquiry into intent is necessary. 25 The focus of the inquiry under the sham transaction doctrine is whether a transaction has economic effects other than the creation of tax benefits. Knetsch v. United States, 364 U.S. 361, 81 S.Ct. 132, 5 L.Ed.2d 128 (1960). Several courts have focused on two related factors, business purpose and economic substance, to determine whether a transaction is a sham. See, e.g., Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1549 (9th Cir.1987); Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir.1985). The determination of whether the taxpayer had a legitimate business purpose in entering into the transaction involves a subjective analysis of the taxpayer's intent. The inquiry into whether the transaction had economic substance beyond the creation of tax benefits, however, does not involve a subjective inquiry. Bail Bonds by Marvin Nelson, Inc., 820 F.2d at 1549 (The economic substance factor involves a broader examination of ... whether from an objective standpoint the transaction was likely to produce economic benefits aside from a tax deduction.) (emphasis added). 26 It is clear that transactions whose sole function is to produce tax deductions are substantive shams, regardless of the motive of the taxpayer. See Mahoney, 808 F.2d at 1220 (inquiry is whether transaction has any practical economic effects beyond the creation of tax benefits); Boynton, 649 F.2d at 1172 (transactions that have no economic effect other than creation of tax losses are shams); Tolwinsky v. Commissioner, 86 T.C. 1009, 1037 (1986) ([w]here transactions serve no 'purpose, substance, or utility apart from their anticipated tax consequences' they are disregarded for tax purposes); Julien v. Commissioner, 82 T.C. 492 (1984) (interest expenses incurred in silver straddles disallowed under I.R.C. Sec. 162(a) because transactions served no economic purpose beyond generating interest deductions); cf. Frank Lyon Co. v. United States, 435 U.S. 561, 583-84, 98 S.Ct. 1291, 1303-04, 55 L.Ed.2d 550 (1978) (where there is a ... transaction ... encouraged by business or regulatory realities, ... imbued with tax-independent considerations, and ... not shaped solely by tax-avoidance features, the transaction is not a sham). 27 We find, based on the record before us, that the sole function of these transactions was to obtain deductions to income for federal income tax purposes. We agree with the tax court's conclusion that this was a prearranged sequence of trading calculated to achieve a tax-avoidance objective--not investments held for non-tax profit objectives. Glass, 87 T.C. at 1163. Consequently, the losses and expenses incurred in connection with these straddle transactions are not deductible under I.R.C. Sec. 165(c)(2). 28 Every taxpayer closed out the option contracts in the first year and incurred significant deductible losses regardless of the effect such an action would have on the overall profitability of the transaction. 11 No taxpayer received a return of the initial margin deposit, regardless of whether the taxpayer earned a gain or incurred a loss; nor did any taxpayer actually receive payment of gains earned. Many taxpayers asserted that these transactions resulted in an absolute loss; yet no taxpayer contributed funds beyond the initial margin. The advertising material sent by finders for the commodity brokerage houses promoted the tax benefits available to the exclusion of potential profit. These facts support the conclusion that these were transactions entered into for the achievement of pre-arranged tax results. 12 29 There may have been an incidental and minimal risk of actual gains and losses. That risk and the fact that the account balances of some taxpayers fluctuated due to changes in the silver futures market do not alter our conclusion that the sole function of these transactions was to obtain tax deductions. We hold that where, as here, the only substance of a transaction is the creation of income tax benefits for a fee, however the taxpayer characterizes that fee, that transaction is a sham for income tax purposes. 30 In certain circumstances, we agree that an inquiry into the subjective intent of a taxpayer is appropriate. For purposes of this decision, however, we need not define with specificity the level of subjective profit motive or non-tax-avoidance purpose a taxpayer must possess in entering into a transaction for that transaction to pass scrutiny under the sham transaction doctrine. Because the sole function of these transactions was to create first year ordinary losses and capital gains treatment for subsequent offsetting gains, the transactions are shams. Whatever the taxpayers' motives in entering into these transactions, the transactions are not of the nature of the transactions at which I.R.C. Sec. 165(c)(2) is directed. If a transaction is not what the statute intended, for whatever reason, then losses and expenses incurred in connection with the transaction are not deductible. 31 Petitioners argue that the tax court erred by focusing on the first year of the transaction. Petitioners argue that by doing so, the tax court failed to assess the business purpose or economic substance of the transaction as a whole. Alternatively, petitioners argue that closing out the first leg of an option straddle transaction can never be a sham, because Section 108 expressly provides for recognition of losses from these transactions. 32 Petitioners are correct in asserting that the tax court was obligated to analyze the entire transaction. See Smith v. Commissioner, 78 T.C. 350 (1982),aff'd without opinion, 820 F.2d 1220 (4th Cir.1987). The tax court did analyze the entire transaction, however, stating, the focus of our attention is petitioners' entire tax straddle scheme, and not each separate straddle. It is the overall scheme which taints the deductibility of the year one losses. Glass, 87 T.C. at 1174. The court then analyzed the interrelationship between the first year transactions and the overall transaction. The court concluded that no taxpayer had a non-tax-avoidance purpose behind the transactions, because the taxpayers could have profited from difference gains in commodity straddle transactions had they not in every instance entered into closing transactions or sold options in year one of the straddle operation. Id. In other words, the court evaluated the first year transactions in the context of the entire scheme and the trading strategy involved. The court found that the fact that the first year transactions lacked a true profit function when considered in the context of the entire scheme supports the conclusion that the scheme itself lacked a profit motive. We agree with the tax court's approach and conclusion. 13 33 Petitioners' second argument, that because Section 108 expressly provides for recognition of losses incurred in the first year of straddle transactions, those transactions cannot be substantive shams, is similarly unpersuasive. Petitioners are correct in asserting that Section 108 allows them intentionally to incur a loss in the first year of a straddle transaction. That does not mean, however, that losses from transactions entered into in the first year of all straddle transactions are deductible. As petitioners correctly argued, the court must consider the entire transaction, not just the first year trades. Although the taxpayers did not need a profit motive behind the first year transactions themselves, the commodity straddle transactions as a whole must not have been shams in substance. The sole function of these transactions was to produce tax benefits, however. Consequently, the transactions are shams in substance, and Section 108 does not apply. 34 Petitioners finally argue that these transactions were not shams in substance because petitioners accepted the risk of difference gains and losses. The record shows that due to fluctuations in the prices of silver futures, many of the taxpayers did not recover in year two the losses claimed in year one. 14 The fact that some taxpayers did not realize the anticipated gains in the second year does not mean the transactions were not shams. The losses in the first year were guaranteed, and the trading strategy insured that in every case the losses occurred. The objective profit potential of a transaction is certainly a factor to consider, but where as here the taxpayers' trading strategy ignored any potential profit in the maximization of deductible losses, the existence of that potential alone does not create the existence of a profit motive. Although there may have been incidental and minimal risks of profit or loss, 15 those risks are insufficient to change the nature of these transactions. The transactions had the sole function of producing taxable losses in one year and offsetting capital gains in the next. The fact that the gains were not exactly offsetting does not alter that fundamental nature. 35 The losses incurred by petitioners in connection with these straddle transactions are not deductible under I.R.C. Sec. 165(c)(2) or Section 108, because the transactions lacked economic substance. We hold that taxpayers have not met their burden of showing that these transactions were not a sham. See Brown v. Commissioner, 85 T.C. 968, 998 (1985). Consequently, we affirm the tax court.