Opinion ID: 71496
Heading Depth: 1
Heading Rank: 8

Heading: The Tests for Determining Sham Transaction

Text: The Tax Court's jurisdiction depends on whether the test for determining a sham transaction under Section 6621(c) requires substantive partner-level factual determinations. The genesis of the sham-transaction doctrine is the Supreme Court's decision in Frank Lyon Co. v. United States, 435 U.S. 561, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978). The Court stated that a transaction will be accorded tax recognition only if it has economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached. Id. at 583-84, 98 S.Ct. 1291. Subsequent case law developed two predominant tests for identifying a sham transaction. In Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985), the Fourth Circuit adopted a two-prong standard, stating that [t]o treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists. Id. at 91. The business purpose prong inquires into the taxpayer's subjective motive for entering the transaction. Id. at 92. The economic-substance prong requires an objective determination of whether a reasonable possibility of profit from the transaction existed apart from the tax benefits. Id. at 94. The other test, adopted by a majority of the circuits, states that the[] distinct aspects of the economic sham theory inquiry do not constitute discrete prongs of a rigid two-step analysis, but rather represent related factors both of which inform the analysis of whether the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes. ACM P'ship v. Comm'r of Internal Revenue, 157 F.3d 231, 247 (3d Cir. 1998), cert. denied, 526 U.S. 1017, 119 S.Ct. 1251, 143 L.Ed.2d 348 (1999); see also Sochin v. Comm'r of Internal Revenue, 843 F.2d 351, 354 (9th Cir.1988), cert. denied, 488 U.S. 824, 109 S.Ct. 72, 102 L.Ed.2d 49 (1988); Rose v. Comm'r of Internal Revenue, 868 F.2d 851, 854 (6th Cir.1989); James v. Comm'r of Internal Revenue, 899 F.2d 905, 908-09 (10th Cir. 1990); Winn-Dixie Stores, Inc. v. Comm'r of Internal Revenue, 254 F.3d 1313, 1316 (11th Cir.2001). The sham transaction doctrine has few bright lines, but `[i]t is clear that transactions whose sole function is to produce tax deductions are substantive shams.' Winn-Dixie Stores, 254 F.3d at 1316 (quoting Kirchman v. Comm'r of Internal Revenue, 862 F.2d 1486, 1492 (11th Cir.1989)). Courts of appeals following the approach followed in most of the jurisdictions to consider the issue have held that while a taxpayer's subjective business purpose or profit motive may be relevant to the sham transaction inquiry, the lack of a subjective profit motive is not required to assess interest at the enhanced rate under Section 6621(c). See Thomas v. United States of America, 166 F.3d 825, 833 (6th Cir. 1999) (by its plain language I.R.C. § 6621(c) imposes no inquiry into the taxpayer's investment motive when the transaction is found to be a sham); Chakales v. Comm'r of Internal Revenue, 79 F.3d 726, 728 (8th Cir.1996) (no basis for reading a separate state of mind requirement into the sham transaction test for purposes of Section 6621(c)(3)(A)(v)); Estate of Carberry v. Comm'r of Internal Revenue, 933 F.2d 1124, 1129-30 (2d Cir.1991) (upholding enhanced interest under Section 6621(c) without considering the taxpayer's motive); Karr v. Comm'r of Internal Revenue, 924 F.2d 1018, 1026 (11th Cir.1991) (upholding enhanced interest assessment without inquiring into taxpayer's motive because Tax Court found partnership activity lacked economic substance); Jackson v. Comm'r of Internal Revenue, 966 F.2d 598, 601 (10th Cir.1992) (the mere presence of a profit motive does not prevent a transaction from being a sham). The Fifth Circuit has recognized, but not resolved, the disagreement between those circuits that apply the two-prong test for finding a sham transaction and those that collapse the prongs into a factors test. The Fifth Circuit has declined opportunities to determine what test should apply. In Compaq Computer Corp. & Subsidiaries v. Comm'r of Internal Revenue, 277 F.3d 778, 781-82 (5th Cir.2001), the court found it unnecessary to determine the appropriate standard for determining a sham transaction because in that case, the taxpayer met its burden on both prongs. See id. at 781-82. [18] Because Compaq did not involve a partnership, the question of how a partner's individual profit motive fits into the sham inquiry was not at issue in that case. Weiner v. United States, 255 F.Supp.2d 624, 657 (S.D.Tex. 2002). In Copeland v. Commissioner, 290 F.3d 326 (5th Cir.2002), a partnership case involving a sham transaction, the Fifth Circuit did not reach the question whether profit motive is to be tested at the individual or partnership level. Id. at 337. Answering this question was unnecessary in Copeland because the IRS relied on 26 U.S.C. § 183 for disallowing the partnership's deductions, a section not applicable to partnerships. Id. at 337.