A Test-by-Test Guide to the Step Transaction Doctrineby
To more effectively serve and further the interests of their clients, every accountant and CPA should take the time to understand the fundaments of the step transaction doctrine.
Though it may be unreasonable to expect every accountant to master the finer points of this judicial doctrine, all accountants should learn enough so that they can at least notify their clients when a transaction with tax consequences may come under this type of legal scrutiny. Mastering the step transaction doctrine in all of its complexity is quite difficult and requires thorough study of numerous court opinions; studying these court opinions is the only real way to truly understand the types of reasoning involved when the step transaction doctrine is applied in real world scenarios.
Learning the basics of this doctrine, however, is certainly within the reach of just about every accountant. As long as a given accountant is willing to put in a bit of extra work, it’s quite reasonable to expect that he or she can point out situations in which it may be beneficial to consult with a qualified tax attorney. Putting in this type of extra work can most definitely help in the building and maintaining of your client base.
In this post, we will provide a practical guide to the step transaction doctrine by going over the specific tests which are used whenever it is applied in reality. Having a basic understanding of these tests will improve every accountant’s ability to identify potential scenarios which may require formal assistance from a tax attorney. If you can spot scenarios which may ultimately trigger the application of one of these tests, you can potentially save your clients a great deal of money and headache by referring them to an experienced attorney.
The Tests of the Step Transaction Doctrine
Few people outside of the legal profession understand precisely how the step transaction doctrine is actually applied. Many laypeople assume that suspect transactions are simply classified under this doctrine as long as they fit within this doctrine’s general concept. In reality, transactions will only fall within the step transaction doctrine – and consequently be regarded as a single transaction – if at least one of three tests can be successfully applied to those transactions.
If none of these tests can be applied, then the original tax treatment will stand and the transactions will be viewed as legally separate. Let’s look at each of these three tests and then discuss how understanding these tests can aid accountants when they work with clients.
The Binding Commitment Test
The so-called “binding commitment test” will combine a series of disparate steps together under the doctrine if the parties involved had a formal obligation to take each step. This test makes intuitive sense, because it is simple to see that disparate steps should be combined and treated as a single transaction if each individual step had to be taken along with the other steps.
Let’s consider an example: in a 1031 exchange, a taxpayer may not exchange into property which he or she already owns. In other words, it would not be possible to sell a relinquished property and then buy a replacement property to which the taxpayer already held title. But, to get around this rule, suppose a taxpayer sold his or her relinquished property, and then bought as a replacement property a piece of real estate which was sold to the taxpayer’s cousin two years prior to the sale of the relinquished property.
And suppose that the taxpayer and cousin entered into a contractual agreement which stated that the cousin was required to re-sell the real estate so that it could be acquired as replacement property in this future 1031 exchange. This would be a scenario which would almost certainly fall under the binding commitment test, because each step, although technically separate, was a requirement of a larger underlying scheme. This is also the type of scenario that you should be able to identify as potentially alarming for your clients.
The Mutual Interdependence Test
The mutual interdependence test will collapse a series of steps into a single transaction if the legal relations or significance of each step would be erased without the completion of the series. Unlike the binding commitment test, this test doesn’t require a formal obligation or contractual agreement to have each step taken in a given series, but instead examines each step in relation to the whole series to determine whether the individual steps have independent significance.
The case of Gregory v. Helvering (1935) provides a good example of a set of facts to which the mutual interdependence test would apply. In that case, a taxpayer owned a company which held shares of stock in another company. To minimize his tax burden, the taxpayer transferred the shares to a new company he set up and then transferred the shares back to him. The taxpayer then immediately dissolved the new company and claimed that the dissolution of the new company fell within the existing statutory construction of a corporate “reorganization.”
If the dissolution did fall within this construction, the taxpayer’s tax burden would be reduced. The court rejected the idea that a genuine reorganization had occurred and contended that the new company was merely a “dummy company” and served no other purpose other than to distribute the shares to minimize tax liability.
There was no obligation to perform any step taken in the series, but clearly each step only has significance as part of the larger whole. When viewed collectively, all of the steps obviously are geared toward the underlying purpose of avoiding tax. This type of situation is quite common, perhaps more common than those targeted by the binding commitment test, and so accountants and other tax professionals need to be able to spot them.
The Intent – or End Result – Test
The final test is known as the intent (or “end result”) test. This test is similar to the mutual interdependence test in the sense that it looks at individual steps within a series to determine how they relate to the series and whether each step has independent significance. However, this test is more subjective than the mutual interdependence test.
With the mutual interdependence test, there is essentially no question that each step would lose any purpose or significance unless the other steps were taken in conjunction with it. But the intent test is usually applied to a series of closely related steps which could conceivably have independent purposes but which likely have only been taken so as to produce a specific tax result. Because of its subjectivity, this test will likely require that a series of steps be viewed in a wider context so as to ascertain the possible motives and intentions of those involved.
Again, mastering the step transaction doctrine in all of its sophistication is not a practical expectation for every accountant, but if every accountant just learned the basics of these 3 tests they would be well on their way to offering superior service to their clients. If you can spot scenarios which you think will probably trigger this type of scrutiny, it’s certainly best to err on the side of caution and seek guidance from a qualified attorney.
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Jorgen Rex Olson is a graduate of Washington State (B.A., cum laude, 2008) and the Indiana University (McKinney) School of Law (J.D., 2012). He writes for Mackay, Caswell & Callahan, P.C., one of the leading tax law firms in New York State.