Kornfeld v. Commissioner as a Practical Guide to the Intent Test
Counseling clients on the mechanics of the step transaction doctrine in tax litigation is one of the surest ways to establish a loyal client base.
The only way that this doctrine can be truly understood is by reading the ways in which it has been applied in real world scenarios. This means studying tax litigation in-depth. If you understand the mechanics of this doctrine, you can begin to provide rudimentary counsel, and highlight when potential issues may arise; you can also point your clients in the direction of a qualified tax attorney when necessary.
As we discussed in a prior article, the step transaction doctrine consists of three distinct tests. These tests are designed to determine the substance of a given transaction.
If one of these tests can be applied to a transaction, then that transaction will be classified as a “step transaction” and its tax treatment will be overturned. The tests are as follows: the binding commitment test, the mutual interdependence test, and the intent test.
One case which can be highly useful for understanding the mechanics of the intent test is the case of Kornfeld v. Commissioner. This case is relatively unknown outside of the world of professional tax law, but hopefully that will change as people come to appreciate its full significance.
In this post, we will discuss how this example can demonstrate how the intent test of the step transaction doctrine operates in reality. If you absorb the lessons from this case, you will be able to provide a higher level of assistance to clients.
Factual Overview of Kornfeld
Kornfeld was an experienced tax attorney who devised a clever plan to purchase a “limited” interest in bonds. His goal was to acquire a life estate interest in the bonds in order to give himself a number of tax benefits.
For one, if he successfully acquired the life estate interest, he believed that he would be able to take a depreciation deduction on the bonds as they were paid off. Normally, such deductions are not allowed for a bond because the bond’s cost basis is incrementally lowed as payments are made.
To reach his goal, he first established a revocable trust through which he intended to purchase the bonds. Next, he entered into an agreement with his daughter. The agreement held that Kornfeld would acquire the life estate interest and his daughter would contribute funds to the trust which were intended to cover the remainder interest.
A second agreement was later reached between Kornfeld, his daughter and his secretary. This second agreement was necessary because the tax law was changed to disallow the desired tax benefits for transactions involving related parties. Ultimately, Kornfeld’s trust purchased the bonds, and then Kornfeld immediately sent checks to his daughter and secretary to cover their financial contribution.
What was the result of this transaction? Did Kornfeld obtain a genuine life estate interest in the bonds? The appellate court (U.S. Court of Appeals, Tenth Circuit) affirmed the decision of the trial court that a genuine life estate interest had not been created.
The court applied the intent test of the step transaction doctrine, finding that the seemingly unconnected actions taken by Kornfeld were clearly part of a preconceived scheme to obtain otherwise unavailable tax benefits. Let’s take a closer look at how the court reached this conclusion.
The Intent – or “End Result” – Test
As we went over in the previous post on the step transaction doctrine, the intent test tries to look at a series of steps and infer that those steps were part of a predesigned plan to achieve a specific result. There need not be any binding or contractual commitment, nor do the steps have to be necessarily or unquestionably intertwined. However, there must be a rational basis for holding that the apparently disparate steps were only taken so as to achieve a certain result.
In the Kornfeld case, the key fact was that Kornfeld immediately sent funds to the other parties involved after the purchase, and those funds were the same amount as those contributed for the remainder interest. This fact, combined with the other circumstances of the case, made it easy for the court to draw the inference that the multiple steps surrounding the transaction were part of a cohesive plan.
In reality, the 10th Circuit Court stated that this case would actually satisfy the “mutual interdependence” test as well as the intent (or end result) test. But the mutual interdependence test is typically easier to fulfill than the intent test.
If a genuine life estate interest had been the true goal of the transaction, then why would Kornfeld make the payments to the other parties? Clearly, under the step transaction doctrine, the subsequent payments had the effect of creating full ownership of the bonds for Kornfeld.
This full ownership means that the deductions and other benefits desired by Kornfeld were not possible. The court upheld the deficiency assessed by the IRS.
This case is valuable for many reasons, but the key thing to take away is that the intent test requires inferential reasoning on the part of the court. If you’re counseling clients, you want to make this point clear to them. If the court has enough reason to draw an inference of intent, then it will do so.
If you spot situations such as these, then you’ll be able to offer at least some guidance and also direct your clients toward a capable tax 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.