On August 31, 2020, the Tax Court issued a Memorandum Opinion in the case of Daichman v. Commissioner (T.C. Memo. 2020-126). The primary issue before the court in Daichman v. Commissioner was whether the petitioners are entitled to a short-term capital loss deduction of $2.1 million in connection with the dissolution of their S corporation or whether their tax transactions lacked economic substance.

Brief Background to the Shenanigans in Daichman v. Commissioner

During 2009 the petitioners transferred personal assets of cash and marketable securities to a wholly owned S corporation, which in turn immediately transferred those assets to a family limited partnership. A few weeks later, the petitioners dissolved the S corporation and received the partnership interest as a liquidating distribution. In connection with the liquidation, the petitioners claimed a nonpassive loss deduction on Schedule E, Supplemental Income and Loss. The claimed nonpassive loss deduction reflected a substantially discounted value for the partnership interest versus the value of the underlying assets recently transferred to the partnership.

The entire “planning” scheme was orchestrated by a CPA/attorney named Mr. Shanks, who apparently suggested the planning structure to a number of his clients. Petitioners’ 2009 tax return was prepared by another CPA who had been preparing the petitioners’ return since 2006. The petitioner-husband explained to the CPA the mechanics of the transactions involving the entities, providing graphs and illustrations depicting how the tax strategy worked. The 2009 joint return was filed timely in reported wages of $700,000 in nonpassive partnership income of $1.4 million. The petitioners also claimed an ordinary loss deduction on Schedule E of $2.1 million, thereby reporting an AGI of -$20,106 and a tax liability of zero.

Examination, Penalty Approval, and Appeal

The IRS determined that the petitioners were not entitled to the loss deduction claimed, and they were, therefore, liable for an accuracy -related penalty under IRC § 6662(a).  The IRS received prior written supervisory approval before imposing the accuracy-related penalty on the basis of a substantial understatement of income tax. See IRC § 6662(b)(2). The revenue agent’s report proposed an additional tax of $450,000 and an accuracy-related penalty of $90,000. The petitioners appealed the proposed adjustment. The appeal was unsuccessful, and the IRS issued a notice of deficiency. In the notice, the IRS determined a deficiency of $1.2 million and an accuracy-related penalty of $232,000.

Too Creative for Its Own Good – The Bounds of the Economic Substance Doctrine

A taxpayer is generally free to structure his business transactions as he wishes, even if motivated in part by a desire to reduce taxes. Gregory v. Helvering, 293 U.S. 465, 469 (1935); see also Smith v. Commissioner, T.C. Memo. 2017-218, at *15. Transactions which do not vary control or change the flow of economic benefits, however, are to be dismissed from consideration. See Higgins v. Smith, 308 U.S. 473, 476 (1940). The economic substance doctrine allows courts to enforce the legislative purpose of the Code by preventing taxpayers from reaping tax benefits from transactions lacking economic reality. Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 543 (5th Cir. 2009).

A court may disregard a transaction for Federal income tax purposes, even one that formally complies with the Code, if the transaction has no effect other than generating an income tax loss. See Knetsch v. United States, 364 U.S. 361 (1960); Smith, T.C. Memo. 2017-217 at *16. Whether a transaction has economic substance is a factual determination for which the taxpayer bears the burden of proof. United States v. Cumberland Pub. Serv. Co., 338 U.S. 451, 456 (1950); Smith, T.C. Memo. 2017-218 at *16.

The Court of Appeals for the Fifth Circuit has interpreted the economic substance doctrine as a conjunctive multifactor test. Klamath Strategic Inv. Fund, 568 F.3d at 544. Within the Fifth Circuit, a transaction will be respected for tax purposes only if: (1) it has economic substance compelled by business or regulatory realities; (2) it is imbued with tax-independent considerations; and (3) it is not shaped totally by tax avoidance features. Id.; see also Frank Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978). The transaction must therefore exhibit an objective economic reality, a subjectively genuine business purpose, and some motivation other than tax avoidance. Southgate Master Fund, L.L.C. v. United States, 659 F.3d 466, 480 (5th Cir. 2011); Smith, T.C. Memo. 2017-218 at *16-*17.

First Prong: Objective Economic Reality

The first prong of the economic substance inquiry requires that the transaction have economic substance compelled by business or regulatory realities, often referred to as “objective economic reality.” A transaction lacks economic substance if it does not vary control or change the flow of economic benefits. Klamath Strategic Inv. Fund, 568 F.3d at 543; Higgins, 308 U.S. at 476. Under the objective economic inquiry, the Court examines whether the transaction affected the taxpayer’s financial position in any way, such as whether the transaction either caused real dollars to meaningfully change hands or created a realistic possibility that they would do so. Southgate Master Fund, L.L.C., 659 F.3d at 481.

A circular flow of funds among related entities does not indicate a substantive economic transaction for tax purposes. Merryman v. Commissioner, 873 F.2d 879, 882 (5th Cir. 1989), aff’g T.C. Memo. 1988-72. In the present matter, the form of the petitioners’ ownership of the assets may have changed, but the substance did not. There was no realistic risk or possibility that the funds or assets would change hands at any point. Therefore, the transactions failed to satisfy the “objective economic reality” prong of the economic substance test.

Second and Third Prongs: Subjective Purpose

The second and third prongs of the economic substance doctrine overlap and derive from an inquiry into the taxpayer’s purpose, i.e., whether the taxpayer had a subjectively genuine business purpose or some motivation other than tax avoidance. See Southgate Master Fund, 659 F.3d at 481. Taxpayers are not prohibited from seeking tax benefits in conjunction with seeking profits for their businesses, and a taxpayer who acts with mixed motives of profit and tax benefits may nonetheless satisfy the subjective test. Id. at 481-482.

Tax-avoidance considerations may not be the taxpayer’s sole purpose for entering into a transaction, however. See Salty Brine I, Ltd. v. United States, 761 F.3d 484, 495 (5th Cir. 2014). However, the fact that a taxpayer enters into a transaction primarily to obtain tax benefits does not necessarily invalidate the transaction under the subjective purpose inquiry. Compaq Comput. Corp. & Subs. v. Commissioner, 277 F.3d 778, 786 (5th Cir. 2001), rev’g 113 T.C. 214 (1999).

In the present matter, the S corporation was organized and dissolved within the same year according to a preset plan which was put in place in an effort to reduce the petitioners’ 2009 income tax liability. Therefore, the petitioners did not have a genuine business purpose for establishing the entities, and the actions were taken solely for tax-motivated reasons. This is further evidenced by the fact that Mr. Shanks charged a fixed fee for both creation and dissolution of the entities, which lends credence to the fact that it was a “prepackaged tax strategy” that he offered to a number of clients in 2009.

As a consequence, the transactions lacked economic substance and the loss was properly disallowed. Because of the amount of the understatement of tax, the substantial understatement penalty pursuant to IRC § 6662(b)(2) was appropriate.

(T.C. Memo. 2020-126) Daichman v. Commissioner

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