Lack of economic substance dooms loss deductions

By James A. Beavers, CPA, CGMA, J.D., LL.M.

The Tax Court held that a taxpayer was not entitled to a passthrough loss from the dissolution of an S corporation because the dissolution was part of a tax structure that did not have economic substance.

Background

Robert Smith worked for National Coupling Co. Inc. for 36 years. At the end of his tenure there he was the company's vice president and the manager of its manufacturing facility. He was in charge of manufacturing, engineering, intellectual property work, and trademarks. Over the years, Smith had procured over 400 patents.

In June 2009, National Coupling was sold and Smith retired, but, after the sale, he continued to provide consulting services to the company. Upon retirement, he received $664,007 of employee compensation and almost $430,000 from the sale of company stock and the surrender of two company-sponsored life insurance policies. During his employment at National Coupling, Smith had worked on a sprinkler device that would automatically apply fertilizer or insecticide. After the sale of National Coupling, the United States, Canada, and the United Kingdom issued patents for the device. Documents relating to the sale of National Coupling did not grant Smith the right to the sprinkler device patent, but Smith believed that he would retain the patent rights to the device after the sale.

At the time of his retirement, Smith felt that he needed estate planning advice. To get it, he and his wife turned to Richard Shanks, an experienced attorney and CPA. To offset the tax liability generated by Smith's compensation income, Shanks recommended a tax planning structure involving an S corporation and a family limited partnership. Under the structure, the Smiths would transfer their cash and marketable securities to a wholly owned S corporation that would then transfer the assets to a family limited partnership. The S corporation would own the limited partnership, and the partnership would hold the Smiths' cash and marketable securities. As part of the structure, the Smiths would organize and dissolve the S corporation within the same tax year. The S corporation would distribute the partnership interest to the shareholders upon dissolution. The fair market value (FMV) of the distributed partnership interest would be determined using large discounts for lack of marketability and lack of control, generating a tax loss upon the dissolution of the S corporation.

To this end, the Smiths organized RACR Ventures Inc. (Ventures), an S corporation; formed RACR Partnership Ltd. (RACR Partnership), a family limited partnership; and created the Smith Management Trust (Smith Trust), a revocable management trust (collectively, RACR structure). Smith and his wife each owned 50% of Ventures. Ventures owned a 98% limited partnership interest in RACR Partnership. Initially each of the Smiths was a 1% general partner. They transferred their general partnership interests to the Smith Trust, of which they were co-trustees and beneficiaries.

From the outset, the Smiths understood that Ventures would not hold any assets, that it would immediately transfer its assets to RACR Partnership, and that they would dissolve Ventures by the end of 2009 to accomplish their tax mitigation plan. Various evidence showed that the Smiths were well aware that the whole setup was a tax-minimization scheme.

In August 2009, the Smiths made a series of transfers of cash and marketable securities totaling in excess of $1.8 million to Ventures brokerage accounts and then to brokerage accounts of RACR Partnership. The Smiths also made various nominal cash transfers between the entities' accounts. At the end of these transfers, the Smiths had transferred most of their assets via Ventures to RACR Partnership. In August 2009, the Smiths took a distribution from RACR Partnership to purchase long-term-care insurance, and, after netting out this distribution, the Smiths had transferred close to close to $1.8 million to RACR Partnership via Ventures. Ventures did not have any business activities in 2009.

In December 2009, the Smiths dissolved Ventures. In the dissolution, Ventures transferred each of the Smiths a 49% limited partnership interest in RACR Partnership. On Ventures' initial and final corporate tax return for 2009, it reported gross receipts of $1,120,675 and cost of goods sold of $1,870,527, resulting in an ordinary loss of $749,852. It reported the values of the 49% limited partnership interests in RACR Partnership distributed to the Smiths as gross receipts. To calculate the values of the distributed partnership interests, Shanks used the cash and the value of the securities that the Smiths had transferred to RACR Partnership via Ventures and applied a 40% discount for lack of marketability and lack of control. The cost-of-goods-sold amount was based on the Smiths' alleged bases in cash and marketable securities that the couple had transferred to Ventures and then to RACR. The Smiths reported Ventures' claimed loss on the distribution of the RACR interests as ordinary loss on their personal return.

The IRS took a less charitable view of the Smiths' transactions. In a notice of deficiency for the Smiths' 2009 tax year, the IRS disallowed the $1,870,527 adjustment for cost of goods sold from Ventures as reported on the Smiths' joint return and increased their ordinary income by the reported gross receipts and, in the alternative, determined that Ventures had gross receipts of zero, resulting in a disallowance of the Smiths' claimed ordinary loss deduction.

The Smiths, predictably, disagreed with the IRS's determination and challenged it in Tax Court. In Tax Court, the IRS contended that the Smiths were not entitled to deduct the 2009 loss upon the dissolution of Ventures because the RACR structure lacked economic substance, or, in the alternative, the loss deduction did not meet the Sec. 165 requirements for a bona fide loss incurred in a trade or business or a transaction entered into for profit. The IRS further argued that if the Smiths were entitled to the 2009 loss deduction, they understated the FMV of the partnership interests distributed by Ventures.

The Tax Court's decision

The Tax Court held that the Smiths were not entitled to deduct the 2009 loss on the dissolution of Ventures because the RACR structure lacked economic substance. Having based its decision on economic substance, it did not address the IRS's other arguments in its opinion.

Because an appeal of the Tax Court's decision in the case would lie to the Fifth Circuit, the court followed that circuit's interpretation of the economic substance doctrine as a conjunctive multifactor test. The Fifth Circuit has held that a transaction must exhibit an objective economic reality, a subjectively genuine business purpose, and some motivation other than tax avoidance, and that the failure to meet any one of these three factors renders the transaction void for tax purposes. However, the Fifth Circuit has also noted that there is a near total overlap between the second and the third factors.

The Smiths claimed in Tax Court that they organized Ventures as part of the RACR structure to manufacture and sell the sprinkler device after Smith received the patent and that they transferred their personal assets to Ventures to finance the start of this new business enterprise. According to the Smiths, Ventures immediately transferred the assets to RACR Partnership for asset protection purposes, but the funds would have been available to Ventures once it started to manufacture the sprinkler device. They further claimed that they dissolved Ventures four months later because of unforeseeable circumstances: (1) The patent had not been issued and (2) Smith was busy with his consulting work.

Objective economic reality inquiry: The Fifth Circuit has held that a transaction lacks economic substance if it does not vary, control, or change the flow of economic benefits and that a circular flow of funds among related entities does not indicate a substantive economic transaction. The Tax Court found that the RACR structure failed to alter Robert Smith's economic position in any way that affected objective economic reality, describing it as a circular flow of funds among related entities used to generate an artificial tax loss to offset the Smiths' 2009 income from National Coupling. The court also found that the Smiths always intended to dissolve Ventures by the end of 2009 and never intended to manufacture the sprinkler device. Thus, it concluded that the RACR structure and Ventures dissolution lacked objective economic reality and failed to satisfy the first prong of the Fifth Circuit's economic substance test. Although it was not necessary, because failure to satisfy any of the three prongs of the test meant that the transaction lacked economic substance, the court addressed the application of the other two prongs of the test to the RACR transaction.

Subjective purpose inquiry: The court explained that while enumerated separately, the Fifth Circuit has stated that the second and third prongs of the economic substance test overlap and derive from an inquiry into the taxpayer's purpose — whether the taxpayer had a subjectively genuine business purpose or some motivation other than tax avoidance. Accordingly, the Tax Court considered these factors together. Under the subjective purpose inquiry, tax avoidance cannot be the taxpayer's sole reason for entering into a transaction; however, a taxpayer can meet the test if the taxpayer has mixed motives and, if the taxpayer does, the fact that the primary motive for a transaction is to obtain tax benefits does not necessarily invalidate a transaction.

After reviewing the evidence and the testimony from the trial, the Tax Court concluded that the Smiths implemented the RACR structure solely for tax avoidance. Consequently, the use of the structure did not meet the second and third prongs of the economic substance test under the Fifth Circuit's interpretation, so the transaction did not have economic substance. The court pointed to various inconsistencies in Robert Smith's testimony and the evidence that belied his claim that the Smiths ever intended to manufacture the sprinkler device through Ventures or operate Ventures as a manufacturing business. Instead, the court found that the evidence indicated that the Smiths intended to use ­Ventures and the RACR structure overall solely to create an artificial tax loss to offset Robert Smith's compensation income in 2009.

Reflections

As one of the reasons that it was upholding the penalties the IRS imposed against the Smiths, the court noted that, although the evidence clearly showed that the Smiths knew from the beginning that the RACR structure was a pure tax-avoidance scheme, the Smiths "continued to perpetuate their tax-avoidance scheme through their testimony at trial that we have found not to be credible or reliable."

Smith, T.C. Memo. 2017-218   

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