Tax Avoidance
Posted on May 15, 2008
Filed Under Federal Income Tax, Key Concepts
A concept appearing time and again in leading tax resources is the idea of “tax avoidance,” and I illustrate this key concept using the example of a clever and complicated tax shelter.
In my research, whether reading law school textbooks on federal income taxation or one of many helpful practitioner guides, the concept of substance over form explains decisions made in many important court cases and serves as a standard to guide practice. In a word, the lay person and the practitioner must understand the “meat” or substance of controversial tax issues in order to structure transactions so they meet not only the letter but also the spirit of the law. If a transaction serves no other purpose than that of tax avoidance you can expect the Commissioner of the Internal Revenue Service and courts of law to reject your claim for favorable tax treatment.
One area where the doctrine of substance over form is commonly applied is litigation examining the economic substance and business purpose of tax shelters (and the very label of “tax shelter” is a clue that the writer of the opinion or law school textbook is a most unsympathetic critic of the taxpayer’s argument).
For example, in ACM Partnership v. Commissioner, a case in the Third Circuit of Appeals (1998), Colgate-Palmolive sells (in 1988) a wholly-owned subsidiary for a long-term capital gain of approximately $104 million. In order to create a tax loss to offset its large gain, Colgate enters into partnership with ACM (owned 94% by Colgate) and makes an installment sale of property to a nontaxable foreign entity. In the first year of the installment sales contract, the foreign entity has a large interest in the partnership and reports a large nontaxable gain, “owning” over 90% of that gain. In year two, after adjustment of ownership interests so that ACM now owns most of the partnership with the foreign entity, the property is sold at a loss, and presto!, ACM (i.e., Colgate) is the beneficiary of a large tax loss it uses to offset Colgate’s $104 million gain.
In the majority opinion, the court looks to the economic substance (pdf file) of this complicated transaction and finds little substantial economic effect other than the conjuring up of a tax loss to offset Colgate’s earlier taxable gain. Moreover, it finds a glaring absence of a sound business purpose and rules the real purpose of the transaction is a scheme to avoid federal income taxes.
Here are some additional resources on tax avoidance:
Many happy returns, Roger
[...] The basis of property acquired by gift also deviates from the general rule; it is the lesser of fair market value or the donor’s adjusted basis at the time of gift. And in contrast to inherited property, the basis of gifted property (in the lexicon of tax law, a “gifted property” is not an exceptionally intelligent property but rather something that is given away) is adjusted for tax paid on appreciation up to the time of transfer. However, if property acquired by decedent within one year of death by gift is transferred back to donor or donor’s spouse upon donee’s death, the rule that property acquired from a decedent is stepped up to fair market value is abandoned and the transferred property is assigned a basis equal to the donee’s immediately before death. This provision in the Code denies the tax benefit of a stepped-up basis to the donor in a transaction that is in substance tax avoidance. [...]