Small Business Taxes & Management

Special Report

Form over Substance


Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.



Form and Substance--A Case

Just conforming to the letter of the law may not be enough. The IRS and the courts can look to the substance of the transaction. That was the situation in a recent case. Because the facts were more involved than necessary for illustration, we won't cite the actual case. While it involved the first-time homebuyer credit (which expired in 2010), that's not the lesson to be learned here.

Here the taxpayer and his wife claimed the first-time homebuyer credit. We won't delve into all the requirements, but the basics are straightforward. You can't have an ownership interest in a principal residence within the past three years and you can't have acquired the property from a related party.

Kevin and Melissa, were living in a property (Madison) recently acquired by Kevin's mother Janie. She had purchased in as an investment property, but Kevin (and Melissa) lived there rent-free. Janie sold Madison to John and Donna, an unrelated couple, for $10 and other valuable consideration. On the same date Kevin and Melissa entered into an agreement to purchase Madison from John and Donna for $85,000, financing the entire amount. They agreed to make payments on the note and make a balloon payment in 2013. Only a few payments were made; John and Donna never attempted collection. Kevin and Melissa stayed in Madison the entire time.

John and Donna were the owners of a property (Columbia) which was their principal residence for many years. They moved into an adjacent house and sold Columbia to Janie on the same date Janie sold Madison to John and Donna. On the same date, John and Donna's daughter, Mollie, agreed to purchase Columbia for $85,000 from Janie for a note with exactly the same terms as that contained in the note signed by Kevin and Mellissa. Mollie never made any payments on the note.

(The significance of the $85,000 for each property may now be lost. However, the first-time homebuyer credit was equal to 10% of the purchase price, with a maximum amount of $8,000. Thus, even if the property price had been twice that, the credit would still be the same.)

The court agreed with the IRS in denying the taxpayers the first-time homebuyer credit.

The court stated it was the substance of a transaction, not its form, that governs when calculating the federal income tax consequences of a transaction. The economic-substance doctrine, also called the sham-transaction doctrine, provides that a transaction ceases to merit tax respect when it has no economic effects other than the creation of tax benefits. Even if the transaction has economic effects, it must be disregarded if it has no business purpose and its motive is tax avoidance. On the other hand, a transaction that has economic effects and a valid business purpose should be respected for tax purposes. Here the court found the substance very different than the form. In essence John and Donna engaged in a property swap with Janie, making it appear their respective children qualified for the credit. John and Donna never took possession of the Madison property. While they had legal title, they never lived in the house, Kevin and his wife never vacated the house and were never charged rent for the time they lived in it but did not own it. Perhaps the worst evidence against the taxpayers was that essentially no payments were made on the identical notes and neither seller ever tried to collect.

The transaction complied with the wording of the law. The parties from whom the properties were purchased were not related and the other requirements were met. But it certainly did not meet the spirit of the law and, there was no economic substance. The first question you should ask yourself is "does this sound too good to be true?" If it does, it's time to consult a professional. There are some loopholes in the tax code, but not many.


Special Situations

There are many situations where the IRS raises the substance over form issue. In some cases there's a provision in the regulations, ruling, or case. Often there's nothing in writing because no one considered the issue. Below are some situations that could cause a transaction to be disregarded for tax purposes.

Reciprocal rentals. There's nothing wrong with renting equipment (or property) to another business and renting equipment (or property) from them. For example, during the summer busy season, Fred rents a tractor from Mike for his farm. In the winter Fred rents a backhoe to Mike for his snow plowing business. Clearly there are valid business reasons. On the other hand, Sue rents her personal 45-foot sailboat to James for a month during the summer; James rents his comparable boat to Sue. Both claim passive losses from the rentals that offsets passive income from other activities. The arrangement is likely to be challenged.

Related parties. Any transaction between related parties is always open to question. Some are in the Code. For example, even if you're on the accrual basis your business can't deduct rental payments for the business property you own until you report the income for tax purposes. Losses on sales between related parties come under special rules as do like-kind exchanges.

If you have more than one business, transactions between the business are subject to scrutiny. The transactions should be at arms' length. In some cases special rules apply. That can extend to a business owned by a relative with which you do business. Paying an excessive (or too low) rental for equipment your brother's business owns can be recharacterized by the IRS.

Protected losses. Madison LLC needs additional capital. Your friend Mike asks you to invest. He guarantees to make you whole from any losses if at the end of three years you need to bail out. Any loss would probably not be deductible. (The wording can be critical.) There can be other situations where you'll be made whole for losses, you agree to repurchase property sold, etc. where you can't take the losses.

Step transaction doctrine. The IRS can collapse multiple steps in a transaction. For example, rather than sell your fully depreciated business assets to Sue you contribute them to a corporation in which you're the only shareholder. The next day you sell all the shares to Sue for a capital gain that you use to offset accumulated capital losses. The IRS could claim the transaction was simply a sale of assets to Sue.

These are some of the more common situations. There are plenty more out there. Some are easy to spot; many are not. Talk to your tax advisor. At a minimum you should be able to avoid the accuracy-related penalty if you rely on his call.


Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536

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--Last Update 05/23/14