Most tax law is made up of very detailed statutes, regulations, case law, and other guidance. Layered on top of that body of law are a number of “judicial doctrines” that seek to serve as a backstop to formalistic analyses that could result in unintended tax results, allow taxpayers to place the form of transactions over the substance of transactions, or otherwise thwart the intent of Congress or the Treasury in developing tax law. Some of those legal doctrines include business purpose, sham transaction, substance over form, step transaction, and economic substance (which has now been codified).
Although courts have sometimes blurred the distinction between these various doctrines, each of them is unique. Particularly with codification of the economic substance doctrine and applicability of a special strict liability penalty to transactions lacking economic substance, it is important that the IRS and courts recognize the separateness of these doctrines. The Court of Appeals for the Federal Circuit recently overturned an opinion of the Court of Federal Claims finding that the trial court improperly used a “hybrid legal standard” by conflating the economic substance doctrine and the step transaction doctrine. In so doing, the Court of Federal Claims recognized the importance of proper analysis.
Economic Substance Doctrine
The codified economic substance doctrine became law in 2010. Although the economic substance doctrine existed well before that time, Congress converted this judicial doctrine to statute as part of the Health Care and Education Reconciliation Act of 2010. Under the codified economic substance doctrine, the steps to the analysis are as follows:
- Determine whether the economic substance doctrine is relevant to the transaction based on pre-codified law;
- If the economic substance doctrine is relevant, then the transaction will be treated as having economic substance only if:
- The transaction changes in a meaningful way (apart from the federal income tax effects) the taxpayer’s economic position; and
- The taxpayer has a substantial purpose (apart from the federal income tax effects) for entering into such transaction.
As illustrated here, once the economic substance doctrine is determined to be relevant, there is an objective and a subjective test. Objectively, was there economic substance to the transaction apart from the purported income tax effects? Subjectively, did the taxpayer have substantial, legitimate non-tax purpose in entering into the transaction? If both elements are met, then the economic substance doctrine will not apply to unwind the taxpayer’s intended transactional form and tax consequences.
Since determining the economic substance doctrine to be “relevant” under the statute is new to the analysis from the prior judicial doctrine, there is little law specific to that issue. However, as cited above, this determination is to be made as if the statute had not been enacted. The result appears to be looking at whether pre-codification case law addressed circumstances similar to those at issue.
Step Transaction Doctrine
The step transaction doctrine is a manifestation of the doctrine of substance over form, i.e. that effect should be given to the substance of a transaction, rather than its form. The Tax Court has described the step transaction doctrine as follows:
The step transaction doctrine generally applies in cases where a taxpayer seeks to get from point A to point D and does so stopping in between at points B and C. The whole purpose of the unnecessary stops is to achieve tax consequences differing from those which a direct path from A to D would have produced. In such a situation, courts are not bound by the twisted path taken by the taxpayer, and the intervening stops may be disregarded or rearranged.
When the step transaction doctrine applies, the individual steps in a complex transaction are collapsed into a single integrated transaction for tax purposes. In determining whether the step transaction doctrine should apply, courts generally use one of three tests:
- The End Result Test: “Purportedly separate transactions will be amalgamated into a single transaction when it appears that they were really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result” (emphasis added due to relevancy in GSS Holdings).
- The Interdependence Test: Whether “the steps were so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series.”
- The Binding Commitment Test: “If one transaction is to be characterized as a ‘first step’ there must be a binding commitment to take the later steps.” This test is designed to cover transactions that span several years.
If any of these tests are met, the IRS may prevail in collapsing various steps in a set of transactions to reach a tax result whereby tax is based on the substance of the transaction rather than its form.
The facts of the GSS Holdings case are beyond the scope of this writing. Rather, I will address the court’s analysis of the economic substance and step transaction doctrines. Important here, the trial court granted summary judgment to the IRS on applicability of the “end results test” under the step transaction doctrine. As stated above, that test requires an analysis of the taxpayer’s intent “from the outset” of a series of transactions. It is that requirement that created the significant legal arguments in the appellate court opinion.
Citing to a case involving the economic substance doctrine, the Court of Federal Claims found a series of transactions to be subject to the step transaction doctrine. The appellate court noted that the economic substance doctrine and the step transaction doctrine are “two separate doctrines.” Although the trial court correctly cited to the end result test’s requirement of rendering the relevant analysis “from the outset,” “rather than proceeding to assess intent from the outset as required under the end result test of the step transaction doctrine, the Claims Court instead focused on the transaction giving rise to the alleged tax benefit as taught by the economic substance doctrine.”
The Court of Appeals for the Federal Circuit held that this “hybrid legal analysis” was in error. As a result, the opinion of the Claims Court was vacated with the case remanded for a determination as to the result based on the proper legal standards. Importantly, the taxpayer and the IRS argued regarding what point in time constituted the “outset” for purposes of this analysis. While the appellate court did not render any conclusion as to this question, instead leaving it for the trial court on remand, this highlights the importance of rendering a proper factual analysis based on the evidence. It may well be that the entire outcome of the case turns on whether one point in time versus another is considered to be the “outset” for purposes of the step transaction doctrine.
Most tax practitioners know about the judicial doctrines discussed in this writing. However, many do not engage in the more analytical process the Court of Appeals for the Federal Circuit required in the GSS Holdings case. We often hear comments to the effect of – “I’m worried about step transaction,” “won’t this be an economic substance problem,” etc. Rarely, when those comments are made, is there any analytical basis behind those comments that is subject to the more formalistic requirements for applying those concepts. That is not to say that a “smell test” developed over years of practice is not valuable. Certainly, it is. Rather, as illustrated in GSS Holdings, after that smell test is triggered, it is important to then evaluate those concerns through the lens of the formal legal requirements.
These issues have come up a number of times lately and continue to be litigated. The resolution of common law judicial doctrines in the face of Congressionally enacted statutes is particularly complex. If Congress has chosen to allow certain tax outcomes, then should these doctrines apply to disallow those very outcomes? Are courts and the IRS allowed to look at Congressional intent to evaluate whether the tax results of a transaction fits within the intent of a statute, even where the form does? The cases seem to turn out differently in different contexts. However, courts have held the IRS to what Congress has allowed. Also, there is ongoing Tax Court litigation involving similar considerations with respect to monetized installment sale transactions. These cases, coupled with IRS positions, continue to serve to develop the law in this area. This will be an interesting area for tax professionals to follow. When these issues arise for taxpayers, whether in a controversy with the IRS or in evaluating the propriety of transactions, relying on knowledgeable tax professionals may prove to be very valuable.
 IRC § 7701(o)
 Under IRC § 6662(b)(6) this is a 20% penalty which IRC § 6662(i) increases to 40% if undisclosed on the taxpayer’s return.
 GSS Holdings (Liberty) Inc. v. U.S., 2023 WL 6152419
 Note that, under IRC § 7701(o)(5)(B), the codified economic substance doctrine does not apply to individual taxpayers except for transactions entered into in connection with a trade or business. In these circumstances, the common law judicial doctrine will continue to apply as articulated in the taxpayer’s relevant jurisdiction and strict liability penalties will not apply.
 Pub. L. No. 111-152, 124 Stat. 1029 (March 30, 2010)
 IRC § 7701(o)(1) and (5)(C)
 IRC § 7701(o)(1)
 See American Bar Association Comments on IRS Notice 2010-62 (January 18, 2011), https://www.americanbar.org/content/dam/aba/administrative/taxation/migrated/pubpolicy/2011/011811comments.pdf
 See Falconwood Corp. v. U.S., 422 F.3d 1339, 1349 (Fed. Cir. 2005); regarding a taxpayer’s ability to raise substance over form, versus the IRS, see Gray Edmondson, “Substance Over Form: No Friend of the Taxpayer,” Jan. 15, 2020, https://esapllc.com/messina9thcir/; and Gray Edmondson, “Substance Over Form: Friend of the Taxpayer,” April 20, 2021, https://esapllc.com/complex-media-2021/
 Smith v. Commissioner, 78 T.C. 350, 389 (1982)
 True v. U.S., 190 F.3d. 1165, 1174-75 (10th Cir. 1999)
 For a more complete discussion of the step transaction doctrine, including these three tests, see Ray A. Knight and Lee G. Knight, “A Walk Through the Step Transaction Doctrine,” The Tax Advisor, May 1, 2021, https://www.thetaxadviser.com/issues/2021/may/step-transaction-doctrine.html#fn_9
 Security Indus. Ins. Co., 702 F.2d 1234, 1244 (5th Cir. 1983)
 King Enterprises, 418 F.2d 511, 516 (Ct. Cl. 1969)
 Redding v. U.S., 630 F.2d 1169, 1178 (7th Cir. 1980), citing Commissioner v. Gordon¸ 391 U.S. 83, 96 (1968)
 McDonald’s Restaurants of Ill. v. Commissioner, 688 F.2d 520 (7th Cir. 1982)
 Coltec Indus., Inc. v. U.S., 422 F.3d 1340
 See, e.g., Summa Holdings, Inc. v. Commissioner, 848 F.3d 779 (6th Cir. 2017). See also, Joshua W. Sage, “Sixth Circuit Clarifies Substance Over Form Doctrine in ‘Midco’ Case,” May 29, 2019, https://www.esapllc.com/hawk2019/
 See IRS Amendment to Answer in the case of Harty v. Commissioner https://www.taxnotes.com/research/federal/other-documents/other-court-documents/irs-amends-answer-in-tax-court-regarding-economic-substance/7hckc, and the taxpayer’s brief in the same case https://www.taxnotes.com/research/federal/other-documents/other-court-documents/couple-argues-installment-sale-transactions-qualify-for-deferral/7hckd#7hckd-0000051
 See, e.g., IRS memorandum regarding application of economic substance issued April 22, 2022, https://www.irs.gov/pub/foia/ig/sbse/lbi-04-0422-0014.pdf