Substance over Form: Friend of the Taxpayer?

In the recent Complex Media[1] case, the Tax Court addressed a taxpayer’s ability to recast the form of a transaction under the “substance over form” doctrine. Since taxpayers typically control the form their transactions take, tax decisions routinely stick taxpayers with the consequences of that form. Some courts have precluded taxpayers from even raising substance over form as an argument. Complex Media gives a detailed discussion about the circumstances when a taxpayer may raise “substance over form” which generally applies when the substance of a transaction is different than its form. In that case, the argument is that the substance of a transaction, rather than its form, should control the tax treatment.

Beyond Complex Media addressing when a taxpayer’s assertion of substance over form will be considered, taxpayers also have recently prevailed in other cases involving substance over form arguments by the IRS in Summa Holdings[2] and two other Circuit Courts of Appeals cases addressing the individual taxpayers in Summa Holdings[3]. While these cases do not address the issue of whether a taxpayer may raise substance over form to recast their own transactions, they show another chink in the armor of the substance over form doctrine as a sword for the IRS.

In those cases, to oversimplify, where the taxpayer’s form was within the requirements of statutes offering tax benefits adopted by Congress then the IRS cannot use substance over form arguments to eliminate those benefits. However, see also a case where a taxpayer lost on the IRS’ substance over form argument on facts similar to Summa Holdings[4] as well as a pair of opinions from the Circuit Court of Appeals denying taxpayers the right to raise substance over form whatsoever[5]. Prior to Complex Media, we wrote about some of these cases, addressing taxpayer victories and defeats in substance over form cases[6]. A discussion of these cases is beyond the scope of this writing but worth mentioning as important, taxpayer friendly developments in the evolution of the substance over form doctrine since historically, this doctrine has been much more friendly to the IRS than to the taxpayer.

Taxpayers’ Attempts to Raise Substance Over Form

Taxpayers have had a tough time in raising substance over form arguments. Since the taxpayer choses the form, traditionally the taxpayer is stuck with the consequences of the form chosen. On the other hand, since the IRS did not choose the form a transaction takes, the IRS is free to seek to recast the tax treatment of a transaction to reflect the substance of that transaction rather than merely the transaction’s form.

As stated above, in a handful of recent cases, taxpayers have lost in the face of their own substance over form arguments. Some relevant quotes from cases addressing a taxpayer’s ability to recast the form of their own transactions include:

  • “While a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not.”[7]
  • “We have not held that the ‘substance over form’ doctrine is available to a taxpayer as well as the government. Indeed, we have previously rejected the notion that the taxpayer can ‘escape the tax consequences of a business arrangement which he made upon the asserted ground that the arrangement was fictional.’”[8]
  • The taxpayer’s “argument for substance over form is a nonstarter. Taxpayers are ordinarily ‘liable for the consequences of the transactions they actually execute and may not reap the benefit of some other transaction they might have made.”[9]
  • “Taxpayers ordinarily are bound by the ‘form’ of their transaction and may not argue that the ‘substance’ of their transaction triggers different tax consequences.”[10]

Clearly, taxpayers have not fared well in seeking to undo the form of their own transactions. Perhaps that is good policy.[11] However, as will be discussed below, these general principals do not always prevent taxpayers from prevailing on that argument.

“A party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.”[12] Also, in a case involving valuation of a noncompete agreement, the Second Circuit Court of Appeals set forth what has been described as the “strong proof standard” that “when the parties to a transaction such as this one have specifically set out the covenants in the contract and have there given them an assigned value, strong proof must be adduced by them in order to overcome that declaration.”[13] However, even when substance over form is a two way street it “seems to run downhill for the Commissioner and uphill for the taxpayer.”[14]

Complex Media

The facts involving the transactions in Complex Media are interesting, but the point of this writing is to specifically address the Court’s discussion of the substance over form doctrine. Judge Halpern went through a lengthy analysis, citing numerous cases involving whether taxpayers may raise substance over form and, if so, what standards should apply. For those interested in the issue, the opinion is a worthwhile read.

After that review, the opinion notes that there is currently no rule which articulates any higher burden on the taxpayer to prove facts supporting substance over form. Likewise, there is no rule which sets forth a higher quantum of evidence needed. While recognizing substance over form is a tougher argument for a taxpayer to make, the rule of law which sets forth that difficulty has not been established other than the subjective standards of Danielson or Ullman (“strong proof”). In Complex Media, Judge Halpern set forth the rule of law as follows:

“the additional burden the taxpayer has to meet in disavowing transactional form relates not to the quantum of evidence but instead to its content—not how much evidence but what that evidence must show by the usual preponderance. The Commissioner can succeed in disregarding the form of a transaction by showing that the form in which the taxpayer cast the transaction does not reflect its economic substance. For the taxpayer to disavow the form it chose (or at least acquiesced to), it must make that showing and more. In particular, the taxpayer must establish that the form of the transaction was not chosen for the purpose of obtaining tax benefits (to either the taxpayer itself, as in Estate of Durkin, or to a counterparty, as in Coleman) that are inconsistent with those the taxpayer seeks through disregarding that form. When the form that the taxpayer seeks to disavow was chosen for reasons other than providing tax benefits inconsistent with those the taxpayer seeks, the policy concerns articulated in Danielson will not be present.”

Working through this analysis on the taxpayer’s facts, the opinion notes the existence of a valid non-tax reason for structuring the transaction in a way that did not conform to its substance for tax purposes. Here, that purpose related to the funding of a series of corporate transactions. Further finding no tax related motivation for this structuring relating to the issues before the Court, the Court allows recharacterization of the transaction in accordance with the taxpayer’s position.

Conclusion

Certainly, notwithstanding Complex Media, a taxpayer does not want to be in the position of having to argue and rely upon substance over form. Proper tax planning should be undertaken as part of structuring transactions to put in place a transactional form which results in the best tax treatment available. Attempts to recast transactions after-the-fact in tax disputes puts the taxpayer in a difficult position. However, as seen in Complex Media, all is not lost for the taxpayer in that unfortunate position. If the taxpayer can meet the proof requirements established in Complex Media, then the taxpayer may find a way to reach their intended result.

It is important to note that Complex Media was not an opinion from the full Tax Court. Rather, it is the opinion of a single judge in a single case. As a result, this does not have precedential effect in other cases. Also, this case was appealable to the Second Circuit Court of Appeals. Had the case been appealable to the Third Circuit or the Fifth Circuit where the Danielson rule has been adopted, then Judge Halpern may have felt compelled to a different result (although the opinion notes that the policy concerns of Danielson were not present in Complex Media which may have allowed the court to avoid feeling bound). Given the split of Circuit Courts of Appeals this potential sets up, it may be that the U.S. Supreme Court ends up speaking on this issue again in a future case.

With the decision in Complex Media, especially if it is followed by the Tax Court in other cases, taxpayers have a much clearer path when trying to invoke substance over form. Combined with the taxpayer victories in Summa Holdings and the related cases involving the affected individual taxpayers from the Sixth, First, and Second Circuits, the IRS has been dealt some serious blows in raising substance over form and attempting to prevent taxpayers from doing the same. For tax advisors, it will be important to follow development of the law in this area. The playing field may be leveling or at least tilting past fully vertical.

[1] Complex Media, Inc., TC Memo 2021-14

[2] Summa Holdings, Inc. v. Comm’r, 848 F.3d 779 (6th Cir. 2017), but see Hawk, Jr. v. Comm’r, 924 F.3d (6th Cir. 2019) clarifying the court’s opinion in Summa Holdings

[3] Benenson v. Comm’r, 887 F.3d 511 (1st Cir. 2018) and Benenson v. Comm’r, 910 F.3d 690 (2nd Cir. 2018)

[4] Mazzei, 150 T.C. 138 (2018), note that this case from a divided Tax Court (4 judges dissenting at least in part to the full court’s opinion) is currently on appeal to the Ninth Circuit Court of Appeals

[5] Messina v. Comm’r, 799 Fed.Appx. 466 (9th Cir. 2019) and Meruelo v. Comm’r, 923 F.3d 938 (11th Cir. 2019)

[6] Sage, Joshua W., “Sixth Circuit Clarifies Substance Over Form Doctrine in ‘Midco’ Case,” May 29, 2019, https://esapllc.com/hawk2019/ and Gray Edmondson, “Substance Over Form: No Friend of the Taxpayer,” Jan. 15, 2020, https://esapllc.com/messina9thcir/#easy-footnote-bottom-12-939

[7] Comm’r v. Nat’l Alfalfa Dehydrating and Milling Co., 417 U.S. 134 (1974)

[8] Messina, 799 Fed.Appx. at 468

[9] Meruelo, 923 F.3d at 944-45

[10] Meruelo at 945.

[11] See discussion of policy grounds supporting disallowing taxpayers from raising substance over form at Danielson v. Comm’r, 378 F.2d 771, 775 (3d Cir. 1967)

[12] Id.

[13] Ullman v. Comm’r, 264 F.2d 305 (3d Cir. 1959)

[14] Estate of Rogers, TC Memo 1970-192