By Alex D. Szarenski, Katz Sapper & Miller
The substance-over-form doctrine broadly holds that the economic substance of a transaction should be considered over the legal form in order to determine the true nature of a transaction. The doctrine is a well-established argument often used by the IRS to dispute transactions that, it believes, lack economic substance. Taxpayers have traditionally had less success invoking the doctrine because they generally play an active role in drafting the form of the transaction. However, in the recent Tax Court case of Complex Media, Inc. v. Commissioner,1 the Court clarified, as the Court’s caselaw has evolved, “it has become more hospitable to taxpayers seeking to disavow the form of their transactions.”
The Court noted that taxpayers face a higher burden of proof than the IRS in challenging a transactional form. While the IRS may meet its by showing that the form of a transaction does not reflect the economic substance, a taxpayer must “make that showing and more.” Specifically, the taxpayer must demonstrate to the Court that the form of the transaction was not chosen in order to obtain tax benefits inconsistent with the treatment sought be the taxpayer.
It is also worth noting that a taxpayer’s success in arguing substance-over-form will likely be determined by the Circuit in which the taxpayer is arguing. For example, in Commissioner v. Danielson2, the Third Circuit held that “a party can challenge the tax consequences of his agreement as construed by the Commissioner only be 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.” The Fifth Circuit has since adopted the Danielson rule in several cases, making it unlikely that a taxpayer’s substance-over-form argument would be effective in either Circuit. However, in Complex Media the Tax Court makes it clear that the Tax Court has never accepted the Danielson rule and will continue to consider substance-over-form arguments made by taxpayers so long as the case in not appealable to any Circuit Court that has accepted the Danielson rule.
Although other Circuit Courts have addressed the Danielson rule in the past, the Tax Court only specifically addresses the Third and Fifth Circuit in Complex Media. At this time, it is unclear how other Circuit Courts will react to the Tax Court’s ruling in Complex Media. However, the Tax Court makes it clear that it will continue to consider substance-over-form arguments from taxpayers. In jurisdictions in which the argument is available, the allowance of a substance-over-form argument by the Tax Court provides an additional opportunity for taxpayers and tax advisors to strengthen their case with an additional, well-reasoned argument.
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1Complex Media, Inc. v. Commissioner, TC Memo 2021-14, February 10, 2021.
2Danielson v. Commissioner, 378 F.2d 771, 775 (3d Cir. 1967).