The Step Transaction Doctrine Explained
The idea behind the Step Transaction Doctrine is that with respect to certain transactions involving multiple parts and components — the individual parts will be treated together as a full transaction — and not as separate individual parts. It is invoked when the IRS believes Taxpayers may have engaged in a series of sham transactions — and that the separate parts to the transactions should not be treated separately — so that the Taxpayer can artificially reduce their tax bill — but rather a single transaction. Common examples include preparing sham corporations to facilitate reorganizations which the IRS may not find Kosher — or when Taxpayers place highly appreciated assets into certain foreign trusts, which are staggered and distributed tax-free — in which the gain that would have otherwise been taxable has the asset been sold in the US. To prevent these artificial tax reductions, the step transaction doctrine serves to avoid the artificial relief from taxation.
IRS Summary of Step Transaction Doctrine
The IRS provides the following summary from a 2008 memorandum: Under the step transaction doctrine, “a series of transactions designed and executed as parts of a unitary plan to achieve an intended result … will be viewed as a whole regardless of whether the effect of so doing is imposition of or relief from taxation.” FNMA v. Commissioner, 896 F.2d 580, 586 (D.C. Cir. 1990), cert. denied, 499 U.S. 974 (1991) (citing Kanawha Gas & Utilities Co. v. United States, 214 F.2d 685, 691 (5th Cir. 1954)); see also Minnesota Tea v. Helvering, 302 U.S. 609, 613 (1938) (“[a] given result at the end of a straight path is not made a different result because reached by following a devious path”).
Courts have applied three alternative tests in deciding whether to invoke the step transaction doctrine:
(1) the “end result” test, under which the transaction will be collapsed if it appears that a series of formally separate steps are really prearranged parts of a single transaction intended from the outset to reach the ultimate result, see King Enterprises, Inc. v. United States, 418 F.2d 511, 516 (Ct. Cl. 1969);
(2) the “mutual interdependence” test, which focuses on whether “the steps are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series,” Redding v. Commissioner, 630 F.2d 1169, 1177 (7th Cir. 1980), cert denied, 450 U.S. 913 (1981); and
(3) the “binding commitment” test, under w hich a series of transactions is collapsed if, at the time the first step is entered into, there was a binding commitment to under take the later step. See Commissioner v. Gordon, 391 U.S. 83, 96 (1968).
With the end-result rest, the idea is that each transaction is a cog on the wheel in reaching a certain final result — and that without the separate transactions, the final result would not be achieved — and so the transaction should be considered as a whole and not the individual parts separately.
Mutual Interdependence Test
The mutual interdependence test relies on the concept that when the transactions are interdependent so that when the first transaction occurred, it would be considered empty but for the second transaction occurring — the step transaction doctrine may be invoked.
Binding Commitment Test
The idea behind the binding commitment test is that two transactions are part of the same grater scheme — and there was a binding commitment to enter into the second transaction when the first transaction occurs. In other words, the second transaction was already arranged to occur at the time of the first transaction — and so the transactions should be treated as a whole and not separately.
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