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By David I. Kempler, Esq. and Elizabeth Carrott Minnigh, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
The "step transaction" doctrine is a judicially developed doctrine which is a part of the so-called "substance over form" doctrine. Its purpose is to condense or recharacterize supposedly separate steps of a transaction into a single step or a different transaction to insure that the substance of a transaction governs as opposed to its form.1 There is no single accepted test as to when and how the step transaction doctrine should be applied; rather the courts have employed three alternative tests in deciding whether to invoke the step transaction doctrine: (i) the "binding commitment" test, (ii) the "end result" test and (iii) the "interdependence" test. A recent case shows the application of the "step transaction" to bargain sales of property to a charity.
As a general rule, a taxpayer who sells property to a charitable organization for less than its fair market value (i.e., a "bargain sale") is entitled to a charitable contribution deduction under §170(a) of the Internal Revenue Code of 1986, as amended (the "Code"), equal to the difference between the fair market value of the property and the amount realized from its sale.2 In Klauer v. Comr.,3 the Tax Court held that the step transaction doctrine did not apply to a multi-phase bargain sale of land from an S-corporation to a non-profit land trust, and, therefore, the S corporation and its owners were entitled to charitable contribution deductions.
An S corporation manufacturing company (the "Company") owned property located in Taos, New Mexico (the "Property"). In 2001, the Company granted the option to a public land trust (the "Trust") to purchase a portion of the Property in three phases over a three-year period. Ultimately, the Trust obtained the funding necessary for each phase of the purchase and exercised its options to purchase in all three phases, paying a total of $15 million. However, the option agreement was amended in 2002 to permit the Trust to purchase a smaller portion of the property in the second phase and to extend the deadline for exercising the option by one month, and was further amended in 2003 to extend the deadline for exercising the option to purchase the balance of the property by one month. The Company reported the sale as a bargain sale, and its shareholders claimed corresponding charitable deductions totaling $2,935,619 in 2001, $1,227,934 in 2002 and $1,665,251 in 2003. However, the IRS disallowed the charitable deductions on the grounds that the step transaction doctrine applied and that all portions sold should be treated as having been sold in 2001 for their fair market value of $15 million.
First, the Tax Court considered the binding commitment test, under which a series of transactions will be collapsed into a single step if, at the time the first step is entered into, there was a binding commitment to undertake the later step or steps.4 The IRS argued that the option agreement between the Company and the Trust was a binding commitment because the Company was obligated to convey to the Trust each portion of the Property upon exercise of the option. However, the Tax Court found that no binding commitment existed, since at the time the option agreement was entered into, the Trust did not have sufficient funding to purchase each of the parcels and the Trust's funding for previous land acquisition projects had relied heavily on appropriations by Congress, which are uncertain, limited and vary from year to year. Moreover, the Tax Court noted that the Trust had to solicit funds in each of the years to complete the three phases of acquisition and, if the Trust had been unable to obtain the funds needed to purchase any portion of the property, the Company would have retained that portion of the Property. Accordingly, the Tax Court found that the binding commitment test had not been satisfied since at the time the agreement was signed the Trust had no assurance that it would be able to solicit the funds necessary to purchase each separate portion of the Property.
The Tax Court then considered the end result test, under which the step transaction doctrine will be invoked if a court concludes that a series of formally separate steps are actually prearranged parts of a single transaction intended from the outset to reach a specific result.5 The IRS argued that the Company intended to sell all of the Property to the Trust and that the sale was broken into as a series of three transactions to increase the likelihood of its success. In support of its contention, the IRS further contended that there was no question that the Trust would find the funding necessary to complete this transaction and that the Company and the Trust worked together to ensure this happened by deviating from the purchase price and the acreage in the second and third phase as scheduled in the option agreement. The Tax Court rejected the IRS's argument and found that the multi-phase option agreement was, in fact, the result of the uncertainty by the Trust of having the funds available to purchase each portion of the property rather than prearranged parts of a single transaction. Moreover, the Tax Court noted that after the purchase of a smaller portion of the Property in the second phase, the ability to purchase the remaining land in the third phase remained uncertain.
Finally, the Tax Court considered the interdependence test, which looks to whether "the steps are so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series."6 The IRS argued that the Company and the Trust intended from the beginning to transfer the entire parcel of land to which the option agreement applied, and that the options were merely interdependent steps to reach that goal. The Tax Court rejected this argument, noting that the option agreement was specifically structured in three phases because the Trust could not be certain of having the funding to purchase each portion of the property because of its need to solicit funds annually and that the Trust's purchase of one or more, but not all, of the specified portions of the Property would not have been fruitless. Accordingly, the Tax Court found that the interdependence test did not apply.
After rejecting each of the step transaction tests, the Tax Court concluded that the Company had made a bargain sale and its shareholders were therefore entitled to a charitable contribution deduction in an amount equal to the difference between the fair market value of the property and the amount realized from its sale.
This case is a good example of the application of the step transaction doctrine in this area.
For more information, in the Tax Management Portfolios, see Kirschten & Freitag, 521 T.M., Charitable Contributions: Income Tax Aspects, and in Tax Practice Series, see ¶2390, Charitable Contributions: Requirements for Deductions.
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