“The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”
-Gregory v. Helvering, 293 U.S. 465, 469 (1935)
Taxpayers frequently rely on this oft-cited quote as the foundation for justifying or vindicating certain tax-friendly business decisions, activities and restructurings. However, such reliance has its boundaries, explained Kendall Houghton and Matthew Hedstrom of Alston & Bird in the recent Bloomberg BNA Webinar “Guarding Against State Sham Transaction or Economic Substance Doctrines.”
According to Gregory, not only must such decisions and activities conform to the letter of the law, they must also accord with legislative intent, Houghton and Hedstrom explained.
In addition to the limitations associated with Gregory, courts and taxing authorities use certain common law doctrines as tools to remediate instances of perceived exploitation of the tax laws, they said. In the years since Gregory, doctrines such as the sham transaction, business purpose and economic substance doctrines, among others, have emerged as tools to disallow certain tax benefits associated with business structures. The federal government, along with several states, has even codified the economic substance and/or sham transaction doctrines to target perceived abusive tax strategies.
Recently, there is a growing trend among state revenue departments to utilize these doctrines. Such utilization has, to date, largely produced favorable results for taxing authorities. Indeed, courts and tax boards/administrative courts have demonstrated a willingness to affirm a tax department’s determinations to set aside or ignore certain business transactions and/or to re-characterize certain corporate structures.
Accordingly, as revenue departments accumulate more and more victories, those departments continue to test the limits of these doctrines. Currently, revenue departments are afforded a certain amount of leeway when determining whether to challenge the legitimacy of tax-motivated business decisions. Revenue departments have these doctrines at their disposal and can wield them more or less at their discretion – a tremendous advantage when audit issues arise.
However, with increased utilization and success, applicability issues emerge. The nature of complex transactions and structures are such that providing any sort of guidance on avoiding audit ramifications is extremely challenging. That being said, the desire for tax reduction or avoidance has not diminished. Taxpayers can still rely on Gregory as a basis for certain tax-motivated planning, they just need to be mindful of the limitations of such reliance.
Houghton and Hedstrom spoke of, among other topics, practical considerations that should be taken into account when constructing tax plans or strategies in states with a recent history of utilizing the aforementioned doctrines.
Specifically, they highlighted the following as guidelines for navigating or defending the state tax audit inquiries and tax assessments where the anti-abuse doctrines are invoked.
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