State Tax Snapshot: Navigating or Avoiding State Tax Audits in the Wake of Increased Use of the Sham Doctrine

“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.

  • For transactions involving entity creation, make sure the entity carries on substantive economic or business activity. A newly-created entity must have “economic substance,” meaning that it must have a business purpose other than mere tax avoidance (although the precise articulation of this standard may vary by state). Characteristics of entities lacking economic substance include a circular flow of funds between that entity and related parties, a lack of a meaningful shift in economic or financial interests, and the unlikelihood of a non-tax potential for profit enhancement.
  • It therefore follows that such structure/transaction must have a legitimate nontax purpose. These could include any of the following: management and operational purposes, financial purposes, budgetary purposes, legal liability or risk management purposes, and regulatory purposes. In addition, it is important to understand that certain transactions will entail different levels of scrutiny – with no set standard to follow. For example, intercompany transactions typically invite heightened scrutiny as compared with transactions involving unrelated parties.  
  • It is important to structure transactions to meet a respective jurisdiction’s doctrinal tests. This is a fact-intensive exercise and needs to be carefully executed and considered throughout implementation. This can be accomplished by understanding how an auditor has been or will be attempting to apply any of the anti-abuse doctrines at his or her disposal.
  • Documentation of facts, concerns, and analysis is vital. In addition, be mindful of what is documented. Cases involving these doctrines are often littered with “smoking gun” memos or emails in which a taxpayer has explicitly divulged a transaction’s true or “sole” purpose of avoiding or minimizing tax.  
  • Taxpayers should avoid transactions with “inevitable” outcomes. Typically, a non-tax business purpose entails risks, as well as benefits, associated with future options and decisions – these should be highlighted and well-documented.
  • If a transaction/structure is of questionable legitimacy to begin with, make sure you develop clear litigation strategy, should the need for one arise. 

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