What Does a "Real" Transaction Look Like?

In my last post, I noted there is a difference between "real" and "tax shelter" transactions, with the former being legitimate and the latter being suspect in the eyes of the IRS and possibly the DOJ. That leads to the following question: what do we, as planners, need to demonstrate or prove in order for a transaction to be recognized as legitimate in the eyes of the taxing and enforcement authorities?

Unfortunately, most anti-avoidance cases express this in the negative -- you can't do this or that. However, the Frank Lyon case (435 U.S. 561 (1978)) provides us with a positive example by providing a list of factors to comply with. Here is the court's syllabus of the facts:

A state bank, which was a member of the Federal Reserve System, upon realizing that it was not feasible, because of various state and federal regulations, for it to finance by conventional mortgage and other financing a building under construction for its headquarters and principal banking facility, entered into sale-and-leaseback agreements by which petitioner took title to the building and leased it back to the bank for long-term use, petitioner obtaining both a construction loan and permanent mortgage financing. The bank is obligated to pay rent equal to the principal and interest payments on petitioner's mortgage and has an option to repurchase the building at various times at prices equal to the then unpaid balance of petitioner's mortgage and initial $500,000 investment. On its federal income tax return for the year in which the building was completed and the bank took possession, petitioner accrued rent from the bank and claimed as deductions depreciation on the building, interest on its construction loan and mortgage, and other expenses related to the sale-and-leaseback transaction.

Central to this case was the fact the regulatory issues prevented the bank from owning the mortgage on its books, forcing the bank to enlist the help of other parties in the transaction. That was a :business or regulatory reality" that made this multiple party transaction "real" from a tax planning perspective.

Here are the factors the court gives us:

-- there is a genuine multiple-party transaction
-- with economic substance that is
-- compelled or encouraged by business or regulatory realities,
-- that is imbued with tax-independent considerations, and
-- that is not shaped solely by tax-avoidance features to which meaningless labels are attached.

When putting together a transaction, planners need to ask the bigger questions beyond mere technical compliance with the law. Donald Korb of the IRS gave a speech in 2005 on the economic substance doctrine that provides a list of questions to ask regarding any transaction:

-- Is there a non-tax business reason to perform the transaction? In the Frank Lyon case, the taxpayer could point to the regulatory realities of the situation as the primary driver.
-- Did the taxpayer and their advisers actually investigate the transaction? Ask yourself -- did they really comply with the "duty of care" imposed on corporate directors? Did the advisers really comply with their fiduciary duties?
-- Is the taxpayer going to really commit money to the transaction? For example, does the taxpayer get an immediate loan back from a party that comprises most of the money he is committing?
-- Are all the parties involved real and separate from the taxpayer? A big giveaway in many tax shelter transactions are partnerships that disappear after being in existence for less than a year, or that only hold a single investment.
-- Were all steps and transactions engaged in an arms length manner?
-- How was the transaction marketed? This is a big giveaway in many tax shelter cases. If the sales literature or the advisers recommending the transaction talk about taxes and spend little time on substance, there's a big problem.

As advisers, we need to move beyond mere compliance with legal technicalities and instead move to the bigger questions underlying the transaction. In the long run, this will make us far more valuable to our clients as our advice not only encompasses the law but other components of our clients' business.