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Foreign. Hello and welcome to the 47th episode of How Tax Works. I'm Matt Foreman. This episode I'm going to talk about the economic substance doctrine and the step transaction doctrine in an episode I'm going to probably largely call tax, you know, relating to tax focused investments. But this is a substance versus form. In the last episode 46, I talked about economic substance. This one I'm really going to focus on step transaction doctrine. But if you've ever talked about these with any, anyone, you'll, you'll learn that not only are they very closely related, they have a lot of overlap, a lot of concepts. They can kind of substitute for each other and they kind of dip in and out. So it's really important. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions that we all make. Administrative stuff. New episodes of two weeks. The next one is going to be on unrelated business taxable income. Ubti. Totally different topic, but you know, an important one, an interesting one and what I run into more often than I thought I would. You know, nonprofits really exist in a world kind of outside of what I do, but at the same time they, I just keep kind of bumping back into it and some level of structuring, which is, which is always really interesting anyway. So, you know, last time talked about a lot of substance versus form stuff, went through the economic substance doctrine. This one I'm going to talk about the step transaction doctrine. And the step transaction doctrine in my view is, if anything, I think it's more complicated, which is probably why this ended up at two episodes. I think if I had gone really fast with economic substance, I could have gotten through step transaction. I could have gotten through about half an episode. But I, I lengthened it a bit, added in some more details because I want to talk about step transaction doctrine in more detail because I think it's important to do so. The step transaction doctrine at its core permits a series of formally distinct steps to be combined and treated as a single transaction. If the steps in substance are integrated, interdependent and focused toward a particular result. That's from Penrod 88 to Tax Court Case 88 TC 1415. The part integrated, interdependent and focused towards a particular result. Spot site 1428 for, for those who are looking for that one. So there's really three parts to it. Okay, to what I just said. One, distinct steps, two, combined into a single transaction, three, if integrated, interdependent and focused toward a particular result. Now, and I think it's really important, you can have steps that are not problematic at all and a large transaction that are integrated, interdependent and focused toward a particular result. I have seen PLRs written where there is an overt, obvious thing that they are structuring to get a tax result that they want. And they tell the IRS this is. And the IRS looks at it and goes, oh, these steps are integrated, interdependent, and focused toward particular result. Go right ahead, have at it. The point is this. You can meet all three of those points and not have a transaction that's collapsed by the step transaction doctrine. There's more stuff that goes on. There's more reason to or not to do things than just that part. But I think Penrod's a really good case to start with because it really, really, really opens up and starts talking about a lot of the core concepts you run into with the step transaction doctrine. So if you're looking to get into it, that's the way to go, Right? I'm going to read it again. Penrod 88TC 1415. All right. So at its core, and the way I think about step transaction doctrine, if the goal is to go from A to B, you can't add in steps to go you from A to Z. Right? You're going to ignore B through. Yes. So the steps, the A and Z exist, you collapse the rest of the transaction. Remember? And this is really an important point, I talked about this, okay? Taxpayers are stuck with the form. Okay? You cannot have a form, then say, oh, this is the substance. This is the substance. This is the substance. Unless you have a reason. However, the IRS or states, right, can reimagine. They can. They can add part. Well, they can't add parts, but they can change things to make it important. So the taxpayer can't say, I could have done this, but I did this other thing. The taxpayer is stuck with this chosen form. Really important language. The IRS can send you to Imagination Land or Bologna or San Angeles. Congratulations. If you can identify all three of those, maybe, I'm sorry, whatever. But three, you know, theoretically fictional places. But, you know, what is fiction these days, right? So anyway, so courts, you know, thanks to, I'll just say inconsistent IRS arguments and courts not always working in conjunction, different circuits, things like that have created and also because of complicated Fact patterns. A lot of times these. And be really candid here, the bad, the really bad ones don't go to courts because they get settled because they know they're going to lose. The really, really. The good fact patterns for taxpayers rarely go to courts because the IRS generally doesn't litigate. So it's the mediocre ones that. Those are the ones that you see. And, and those are the ones that tend to have complex fact patterns. Okay. So because of that, we have, you know, what we have is this weird mesh of inconsistent formulations of the step transaction doctrine. Penrod, I think, I think Penrod talks about that, the different ways to do it. And remember, before I get into the formulations of step transaction doctrine, really important to remember, unlike the economic substance doctrine, there is nothing statutory in this. This is case law driven. So the rules can be different in different circuits. They can look at different things in different circuits. Tax court looks at things differently than the various circuits, et cetera. So be careful when you're doing this. As a general rule, if you meet all three, you're good, you're fine, not an issue. So I think that's fine. All right, on that note, could take a quick music break and we are going to come back for the three formulations of the step transaction doctrine. Okay, we're back. It's time to talk about the three different formulations of the step transaction doctrine. They are not as clean different as you think. They have a lot of overlap, and I think that's really important. All right. The three are, one, the binding commitment test, two, the end result test, and three, the interdependent test. It is really important that I talked about integrated interdependent and focused toward a particular result. Focus toward a particular result. That's end result test, integrated. Right. Binding commitment, interdependent, interdependence test. That's it. Right. Penrod talks about all three. It's why, it's why I like it as a case to start with because it really does kind of get through a lot of the stuff you need to talk about and need to go through. We're talking about the step transaction. All right, what? Let's talk about the binding commitment test. Okay. It is, I think it's the narrowest. Some people have argued otherwise. They've said, well, no, I don't, I don't think the binding commitment is. I think it's the interdependence, but whatever, fine. It's my podcast. It's an arrow. No, no, no, no, no. Series of transactions and then here's what the binding commitment test, right? A series of transactions will be stepped together if at the time of the first step there is a binding commitment to undertake a later step or multiple steps. So step together. I'm going to talk about step together. And what that means is you take steps and you collapse them, you combine them, you just sort of put it into one. And what you do is you take it as if you look at the start of one step at the end of the other and you think, well, how can I collapse this? Do I just take out the step? Do I take out a couple steps? Do I really need this little intermediate part? You don't actually, and this is really important, people say, oh, you need a binding commitment. Well, I winked and I nodded. And then the answer is, you do not literally need a binding commitment. Revenue ruling 91 47, there were a lot of revenue rulings on this the early to mid-90s. I'll talk about some of them somewhat, but in revenue ruling 9991 47, I'm going to read it. Steps may be disregarded where there is a pre existing understanding between the parties, even if there's no binding commitment. This is what. And, and I talk about this with lawyers from say, I talk about this as a lawyer fairly frequently, which is like, look, you know, I'm going to do this transaction, but like we don't have a signed agreement. There's nothing binding. And I always say, look, if you were to back out now, would that person be angry at you and consider suing? That's where the binding commitment comes in. That's where the case law comes in. Right? That, that's what they're trying to prevent. They're not trying to prevent they, they being the Internal Revenue Service or state Revenue Agency. They're not really worried about a situation in which you do something and six months later something happens and six months later something else happens and six months later a third, you know, fifth thing. And we're at four years. What they're looking at is, are you right before, you know, do you have an loi? Right. That's not a binding commitment test. It's not a binding commitment. But for the binding commitment test, an LOI or even probably an ioi. Intention, Right. Letter of intent. Intent. You know, IOI is sort of like a promise ring. Then you have the engagement ring and then you have the marriage. Right? Well, look, you have any of those, you probably have a binding commitment. So you may have a binding commitment even if you literally and legally don't have a binding commitment. I always sort of juxtapose this to the concept of real estate closings. And someone once laughed at that because it's kind of silly. But real estate is probably the last area of law that exists where handshakes don't really matter. You could sue someone, probably, but real estate, because it has to be recorded, really needs certain things to happen. Blockchain type transactions maybe too, because they need an actual transaction. But the vast majority of agreements shake a hand. Verbal contracts work. That's it. Number two, end result test, likely the broadest. I think this one's pretty, pretty much guaranteed to be the broadest. But a series of transactions will be stepped together if the transactions are prearranged parts of a single transaction and are intended from the onset to reach an ultimate result. So this focus on intent and at the outset of the transaction there have been transactions that I have been a part of where at the outset they were trying to do something and there was a market shift, someone else came in and we were able to do stuff and sort of shift in a way that it created a good tax result that is okay, that is non problematic. And the reason that it is non problematic is because the, the, the end result test says from the onset. But here's what's really important. A transaction can be defined in different ways and from different starting points and ending points. And they could say it's actually four transactions, right? And a transaction can be a step and transaction itself can have steps, right? So parts, subparts. Think of a book, think of chapters. Chapters have pages, right? So different subsets of each. It's really, really, really, really, really important. And I'm going to say really again because. Because it's really important is that you have to understand that the onset of the transaction can be at different points in the transaction and does not as literally meant the onset the very first moment. It's just not. That's just not what it means. And I've had people argue with me on that. And there's case law on it. That onset and the word transaction defined really narrowly or broadly. So this gives the end result test an incredibly broad application because it can wiggle its way in right? Then. So again, intent at the onset of the transaction. Then third interdependent test, right? A series of transactions will be stepped together if the transactions are so interdependent that the legal relations created by one transaction will be fruitless without the completion of the series. The focus is on the relationship between the transactions, not the End result itself. But you wouldn't do. If you wouldn't do three without doing four, without doing five. Right. Well, that could be problematic now. Okay. If you've ever done certain things right, there are a lot of really non nefarious transactions that you have to do one, then do two, then do three, then do four. That, that's fine. That's a different fact pattern. I'm not worried about that. No one's worried about that. And a lot of those transactions, right, triangular reorgs and things like that, they have multiple steps in them and Congress or courts have said, no, no, that one's fine. We're not worried about that. You could do it otherwise. And what I always say in this is if you could accomplish the exact same tax result by adding in six steps, but you're doing it the same by eliminating steps, you don't have a step transaction factor. But if you're adding in 11 steps to get the same transaction, you could have done with two steps, but it happens up some other weird benefit, that's it. Sometimes you have to do weird stuff because there are regulatory reasons. That's a business purpose. That's different. You know, that's a different function. And that's really important to think about. All right. It can be a, I'll use the word challenge sometimes to know which one to apply. The IRS will apply whichever one works best for it. So whenever I'm analyzing whether we have a step transaction doctrine, I analyze all three. Because if you are fine with all three, then you're fine. If you're fine with two out of the three, then you're checking what circuit and what the rules are. Within each circuit there's a, there's a case. McDonald's of Zion, it was reversed under a new name. I'm not saying the Latin. I took, I took Spanish. My accent is terrible. That's all we got. But 76 Tax Court 942, it was, it was reversed under a new name. McDonald's Restaurants of Illinois. That I can say. 688. Fed Second 520. I did not write down what circuit that is. Illinois 7th Circuit. I know that one. Look at me. The tax court said use the interdependence test and it was fine. The 7 Circuit said, no, no, we're using the binding commitment test to collapse under sub transaction doctrine. And then they say they stepped together. They would have stepped it together under any three of the tests. So like, it's really important to say, like, look, just, just do all of them look at all of them. That's your analysis. That's how you should do it, because you never quite know what you're going to get. The tax court actually still follows McDonald's I. Except in the 7th Circuit. Right. And there's different circuits. It follows different things, different rules, stuff like that. So the case law on this can be really tough, really, really tough to kind of work through and figure out what exactly is going on. The factors in applying. There's really important factors, really, really, really important factors in applying the step transaction doctrine. And I think this is in some ways the first one. The first one is the intent. You know, at the first step or first transaction. Remember, there can be multiple steps. There can be multiple transactions. What is your intent? What are you trying to do? I think with any of them, you have to look at the intent. Intent's really important to temporal proximity. Temporal means related to time. So not. Not temper. Right. But time. Less time is bad. Passive time creates or increases really economic risk. Two years, then maybe, you know, five years is pretty good revenue ruling 6623. It depends. There's no firm rule. I will tell you that if you have, you know, 10, 15 years between steps, you know, they're going to have a really. Unless the bill. The business is like the holding of treasury bills may not be a business anyway, but you know, two years, you know, I've seen one's like, oh, we're going to do this on December 31st and this January 1st, so there's a year between them. And I'm like, those are different tax years. But that's not a year. You know, this isn't. This isn't like, you know, one of the planets like Venus that has like a 250, 250 Earth days for a single day on Venus, but I think it actually goes around the sun faster than it spins. Makes, you know, one day. So the year is longer than the day. Which of course really throws into like the whole idea of days and years into, like, question. But that's way more existential than you probably thought I'd ever get on this podcast. But anyway, so look, there's no firm rule about temporal proximity, but I always tell you, look, let's talk about it. What is business risk? What happens? What. What industry are you in? Some industries risk is six months. Some industries risk is four hours. Exaggerating about four hours. But, you know, it's a thought, right? So that's it. All right. We're going to get a little more music in and Then I'm going to talk about the limitations on the step transaction doctrine, which I think really dovetail well with the factors in applying them. Because these are ways, factors and things you look for the one you aren't allowed to apply them. Well, the irs, not you. I don't, you know, I don't think any of us go around applying the step transaction doctrine. Maybe it's a way to catch small children who are doing nefarious things, but here we are anyway. Be back in a second. Enjoy the music. Foreign. We're back with the step transaction doctrine. Fun. Let's talk about the limitations on the step transaction doctrine. Simply the first one that I always talk about is the simple existence of temporal proximity. So closeness in time does not mean that you should use a step transaction doctrine. Right. Just because they're close doesn't mean anything. And I think that's really important. If two or more transactions or steps. Right. Depends on it. Have economic significance independent of each other or multiple steps. Right. You don't get a step together. You general, you know, this is generally not always. Sometimes each step has a literal, you know, economic or business reason. But if you look at them, you're just like kind of, you know, one does one thing in a bad way and oh, we have to do this to fix that part. And you're like, why did you do both? You could have just skipped them both. And that, you know, sometimes, sometimes the step transaction doctrine will collapse even when each step has a business purpose. But you look at the larger business purpose, you're like, well, why did I do those nine? You know, that's, that's, that's suboptimal. If binding commitment exists for the second step at the time the first step occurs, even functionally independent steps may be stepped together under the binding commitment test. And I say that and I think it's important. Right. So just because steps temporal proximity just cause they're close doesn't mean you put them together. Just because they're far apart, just cause there's independent reason for each doesn't mean they don't get stepped together. You have to look at the overall right purpose, what you're trying to do. Binding commitment. Binding commitment can be really powerful, which is probably why it's, it's often so narrow. Because you need it, right. There's a good example in revenue ruling 79 250. There were two acquisitive reorgs. There's an acquisitive D reorg and then an inquisitive F reorg. Used to move states. Both the D and the F were mergers. I'm not going into the details as to how that works candidly because it's just outside of what I want to talk about and I don't really feel like spending five minutes on that. It's not worth it. Due to changes in the ownership as a result, particularly of the D. Right. If they were stepped together, the F reorg would fail. Okay. Because of the ownership changes. The IRS did not step because each merger was real substantial and had separate economic motivations. So they were close in time that, you know, you look at what they're doing. They were only going to do one if they did. The other said no, no. But each one had a separate reason. They were just done in time and they made sense to do together. Right. They modified 79, 250 with revenue ruling 96 29. I'm not going to do it. There's also a lot of case law on this stuff that I am absolutely not going to go through. I'm just trying to summarize it and summarize some of it that I think is a more important point. The the IRS and states are not allowed to actually invent or create steps. This is why I talked about about Bologna can't create things. Right? Or Imagination Land or whatever. But, you know, they seem to think they can. The best case about this, I think, is Grove. It's a second Circuit case, maybe kind of New York. I think about this a lot. 490 Fed. Second 241. There's also a field service advisory. 200122 007. So 2001 22. James Bond. You know, it says that the IRS cannot invent steps they can only do. This is not going to get back to this. But right. Bologna and Imagination Land, if you look them up, that's creating stuff out of whole cloth. Whereas San Angeles is actually combining things that are already there right into one thing. So, so that's where different. The IRS can't make you have an alternative simply because it has a higher tax. Gilmore Good. Third Circuit case 130 Fed. Second 791. The spirit and purpose of the code must be followed. So simply because you chose the lowest tax alternative doesn't mean that you're wrong. This is somewhere where I would verbally, but never in writing cite Gregory and say, look, you know, I don't have to pay a lot of tax here. I can just kind of do what I want and that's important. So I can choose it. But I Have to be right in choosing what I'm choosing. And that's really important. You must have a real. This is a really important one, a really important limitation. If there is a real and meaningful shareholder vote, you know, if there is a real and meaningful and real and meaningful is real, real phrase shareholder vote between stats, it's hard to step them together. This is a big thing of public companies versus private companies. This is a really important point. Right. Public companies, real and real shareholder votes. There are very few public companies that are controlled by very few people. For Google, few others like that. Facebook. Right. Meta, whatever, whatever we're calling it Facebook, you know, because they have controlling shareholders or a couple controlling shareholders or multiple classes of stock that create a controlling shareholder. Shareholders. The votes tend to be less important. But for private companies, you know, there's winks and nods. Right. For two 80g. Right. It pretends that all votes are real even if they're not. They're you know, one person or two person, two people voting. But you know, for a public company can be really big. Private can be real too. Look at the facts and circumstances. You may still need it. There could be enough or it could just be a real vote that it actually has to happen. You look for more than just the existence of a vote. You look at the underlying facts of the vote. Revenue ruling 75406 modified by Revenue ruling 9630 talks about it. Kind of an important point there. Anyway, so IRS's ability to recharacterize is really important to talk to it. So this to talk about. So the IRS may recharacterize. The taxpayer cannot. Taxpayer is bound to form. That's Danielson 378 fed. Second 771 if my handwriting can be done. It's in the third circuit. Also adopted in fifth, sixth, 11th fed and price second. The tax court however and all the other circuits I didn't mention, it's show strong proof that the form should not be controlling. Okay. So in Danielson the taxpayer must show one, the taxpayer and the other party wants to alter the terms or an agreement is unenforceable because of a mistake, undue influence fraud or duress, one of those two. So look, if the taxpayer, the counterparty, if the two counterparties agree to alter it, they can alter it. Or there was some sort of mistake, undue influence fraud, duress, some problem underlying it. Right. The IRS may choose to not recharacterize under the transaction doctrine. They don't have to. It's non mandatory. Always thought that was interesting. There are examples in the regs in revenue rulings. Parties must report consistently. This is, I believe my research is right. What happened to Danielson one party. We're going to report something else. Courts have recharacterized for one, not both, the key to whether the actions of one party or both parties trigger the step transaction doctrine. So if only one party's actions triggered it, then only one party's transaction gets stepped. If both, then both get stepped. Right. Generally not always the innocent party may want indemnification. Often with escrow, this is pretty common. You know, parties will agree to tax or if one party thinks the other party's going to do stuff, they're going to hold back with an escrow or tax insurance. Ooh la la. Right. So that's an important thing. All right, we're going to go for some music. I know I'm going a little longer than I probably should on this one, but here we are. And then I'm going to, I'm going to bring it on home with a really specific example of this, that transaction doctrine being inapplicable. Be back in just a moment. All right. And we're back. So now, now, you know, in talking about the steps and act of doctrine, I'm going to talk about a very specific example of a situation where there's a number of steps put together that are independent, done for effectively tax purposes that exist. But I explain why it's inapplicable. And this is how I think about the step transaction doctrine a lot. You know, one is like a pre reorganization partnership, electricity, a C corp. It depends. And what that is is, you know, there are certain things you can't do if you're a partnership that will have tax consequences. And if you were a corporation, you know, crs, you could do certain reorganizations tax free. Right. Divisive reorganizations become a little easier, et cetera, et cetera, Especially if there's a lot of debt. Right. It depends. You know, the rules for 108 are different if you have a C or S corp than if you have a partnership. So it depends. And those are ones where steps come in, you know, where a pure election may happen to do it. And that's, you know, binding and that things already happen. It's about to happen, things like that. The other one that I want to talk about, and this is a really important one, is the F reorg. Under Revenue Ruling 2008-18, convert to an LLC. Now it's a disregarded entity. Then part sale or contribution trigger revenue ruling 995 or 99,6. This is the F reorg. This is the thing that everyone talks about, oh, you're doing an F reorg, you're doing an F reorg, you're doing an F reorg. This is it. And I always say, look like, well, shouldn't this have a problem with the SB step transaction doctrine? I say no, because you can really accomplish the same thing by forming a new entity below and then doing it. Or you could do it by doing a part sale, part contribution to an entirely unrelated partnership that someone else puts cash into, and then it just becomes a disguised sale as the money's put back, you know, passed back up, which would have the same tax consequences entirely as what you just did. So this goes back to, you know, understanding the alternatives. What could you have done? And did you end up with the same one? So whenever people say, oh, you know, F reorg, it's tried and true. Everyone knows it. I think it exists because the. The IRS has come to the conclusion that the, the taxpayer could do this anyway without even really asking them. So it makes more sense at at least a conceptual level to just kind of let it go. It's easier. It might even be easier for the irs. Definitely easier for taxpayers not changing eins. Or maybe you are talked about that more than enough. But it's important to understand your alternatives. What else can you do? What else do you want to do? And that's. That, in my view, is important. Important. All right, let's bring it all home, right? We're bringing it back for the step transaction doctrine and the economic substance doctrine. We're going to bring it back to why I spent all this time talking about, in what is a somewhat amorphous topic, right? Because it all comes from case law. Economic substance got codified, but at its core, it's all coming from case law. So it's a little bit of wiggles, right? You evaluate. I always evaluate it in two ways. One, does this work? And two, how does this not work? Right. How can the IRS or a state revenue agency attack it? Do you meet the literal requirements? Do you meet the spirit and the purpose of the literal requirements? Are there too many steps? Are there superfluous? Superfluous steps? I'll get that right someday. Is there a non tax benefit? Is there a non tax purpose? Right. What are you trying to accomplish? Part of the reason that whole f. Re. Org stuff works is because the goal is to then sell. And I found the IRS is generally pretty permissible, permissive, pretty permissive in letting you do things when you're trying to have a larger goal that results in tax, and you're just sort of setting it up for it. And I think that's important. You also want to look at extending the code regs, case law pronouncements too far, right? You know, I talk about this a lot with. With people, and I say, look, like. Like, oh, you know, this case law does this and it says this. I'm like, yeah, but like, this is a materially different fact pattern, so I'm not sure this works. And they're like, no, no, no, no. You just. Under this. This is the rule. And so I always kind of go, well, maybe you're extending it too far. Right. Or maybe it's just a narrow interpretation, right? You're saying, well, it doesn't cover this. So therefore I'm like, well, I think it might, right? So it's about risk. Risk tolerance, risk analysis and what exists. And I always point this out. Tax professionals are not permitted to advise whether to do something or whether or not so whether to do something based on the likelihood of an audit. They are merely allowed to advise on this, on the likelihood of prevailing in an audit, appeals or litigation. Okay, that's circ230, right? That. That. That's tax professional stuff. That is the ethics rules. Probably CPAs and EAs, definitely attorneys. So I think it's important. I will tell clients, I think if you do this, you will lose an audit. I think if you do this, you will win in litigation. And that is a viable argument because the IRS may disagree, but I think they're wrong. And it may. They may only disagree in a plr. Doesn't mean they're right. Revenue ruling. Doesn't mean they're right. Right. Regs, maybe. Maybe have more, maybe not. It depends, you know, in the mortal words of every lawyer. So. So that. That's how to think about it. All right. This was supposed to be one episode. It turned into two. So I'm going to kind of do it, even though this one went, you know, much longer. That was the 47th episode of How Tax Works. Hope you learned something. I'll be back in two. Two. Short or long weeks. And how much you like me with the 48th episode. We're all talking about UBTI. Unrelated business, taxable income. Hope you learned something. And talk to you. Thank you so much for listening. Sa.