Facts. Sundrup operated a trucking business as a proprietorship. In 2000, Sundrup formed a C corporation (“Transfer”), which began to operate the previously unincorporated trucking business. Transfer paid compensation and provided medical benefits to Sundrup and others. Sundrup transferred assets used in the trucking business to Leasing LLC, and Leasing leased the business assets to Transfer. Sundrup also transferred certain rental property to Leasing, which Leasing contracted to rent out, but sometimes Sundrup used. Sundrup incorporated another C corporation, Consulting, which contracted to provide management services to Transfer and to Leasing. Consulting employed Sundrup. Consulting paid various personal expenses of Sundrup and bought his house on credit. As a result of the intercompany payments and depreciation, Transfer reported no net income, Leasing reported losses, Consulting reported no net income and Sundrup reported taxable income after netting losses from Leasing.
IRS Adjustments. The IRS made these adjustments: as to Transfer, the principal adjustments were reductions from $13,000 to $4,000 of a deduction for employee benefit programs, and denial of deduction for payments to Consulting; as to Consulting, the IRS basically denied deductions for various payments of Sundrup’s personal expenses, presumably on the view that they were dividends; as to Sundrup, the principal adjustments related to Leasing—the IRS denied certain deductions and reduced Sundrup’s interest income evidently on the view that Leasing did not really buy the house. Also, Leasing’s deductions for certain payments to Consulting were denied.
Court’s Analysis. The court dispatched the questions about the intercompany payments with this paragraph:
Based upon our examination of the entire record before us, we find that the only intended objective of the respective transactions between (1) (a) Transfer and Consulting and (b) Leasing and Consulting, under which Consulting purported to provide to each of those companies certain services, and (2) the Sundrups and Consulting, under which Consulting purported to agree to buy the Sundrup residence, was the Sundrups’ tax-avoidance objective of having Consulting pay the Sundrups’ personal living expenses with funds which Transfer and Leasing paid to Consulting and for which Transfer and Leasing claimed tax deductions for their respective taxable years at issue. On that record, we find that the respective transactions at issue were not entered into for nontax business reasons, were entered into only for tax-avoidance reasons, and did not have economic substance. ….Based upon our examination of the entire record before us, we hold that the respective transactions between (1) Transfer and Consulting, (2) Leasing and Consulting and (3) the Sundrups and Consulting should not be respected for tax purposes.
Opinion’s Significance. This Memorandum opinion shows that Treasury and the IRS are overly optimistic when they refuse to give guidance on the “relevance” of the now codified economic substance doctrine because “The IRS anticipates that the case law regarding the circumstances in which the economic substance doctrine is relevant will continue to develop.” Notice 2010-62, 2010-40 I.R.B. 411. If this opinion is an example of such continued development, it means there will be no guidance from the courts or the IRS or the Treasury on “relevance” of the economic substance doctrine.
The second reason this opinion is troubling is that it pursues the all too common course of conflating (1) fact finding and (2) statutory interpretation with (3) the economic substance doctrine. If the case were decided under section 7701(o), it clearly would be treated as based on the economic substance doctrine, and the 40 percent no fault penalty would apply. And yet, the way the opinion stated its basis sounds like the court (1) did not believe the contracts with Consulting were real and did not believe the purchase of the house was an ordinary and necessary business transaction and (2) believed that some controlling section of the code, like section 162, had an explicit or construed business purpose requirement (which it does).
If the opinion had stated those reasons, it would have been unremarkable. But it’s pretty clear that section 7701(o)(5)(A) defines the economic substance doctrine essentially the way the opinion stated it, and requires that the taxpayer prove a substantial profit potential and a substantial business purpose (which is not exactly what the court required, because the years at issue preceded the section 7701(o) effective date).
Therefore, if this case were decided under section 7701(o), the decision would not be based on finding whether the consulting really occurred or what a particular section requires. Rather it would be based on the taxpayer being unable to prove a substantial profit potential (or other meaningful economic change), and the reasoning would have to apply a “substantial” business purpose requirement that section 7701(o) lays over potentially every taxpayer-favorable rule in the code (unless the court finds the doctrine not to be relevant).
The third reason this opinion is troubling is that it not only skips over the step of deciding relevance of the economic substance doctrine, but it skips over the approach courts would have applied 30 years ago when confronted with essentially the same scenario. Incorporating business and leasing business assets to the corporation and forming a management or consulting company just are not odious tax shelter activities; they are standard organizational methods used every day, not only by mom-and-pop businesses but also by giant corporate groups.
The proper questions to ask in these cases include standard section 162 ordinary and necessary business expense questions, dividend versus compensation questions and “did they do what they papered?” questions. For example, when the doctors were all incorporating about 40 years ago, many of them cut corners. The Tax Court knew how to assess the facts, as for example in Roubik:
Nor do we think that the corporation was ever, as a practical matter, given the right to direct any of its “employees” in their professional activities. Article 1 of their employment agreements with the corporation, which purports to transfer such control to Pfeffer Associates, seems to us to have been carefully drafted to create the appearance of such control in the hands of the corporation while leaving the petitioners free, as a practical matter, to continue their separate practices just as they had prior to 1961. Roubik v. Commissioner, 53 T.C. 365 (1969).
Conclusion. The Sundrup opinion does not analyze the facts and the law, but rather it applies the economic substance doctrine without questioning its relevance . . . or maybe it doesn’t. Maybe it did decide as a matter of fact that nothing happened under the contracts that purported to created business expenses, and just short-circuited the analysis by referring to the economic substance doctrine.
Our inability to know exactly what the court did is the fundamental problem with the economic substance doctrine. No one can agree on what it is and for now that seems to suit the Treasury just fine, because the more confusion, the more taxpayers may be frightened away from tax benefits to which they are actually entitled.
