An attempt to combine the concepts of valuation discounts for family limited partnership often used in estate planning with a short-lived S corporation to create an income tax benefit was not looked upon positively by the Tax Court in the case of Smith v. Commissioner, TC Memo 2017-218.

The taxpayer had substantial income in 2009 that arose from a bonus and other income he received when his employer of 36 years was sold, the same year in which Mr. Smith retired.  Faced with the sudden influx of income, Mr. Smith consulted an estate planning attorney who suggested the following plan as outlined in the opinion:

Mr. Shanks also recommended a tax planning strategy intended to mitigate the effect on petitioners' tax liability of Mr. Smith's compensation from National Coupling. The tax structure involved the organization of an S corporation and the formation of a family limited partnership. Under the structure, petitioners would transfer their cash and marketable securities to a wholly owned S corporation that would then transfer the assets to a family limited partnership. Mr. Shanks explained to petitioners that the family limited partnership would provide asset protection. The S corporation would own the limited partnership, and the partnership would hold petitioners' cash and marketable securities. As part of the structure, petitioners would organize and dissolve the S corporation within the same tax year. The S corporation would distribute the partnership interest to the shareholders upon dissolution. Mr. Shanks would determine the fair market value of the distributed partnership interest using large discounts for lack of marketability and lack of control, generating a tax loss upon the dissolution of the S corporation. The S corporation's dissolution and the distribution of the partnership interest were both necessary to generate the tax loss. A third entity in the planning structure was a revocable management trust that would hold the general partnership interest. Mr. Shanks advised that the tax structure could generate either a capital or an ordinary loss deduction on the basis of the business purpose of the S corporation. He had implemented similar structures for 10 to 15 other clients between 1999 and 2009.

The IRS attacked this structure, claiming that it lacked economic substance since the structure had no effect aside from generating an income tax loss.

Since any appeal of the results on this case would be heard by the Fifth Circuit Court of Appeals, the Tax Court looked to the Fifth Circuit’s holdings on how to determine if a transaction lacks economic substance.  The Court outlined those standards as follows:

The Court of Appeals for the Fifth Circuit has interpreted the economic substance doctrine as a conjunctive “multi-factor test”. Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United States, 568 F.3d 537, 544 (5th Cir. 2009). In Klamath, the Court of Appeals stated that a transaction will be respected for tax purposes only if: (1) it has economic substance compelled by business or regulatory realities, (2) it is imbued with tax-independent considerations, and (3) it is not shaped totally by tax-avoidance features. Thus, a transaction must exhibit an objective economic reality, a subjectively genuine business purpose, and some motivation other than tax avoidance. Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors LLC v. United States, 659 F.3d 466, 480 (5th Cir. 2011). Failure to meet any one of these three factors renders the transaction void for tax purposes. Klamath, 568 F.3d at 544. While Klamath phrases the economic substance doctrine as a conjunctive, three-factor test, the Court of Appeals for the Fifth Circuit has recognized that “there is near-total overlap between the latter two factors. To say that a transaction is shaped totally by tax-avoidance features is, in essence, to say that the transaction is imbued solely with tax-dependent considerations.” Southgate Master Fund, 659 F.3d at 480 & n.40.

The Tax Court found this structure failed to meet any of the standards outlined by the Fifth Circuit.

The Court first noted that the structure did not change the “petitioners' economic position in any way that affected objective economic reality.”

The Court also found that the taxpayers also failed to meet the final two standards, ones that are closely intertwined.  The taxpayer had come up with a “business purpose” which the Court did not find persuasive. 

The opinion noted:

Petitioners claim that they organized Ventures to manufacture the sprinkler device but changed their minds because the patent had not been issued by the end of 2009 and Mr. Smith was busy with his consulting work. The record is not clear as to whether Mr. Smith owned a right to the sprinkler device patent.4 Even if we assume that Mr. Smith had the right to the sprinkler device patent, we do not find petitioners' claims that they organized Ventures to manufacture the sprinkler device to be credible. First, Mr. Smith's testimony relating to the Canadian and U.S. patents conflicts with the record. He testified the Canadian patent was issued before the National Coupling sale, but documents in the record show that it was issued in October 2009. Mr. Smith also testified that on the basis of his experience he expected that the USPTO would issue the sprinkler device patent shortly after the Canadian patent's issuance. Thus, according to his testimony he should have expected the U.S. patent to be issued shortly after October 2009. However, petitioners began to dissolve Ventures only one month later. Mr. Smith is an experienced businessman familiar with patent procedure. The U.S. patent application was submitted in 2006. By the end of 2009 he had already waited three years for the patent. In the light of these inconsistencies, we do not find Mr. Smith's testimony that he intended to manufacture the sprinkler device through Ventures to be credible. Nor do we believe that petitioners decided to dissolve Ventures because the USPTO had not issued the sprinkler device patent by November 2009. Rather, we find that petitioners never intended to operate Ventures as a manufacturing business. They intended from the beginning of the RACR structure to organize and dissolve Ventures within the same year to generate a tax loss to minimize their 2009 income tax liability.