The Tax Court in the case of Complex Media Inc v. Commissioner[1] attempted to explain how it views the opportunity for a taxpayer to raise a substance over form argument in a tax matter.

The Doctrine and Why a Taxpayer Raising the Issue is Different

The substance over form claim argues that the transaction in question should not be evaluated based on the formal legal structure of the transaction, but rather the tax impact should be driven by the underlying substance of the transaction.  The IRS raises this argument often when the government believes the transaction was structured in a manner that lacked any real economic substance, but was specifically chosen to achieve a specific tax objective.

Traditionally taxpayers have had a tougher time raising such an argument for the simple reason that, unlike the IRS, the taxpayer generally has had a hand in selecting the form of the transaction.  And, in some Circuits, the courts have held that the argument simply isn’t available to taxpayers.  See our article from December of 2019 “Taxpayer Not Allowed to Assert Substance Over Form, No Debt Basis for Loans from Related Corporation,” when the Ninth Circuit panel deciding the case indicated not only had the Circuit never held a taxpayer could use the doctrine, but specifically that a taxpayer cannot escape the consequences of a specific arrangement by arguing it was fictional.[2]

The Third Circuit similarly has precedent effectively barring a taxpayer from arguing substance over form generally, noting in the Danielson decision that:

…a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.[3]

The Tax Court’s Attempt to Clarify Its Position

But the Tax Court in this case was looking at a somewhat messy transaction where the final form of the transaction had been driven by a personality conflict between one owner of an enterprise looking to acquire a second and members of that second enterprise.  The resulting transaction used cash from the acquired entity to redeem the interest of the owner in the acquiring enterprise with the personality conflict.

The transaction’s details are complex—and a large reason why the opinion goes on for over 100 pages.  But what is the most interesting item is the court’s analysis of when a taxpayer can argue for basing the tax treatment of the transaction on its substance rather than the form the taxpayer had chosen.

The opinion notes that the Tax Court’s views have changed over the years, as well as noting that quite often the Court is constrained by the Golsen rule to follow the specific precedent in Circuits that either bar the ability of a taxpayer to challenge the form of the transaction, or make it exceedingly difficult.  But in cases where the Tax Court does not face that restriction, the opinion looks to outline how the Tax Court is now going to approach this issue.

The opinion notes that the Tax Court has indicated that a taxpayer bears a different burden than the IRS in carrying this issue, but had not been clear in stating exactly what that extra burden actually is:

In sum, as our caselaw has evolved, it has become more hospitable to taxpayers seeking to disavow the form of their transactions. While we no longer reject those arguments out of hand, as we did in Swiss Oil Corp., J.M. Turner & Co., and Television Indus., we have repeatedly indicated that taxpayers may face a higher burden than the Commissioner does in challenging transactional form. On occasion, as in Glacier State Elec. Supply, we have suggested that the taxpayer’s higher burden might be an evidentiary one. But we have not identified specific factual questions that should be subject to a higher burden than that imposed by Rule 142(a) or articulated the quantum of evidence necessary to meet that burden. Nor have we offered a clear justification for imposing on the taxpayer a higher burden to prove facts relevant to the disavowal of form than the generally applicable preponderance of the evidence standard.[4]

In this opinion, the Court looks to clarify the issue, beginning with the showing the IRS must make to prevail on this argument:

Therefore, we now conclude that the additional burden the taxpayer has to meet in disavowing transactional form relates not to the quantum of evidence but instead to its content — not how much evidence but what that evidence must show by the usual preponderance. The Commissioner can succeed in disregarding the form of a transaction by showing that the form in which the taxpayer cast the transaction does not reflect its economic substance.[5]

But the opinion notes that while a taxpayer must still show the form does not reflect the transaction’s economic substance, the taxpayer must go beyond just that:

For the taxpayer to disavow the form it chose (or at least acquiesced to), it must make that showing and more. In particular, the taxpayer must establish that the form of the transaction was not chosen for the purpose of obtaining tax benefits (to either the taxpayer itself, as in Estate of Durkin, or to a counterparty, as in Coleman) that are inconsistent with those the taxpayer seeks through disregarding that form. When the form that the taxpayer seeks to disavow was chosen for reasons other than providing tax benefits inconsistent with those the taxpayer seeks, the policy concerns articulated in Danielson will not be present.[6]

The Danielson concerns involved, for example, the potential for a taxpayer to structure a transaction to achieve a better tax result for the other party, obtain a higher price for having accepted a “disadvantageous” structure, and then disown the form on its own tax return.[7]

In this case, the Court found that the form was clearly chosen for other than tax reasons and, more to the point, if properly applied, the other party (the redeemed interest holder) does not end up with a fundamentally different tax result.  The only difference is that if the substance controls (shares issued and then “redeemed” on the same day aren’t really shares of the soon to be ex-interest holder, but rather an additional cash payment for the purchase of the acquired firm) is that the acquiring company will end up with a §197 intangible that can be amortized over 15 years, rather than a stock redemption payment to a shareholder.

So Is This the Final Word?

While an interesting exposition on what the Tax Court believes should apply to determine when a taxpayer may challenge the form of a transaction he/she had a part in designing, it is important to remember that the opinion cites opinions in other Circuits that present a much higher bar to a taxpayer successfully disputing the form of a transaction.

Thus, advisers are well advised to carefully read this case, especially as it discusses more restrictive holdings in Circuits other than the one to with jurisdiction in this case (the Second Circuit).  The opinion and our prior discussion of the Ninth Circuit’s 2019 decision indicate that, at a minimum, the Third, Fifth and Ninth Circuits are likely to be skeptical about this opinion.

[1] Complex Media Inc. v. Commissioner, TC Memo 2021-14, February 10, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/transaction-form-disavowed%3b-amortization-deductions-determined/2r4vw (retrieved February 14, 2021)

[2] Ed Zollars, “Taxpayer Not Allowed to Assert Substance Over Form, No Debt Basis for Loans from Related Corporation,” Current Federal Tax Developments website, December 31, 2019, https://www.currentfederaltaxdevelopments.com/blog/2019/12/31/taxpayer-not-allowed-to-assert-form-over-substance-no-debt-basis-for-loans-from-related-corporation (retrieved February 14, 2021)

[3] Commissioner v. Danielson, CA3, 378 F.2d at 775

[4] Complex Media Inc. v. Commissioner, TC Memo 2021-14, pp. 63-64

[5] Complex Media Inc. v. Commissioner, TC Memo 2021-14, p. 64

[6] Complex Media Inc. v. Commissioner, TC Memo 2021-14, p. 64

[7] Complex Media Inc. v. Commissioner, TC Memo 2021-14, p.