IRS Shouldn’t Force Taxpayers Into Tax-Maximizing Transactions

While tax evasion is a crime, the Supreme Court has long recognized that taxpayers have a legal right to reduce how much they owe, or avoid taxes all together, through careful tax planning. Whether that planning takes the form of an employee’s deferring income into a pension plan, a couple’s filing a joint return, a homeowner’s spreading improvement projects over several years, or a business’s spinning-off subsidiaries, so long as the actions are otherwise lawful, the fact they were motivated by a desire to lessen one’s tax burden doesn’t render them illegitimate.

The major limitation that the Court (and, since 2010, Congress) has placed on tax planning is the “sham transaction” rule (also known as the “economic substance” doctrine), which, in its simplest form, provides that transaction solely intended to lessen a commercial entity’s tax burden, with no other valid business purpose, will be held to have no effect on that entity’s income-tax assessment. The classic sham transaction is a deal where a corporation structures a series of deals between its subsidiaries, producing an income-loss on paper that is then used to lower the parent company’s profits (and thus its tax bill) without reducing the value of the assets held by the commercial entity as a whole.

We might quibble with a rule that effectively nullifies perfectly legal transactions, but a recent decision by the U.S. Court of Appeals for the Eighth Circuit greatly expanded even the existing definition of “economic substance,” muddying the line between lawful tax planning and illicit tax evasion. At issue was Wells Fargo’s creation of a new non-banking subsidiary to take over certain unprofitable commercial leases. Because the new venture wasn’t a bank, it wasn’t subject to the same stringent regulations as its parent company. As a result, the holding company (WFC Holdings Corp.) was able to generate tens of millions of dollars in profits.

Despite the very real economic gains to the subsidiary (and the parent), the Eighth Circuit held that the set-up was a sham because not every individual component of the restructuring produced a substantial economic benefit or was justified by a non-tax-related business purpose. In effect, the court created a new rule by which a deal with an unquestionable business purpose can still be declared a sham if the companies involved choose to structure it to be as tax-efficient as possible.

Joined by the U.S. Chamber of Commerce and the Financial Services Roundtable, Cato has filed an amicus brief supporting Wells Fargo’s petition for Supreme Court review. We present three arguments: (1) The Eighth Circuit’s ruling, which conflicts with those of its sister circuits, adds to the general confusion surrounding the economic substance doctrine—such that even the most sophisticated taxpayers, assisted by teams of lawyers and accountants, can’t predict how much tax they will owe at the end of the year. (2) This confusion creates substantial burdens for businesses and consumers, without any benefit to the economy. Legal uncertainty causes companies to shy away from complex deals and to waste millions of dollars on tax planning and litigation, money that could be better spent on growing their businesses (creating new jobs) or R&D (creating better products for consumers). (3) Taken to its logical extreme, the lower court’s rule requires taxpayers with a valid business purpose to select the transaction that fulfills that purpose with the highest possible tax liability. That rule is profoundly unwise and contrary to precedent, which holds that “[a taxpayer’s] legal right … to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”

The Supreme Court hasn’t revisited the economic substance doctrine in nearly 75 years, so it’s high time it provided some clarity. The Court will likely decide whether to review WFC Holdings Corp. v. United States by the time it recesses for the summer; if it takes the case, oral argument will be in late fall.

This blogpost was co-authored by Cato legal associate Gabriel Latner.