A taxpayer has the legal right to minimize his or her taxes, or to avoid them completely, by any means that the law allows. However, this right does not give the taxpayer the right to structure his or her affairs by using “business entities” that have no economic reality and that are employed only to avoid taxes. One business owner recently learned this lesson the hard way: the Tax Court was his teacher.

Wheeler v. Commissioner

In Wheeler v. Comr., Taxpayer owned and operated a business out of an S corporation from the late 1980s until 2002, when the corporation (“Corp”) was liquidated and distributed its assets to Taxpayer.  Corp’s assets, which Taxpayer presumably took with a fair market value basis, consisted primarily of equipment and inventory, and Corp operated in a factory building owned by Taxpayer. After Corp liquidated, its business continued in the same location through a separate limited liability company (“LLC”) that was managed by one of Taxpayer’s daughters. In late 2002, an entity that purported to be a “business trust” (“Trust”) was formed, and its capital units were issued to Taxpayer’s daughters.

In early 2003, Taxpayer and Trust entered into an agreement by which Taxpayer purported to grant Trust the option to purchase Taxpayer’s factory and equipment. The exercise price for the option was $1.65 million, payable with two promissory notes. The agreement was contingent upon a separate rental agreement between Trust and LLC for the latter’s use of the factory and equipment. Both agreements were drafted by Taxpayer, who also unilaterally determined their economic terms.

Notwithstanding the fact that Trust did not exercise the option to purchase the factory and equipment until 2004, LLC began making significant rental payments to Trust in 2003.  Trust in turn paid the exact same amounts to Taxpayer, presumably in partial satisfaction of the promissory notes.

In mid-2004, LLC stopped making rental payments to Trust, and Trust stopped making note payments to Taxpayer. In fact, Taxpayer explained that the remaining payments owed to him under the option notes were “gifted” to Trust.

After examining the foregoing arrangement, the IRS asserted that Taxpayer’s sale of the factory and equipment to Trust should be disregarded because Trust was a sham entity and the lease payments from LLC to Trust were merely lease payments to Taxpayer.

According to the Court, the “true earner” of income is the person or entity who controls the earning of such income, and not necessarily the person or entity who receives the income. “‘The crucial question,” the Court stated, “[is] whether the assignor retains sufficient power and control over the assigned property or over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes. . . . An anticipatory assignment of income from a true income earner to another entity by means of a contractual arrangement does not relieve the true income earner from tax and is not effective for Federal income tax purposes regardless of whether the contract is valid under State law.”

The Court concluded that Taxpayer was the true earner of the rental income paid from LLC to Trust. First, Taxpayer owned the assets that Trust leased to LLC throughout the period at issue up until March 2004, when he deeded the assets to Trust. Therefore, at a minimum, LLC’s 2003 rental payments and its first few 2004 rental payments were properly allocable to Taxpayer as the owner of that property.

Second, Trust acted as a mere conduit for the flow of income from LLC to Taxpayer. Trust received income attributable to Taxpayer’s assets and subsequently paid petitioner the same amounts it received from LLC. When LLC suspended rental payments to Trust in June 2004, Trust ceased making payments to Taxpayer.

Finally, there was no separation of Trust administration from the operation of LLC, and Taxpayer retained substantive control over Trust. Taxpayer drafted the contract between Trust and LLC. Neither Trust nor LLC negotiated the terms of the contract, and Taxpayer set the price for the lease. When LLC ceased its rental payments, Trust did not take any action to enforce the lease terms because the trustee felt that it was a “family matter” and he could not take action. Similarly, Taxpayer testified that the remaining payments owed to him under the option contract were a “gift” to Trust. Taxpayer failed to provide persuasive evidence that the option contract and the lease were entered into in good faith and that the parties to these contracts intended to be bound by their respective agreements and expected to have to honor them. Instead, the Court concluded that the agreements were shams.

Because Taxpayer had sufficient power and control over Trust’s receipt of income from LLC, he was the true earner of the income. As the payments were rental payments to Taxpayer in substance, Taxpayer could not use the alleged basis he had in the assets to offset this income. Consequently, the rental income paid by LLC to Trust was taxable to Taxpayer in its entirety.

The Economic Substance Doctrine 

The foregoing discussion highlights one application of the economic substance doctrine. Under this doctrine, a court may deny a taxpayer any tax benefit arising from a transaction that does not result in a meaningful change to the taxpayer’s economic position other than a reduction in federal income tax.  In other words, a transaction that would otherwise result in beneficial tax treatment for a taxpayer will be disregarded if the transaction lacks economic substance.

The tax advisers to closely held businesses need to familiarize themselves with the economic substance doctrine. It is in the context of such a business (as in Wheeler) that one will frequently encounter transactions between the business and its owners, or between the business and a related entity. As a general rule, the relevant question should be whether the transaction that generated the claimed tax benefit also had economic substance and/or a business purpose in order for the transaction to withstand IRS scrutiny. In making that determination, it may help to compare the transaction at issue with transactions between unrelated parties in a bona fide business setting.

In all cases, these inquiries should be made, and the responses thereto should be memorialized, in advance of the transaction. The taxpayer and his or her advisers should never forget that the taxpayer will bear the burden of proof in any examination by the IRS.