Step Transaction Doctrine (substance over form)

The “Step transaction doctrine”, sometimes referred to the ‘substance over form’ rule is a framework used by the IRS to deny tax benefits normally applicable to a series of transactions if those transactions are assessed to be motivated primarily by tax considerations. Under step transaction doctrine individual transactions will be looked at in concert, with scrutiny being applied to the nature of each transaction, their relationship to one another, their timing, and the rationale behind them.

Familiarity with step doctrine is helpful for tax and investment planning practitioners, however with some limitation as there are no official public guidelines for its application, meaning that interpretations are tested in real-time at tax court when the IRS contests taxpayer transactions.

Thankfully, there are three tests employed to see if a series of transactions pass the sniff test.

1) Binding commitment test
Does one transaction explicitly compel the next transaction.

2) Interdependence test
Is each transaction still bona fide and practical in its own right when disregarding its purpose in the total series of transactions.

3) Intent test
Is it apparent that the taxpayer intended for each transaction to function primarily as a part of the total group of transactions, for which there would be a tangible tax benefit.

Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004), was a court case argued before the United States District Court for the District of Connecticut that concerned a tax shelter used by Long-Term Capital Management, a failed hedge fund.

The tax shelter had been designed by Babcock & Brown for Long-Term Capital to shelter its short-term trading gains from 1997. The IRS successfully argued the application of step doctrine to apply scrutiny to a series of individual transactions which, in aggregate, would have provided tax benefits that were not in the spirit of the IRC.

The case was an appeal of an Internal Revenue Service denial of the plaintiffs’ claim of $106,058,228 in capital losses during the 1997 tax year and associated penalties. After a bench trial, Judge Janet Bond Arterton ruled, on August 27, 2004, that the transactions employed by Long-Term Capital Holdings did not have economic substance and so were disregarded for tax purposes.