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Step Transaction Basics & the IRS

One of the things that makes law such a fascinating field is the way that it forces us think in ways which are generally foreign to most of us. To think in “legal terms” is to think analytically, to mentally break down events in such a way that causality can be unraveled and properly assigned. This thought process doesn’t come naturally to most people – including many trained lawyers – and so it’s not uncommon for many people to struggle grasping certain legal concepts. The so-called step transaction doctrine is a good example of a legal theory that uncovers the correct nature of a business transaction using analytical reasoning.  

An Umbrella of Legal Tests

The IRS has provided insight into its interpretation of the step transaction doctrine and its application to tax-free reorganizations.  In Revenue Ruling 2008-25, the IRS clarified that it considers a step transaction an umbrella concept encompassing several distinct legal tests. If one of these legal tests applies to a given set of steps, they can collapse and be seen as a single step for tax purposes. This means that if those steps were taken to alter the tax treatment of a transaction, then this treatment may, itself, end up changing, under the step transaction doctrine. In this article, we will discuss in detail the nature and significance of the step transaction doctrine and then examine an important legal case which helps illustrate this doctrine in practice. 

Basic Mechanics of the Step Transaction Doctrine 

The step transaction doctrine is simply stated as follows. If a step within a multistep transaction is taken solely for the purpose of altering the tax classification of the transaction, then this transaction may collapse and its tax classification may be changed accordingly. The step transaction doctrine consists of three separate tests – the binding commitment test, the mutual interdependence test and the intent test. 

Binding Commitment Test

In the binding commitment test, the court will review multiple steps which all had to be completed as part of a series of steps. In other words, if there were an obligation to complete each step within a group of steps, then this scenario may fall within the binding commitment test. As such, it will also fall under the step transaction doctrine. This test was first introduced in the case of Commissioner v. Gordon (1968). 

Mutual Interdependence Test

In the mutual interdependence test, steps which otherwise would be pointless outside the context of a series of steps may be collapsed together. In other words, if the individual steps within a series of steps be so interdependent as to be meaningless if taken out of context, then the mutual interdependence test may apply.  

Intent Test

Finally, the intent test (or “end result test”) looks at the subjective intent behind the multiple steps in the transaction. If someone performs a step with no purpose other than just to take the next step, then the intent test may apply. 

The Case of Kornfeld v. Commissioner (1998) 

Kornfeld v. Commissioner is a factually complex case. It involves the creation of a new type of ownership interest in a bond. Kornfeld was a highly experienced tax attorney. He tried to create a life estate or limited term interest in a bond using a revocable trust. Next, he set up separate agreements with his daughter and secretary. He did so so that someone could accept the remainder interests created by the life estate interest. The whole purpose of creating the life estate in the bond was so that Kornfeld could take advantage of the amortization deduction typically available for such interests.

A “Nonentity”

Here, however, Kornfeld clearly created a “nonentity”. That is, he established a life estate interest in a bond that couldn’t be upheld. That’s because upholding the interest would result in a windfall. Bonds are not depreciable assets, but instead have a cost basis which is decreased over the course of its life; an amortization deduction on top of this would be nonsensical. 

An Artificial Interest

The court impugned this transaction using the step transaction doctrine. It collapsed the transactions made between Kornfeld and his daughter and secretary. The transactions between Kornfeld and the other parties had no purpose other than to create an artificial bond interest.  Kornfeld’s daughter and secretary never actually paid for their supposed remainder interests. Rather, Kornfeld gave both of them checks equal to the amount they originally paid to the revocable trust. Hence, the agreements lacked adequate consideration. Accordigly, they were contractually invalid given that they served no independent function. 

Kornfeld v. Commissioner is a perfect example of how the step transaction doctrine operates. Kornfeld not only developed a “fake” interest in the bond. His transactions also show a clear intent to deliberately alter his tax classification. Though the facts of this case are quite complex, this scenario does well to illustrate the mechanics of the doctrine. 

Call Us For Assistance!

Knowing the finer points of the step transaction doctrine is one of those things which helps define a great attorney. A great attorney will be able to identify potential applications of the step transaction doctrine and counsel his clients accordingly. It’s not uncommon for people, particularly those conscious about minimizing tax liabilities, to consider steps to alter their tax status. A great attorney should be able to identify when the step transaction doctrine may come into play. Taking steps to minimize one’s tax burden is perfectly fine and acceptable. The problem arises when said steps have no independent purpose. If you’re in need of experienced New York City tax attorneys, reach out to Mackay, Caswell & Callahan, P.C. Take advantage of our expertise.  

Image credit: Sole Treadmill