Judge Schiltz of the U.S. District Court of Minnesota recently issued an opinion in Wells Fargo & Co. v. United States, that qualifies as a key development in the law of economic substance. Taxpayers have battled the government for decades over the precise contours of the judicially-created doctrine often advanced by the government and employed by the courts to deny tax benefits of particular transactions that comply with the strict terms of the Tax Code, but which were arguably motivated solely by tax avoidance. Most everyone agrees that the economic substance doctrine traces its origins to the Supreme Court’s 1978 ruling in Frank Lyon Co. v. United States, where the Court ruled in the taxpayer’s favor, reasoning that:
Where, as here, there is a genuine multi-party transaction with economic substance that is compelled or encouraged by business or regulatory realities, that is imbued with tax-independent considerations, and that is not shaped solely by tax-avoidance features to which meaningless labels are attached, the Government should honor the allocation of rights and duties effectuated by the parties.
The economic substance doctrine has evolved to distill the Frank Lyon Co. factors into only two — an objective component, i.e., whether the transaction has a reasonable possibility of profit apart from tax benefits, and a subjective component, i.e., whether the taxpayer had a nontax business purpose for engaging in the transaction.
Of course, the very existence of the economic substance doctrine is in tension with the companion axiom that taxpayers are free to structure their transactions with tax considerations expressly in mind and to explore options that create the most tax-efficient outcome. Striking the right balance and achieving consensus on when the economic substance doctrine should invalidate a transaction, however, has proved difficult and slow. Among the several points of contention between the government and the private bar is whether a transaction must fail both the objective and subjective prongs, or only one of them before a court should apply the doctrine to disqualify the claimed tax treatment. Congress seemingly weighed in on this debate in 2010 when it formally codified the economic substance doctrine at 26 U.S.C. § 7701(o)(1) using conjunctive language requiring that a transaction have both objective economic substance and a subjective non-tax business purpose to avoid the doctrine. But Congress also added that “[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted,” Section 7701(o)(5)(C), leaving intact the body of common law on this issue.
Courts that have ruled definitively on this issue generally fall into one of three camps. The Fourth Circuit, for example, has ruled that a transaction must fail both the objective and subjective prongs in order to be invalidated by the economic substance doctrine. Other courts, such as the Fifth and Sixth Circuits, have ruled that the doctrine will invalidate a transaction if it fails either the objective or subjective prongs. In the middle ground are those courts like the Third Circuit that have opted for the so-called “flexible” approach, where judges merely consider the objective and subjective prongs as factors, but do not treat them as rigid tests that a transaction must pass or fail before applying the doctrine. To date, the Eighth Circuit has avoided having to expressly adopt any of these approaches, which sets the stage for the Wells Fargo decision cited at the outset of this comment.
Wells Fargo involved a tax shelter known as “Structured Trust Advantaged Repackaged Securities,” or “STARS.” Following trial, a jury returned a verdict treating STARS as two separate transactions — a trust structure and a loan. The jury concluded that the trust “had neither a non-tax business purpose nor a reasonable possibility of pre-tax profit.” The economic substance doctrine, therefore, clearly applied to disallow the tax consequences claimed for that portion of the STARS transaction. The jury’s ruling on the loan portion, however, was critically different in that it concluded that “the loan had a reasonable possibility of pre-tax profit but that Wells Fargo entered into the loan solely for tax-related reasons.” As Judge Schiltz articulated, “[t]he jury’s findings thus squarely present the question that the Eighth Circuit has avoided in the past: Will a transaction be disregarded as a sham if it had objective economic substance but the taxpayer lacked a subjective non-tax business purpose?”
The government, of course, contended that the court should treat the loan as a sham even though it had objective economic substance, simply because Wells Fargo had no subjective, non-tax business purpose. To resolve the controversy, the district court set out to “predict which approach to the sham-transaction doctrine the Eighth Circuit will choose to adopt.” The court adopted the flexible approach, and in so doing, ruled that Wells Fargo would be awarded the tax consequences of the loan component of the transaction. “The fact that Wells Fargo would not have entered into the loan but for the opportunity to gain unrelated tax benefits does not change” the transaction’s objective economic substance. Marching through prior precedent, the court noted that while several cases, both inside and outside of the Eighth Circuit, have paid lip service to the notion that a transaction with independent economic substance will still be treated as a sham where the taxpayer had no subjective independent business purpose, none of them have actually practiced what they preached: “Again, there is a gap between what courts say and what courts do . . . courts have been reluctant to disregard economically substantive transactions solely on the basis of taxpayer’s subjective motivations.”
The court defended its ruling on several bases. The doctrine must remain flexible, the court explained, given that it is intended to “counter the creative and ever-evolving abuse of the tax code.” The court also believed the flexible approach is consistent with the Supreme Court’s language in Frank Lyon Co., quoted above, which “reads more like a list of factors to weigh than a series of boxes to check.” The court also noted that ruling otherwise would lead “to the absurd result of two identical transactions being treated differently for tax purposes based solely on the subjective motivations of the two taxpayers.”
Taking a step back, while Wells Fargo is a noteworthy development in Eighth Circuit and economic substance jurisprudence as whole, what is most remarkable is its award of tax benefits to a taxpayer who, according to findings by a jury, engaged in the relevant transaction solely for purposes of tax avoidance. As Wells Fargo explained, though courts have saber-rattled in dicta that such “nefarious” subjective intent would certainly doom claimed tax benefits regardless of objective economic substance, when the rubber met the road, at least here, the outcome was just the opposite. If this ruling gains traction, the consequences could be significant. It could mean that shelter promoters could openly market transactions solely for their tax benefits, so long as they can design such transactions as otherwise economically substantive. In fact, the government’s post-trial brief in Wells Fargo expressly contended that the “designers of STARS added a loan to try to insulate the trust from the economic substance doctrine.” It also could mean that taxpayers could openly shop for tax strategies with no preconception or independent business motivation for whatever transaction they ultimately choose, so long as the transaction has real economic consequences.
Of course, the caveat that a transaction must still have real economic consequences is significant, especially given that tax shelters of old have typically failed that prong miserably. Moreover, though Wells Fargo rejects a rigid test, it remains to be seen how tenable a case would be where a taxpayer had a subjective, albeit misguided, non-tax business purpose, but where the transaction otherwise lacked all objective economic substance. In other words, though Wells Fargo stands for the proposition that a taxpayer’s failure as to the subjective prong will not necessarily taint its satisfaction of the objective prong, it is unclear whether the inverse is true. On a whole, however, Wells Fargo is a pro-taxpayer development, especially with the prospect of micro captive insurance companies as the potential next wave of transactions deemed to be tax shelters by the IRS.