Daniel J. Glassman, “It’s Not a Lie if You Believe it”: Tax Shelters and the Economic Substance Doctrine

58 Fla. L. Rev. 665 (2006) | | | |

INTRODUCTION :: In an episode of Seinfeld, Jerry was confronted with the requirement of taking a polygraph test after denying, to a woman police-officer whom he was dating, that he watched the television show Melrose Place. Deeply concerned about his pending polygraph examination, he turned to George Costanza, his friend who Jerry felt had the unique ability to deceive a lie detector. After George counseled Jerry as to the difficulty of deception, Jerry was ready to leave for the test, resigned to his fate. Then George offered these final words of advice: “Jerry, just remember, it’s not a lie if you believe it.” Although that episode of Seinfeld was simply attempting to entertain us by showing one particular character’s attitude toward the truth, what we as a society find humorous very often reflects society’s underlying attitude.

The example from Seinfeld illustrates American society’s growing view that in many cases the ends justify the means, even if that involves creative interpretations of the truth. Regardless of whether one is a supporter or opponent of former President Bill Clinton, most would agree that the low point of his presidency was when, during testimony via videotape before a federal grand jury, he quibbled over the meanings of the words “sex” and “alone,” and, alas, when he answered one question with the response of “that depends on what your definition of ‘is’ is.” While many supporters made the legitimate argument that Clinton’s private personal conduct should not be considered an impeachable offense, Clinton took the position that he had done nothing wrong because his answers were “legally accurate.” The near uniform support among fellow Democrats and the President’s maintenance of strong approval ratings from the public demonstrated that society’s attitude was that the end results justify creative interpretation of facts and occurrences to fit the desired ends.


Many, including the IRS, have argued that corporations and wealthy individual taxpayers should not have the ability to use “loopholes” in the tax law to reduce their tax liability in ways “unintended” by Congress. They argue that it is unethical for accountants and tax attorneys to design or create transactions that have no economic effect and simply generate “paper” losses, expenses, or credits with the purpose of reducing a client’s tax liability. Frequently in the case of corporate taxpayers, courts and commentators use phrases such as “no business purpose” when they describe these transactions. What they fail to consider is that from the perspective of the corporation, income taxes are an expense, no different than wages, rent, or interest. When a corporate officer chooses to engage in a transaction where the company can reduce an expense by incurring transaction costs far less than the amount saved, that decision is not based on anything learned in an MBA program. It is just plain common sense.

Often corporations and the wealthy are easy targets for complaints about tax “loopholes.” Politicians are able to score points with voters by expressing outrage at the corporations and wealthy individuals that “abuse” the laws that the politicians wrote by following the rules in a way that decreases their tax liability. When budget deficits are continuing to increase and the public desires for government spending to increase at the same time, corporations become easy targets for what some view as an abuse of the tax system. Since the enactment of the income tax in 1913, courts have used a variety of substance over form rules to restrict the ability of corporations and individuals to “shelter” income. Now some members of Congress want to make these judicially created doctrines part of the tax code itself. These proposals, along with the judicially-developed doctrines, essentially would allow the government to say, regarding the tax code, that the existing rules do not apply when the IRS and some sympathetic judges do not like the “smell” of what the taxpayer is trying to achieve.

This is not a Note about politics or ethics. This is a Note about tax law and the tax consequences of highly complex, real transactions entered into by corporations and wealthy individuals in an effort to reduce their income taxes. But the overall attitude society has regarding playing games with the truth and reality affects the perception of how far tax practitioners can go in aggressively structuring (or, more cynically, creating) transactions solely for their “unintended” tax consequences. The line between aggressive, yet permissible, tax planning and improper, and sometimes criminal, tax evasion, like many lines in the law, is not at all clear or even straight. There are often things far away from that line that are unquestionably permissible or undoubtedly illegal. The problems come in the cases that fall closest to the line. In those instances, honest and honorable professionals can disagree about the correct result that comes from applying the rules embodied in the Internal Revenue Code and Treasury Regulations, which often contain a combination of objective rules and subjective standards.

In this Note, I will argue that the economic substance doctrine is unnecessary as either a judicially created common law standard or as a part of the Internal Revenue Code. I will show how many tax law provisions depend on a court determining the economic substance of transactions to apply the plain meaning of the statute. In the instances raised by certain recent cases, where the Code and Regulations clearly allow taxpayers benefits that were not contemplated by Congress or the IRS when the provisions were enacted, it is the place of Congress and the IRS, not the courts, to close the “loopholes.”

Abandoning the economic substance doctrine would not allow taxpayers to characterize their transactions in whatever way they choose. The characterization would still be governed by applying the facts and circumstances of a transaction to the statute. It would, however, prevent the government from changing the rules after the game has been played. I am not arguing that economic substance has no role to play in tax law. Nor am I arguing that the current version of the Internal Revenue Code strikes the proper balance between subjective standards and objective rules. In a tax system that is a mixture of standards and bright line rules, there will always be situations where substance governs and other where form governs; and it will always be true that substance “controls over form, except, of course, in those cases in which form controls.” My argument in this Note is that the plain language of the statutes enacted by Congress, not the opinion of judges on what the correct rule should be, determines whether the substance or form of a transaction controls its tax treatment. All taxpayers should be able to rely on the rules that are written to plan, and even create, transactions with predictable tax consequences. A corporation does not forfeit its right to due process simply because it is profitable and large enough to make it cost effective to hire bright tax advisors to devise ways within the system of laws enacted by Congress to reduce the corporation’s tax liability.

Part II of this Note briefly discusses the complex nature of the tax law and how many transactions that are labeled tax shelters rely on the tax treatment the IRS sought for nonrecourse debt. Part III traces the development of the economic substance doctrine. Parts IV & V look at recent cases decided by the courts under the economic substance doctrine (the inconsistent results demonstrate Judge McKee was correct in stating that the courts apply the economic substance doctrine as a “smell test”). Part VI examines the shelter that was part of the recent scandal involving KPMG’s tax practice and describes how the shelter fails to deliver the claimed tax result even without any consideration of the economic substance doctrine. Part VII argues that changing the rules after the game is played is inappropriate and that many tax rules depend on ascertaining the economic substance of transactions to properly apply the law; therefore, the economic substance doctrine is either inappropriate or redundant.

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