Substance Over Form Doctrine

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Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”- Judge Learned Hand[1]

Strange names aside and a relatable dislike of paying too many taxes, Judge Hand formulated this theory in his 1934 Second Circuit Court of Appeals ruling. Yet, he went on to explain that corporate reorganizations should not be carried out solely to avoid paying the requisite taxes; there should be a reason relevant to the business’s operations or goals for undertaking a reorganization. The Supreme Court reinforced Judge Hand’s ruling a year later, and thus the “substance over form doctrine” was born. Economic “substance” refers to any economic consequences of the transaction, which includes benefits and losses. “Form” relates only to the legal status of the transaction. To illustrate this concept, let’s examine at the facts of the situation of Gregory v. Helvering.

 

Gregory v. Helvering[2]

Evelyn Gregory was the sole owner of all the shares of United Mortgage Company. United Mortgage (and by proxy, Evelyn) owned 1,000 shares of stock of another company, Monitor Securities Corporation. Evelyn then created a third company, Averill Corp. Three days later, the United Mortgage Company transferred the 1,000 shares in Monitor to Averill Corp. Averill Corp then dissolved soon after, and the entirety of the 1,000 shares were distributed only to Evelyn Gregory. She then turned around and sold the Monitor shares for $133,333.33 (roughly equivalent to over $1.9 million in today’s dollars) and paid capital gains taxes on $76,007.88. Her cost basis was $57,325.45. Evelyn’s return on investment wound up being quite a tidy sum, for 1928, anyway.

It is important to note that her sole reason for creating Averill Corp. was to avoid taxation. It is not the tax avoidance that Judge Learned Hand and the Supreme Court took issue with, but rather that they believed that reorganizations should match Congress’s intent in the creation of the Revenue Act of 1928. The issue at hand in this piece of legislation revolved around the “transfer of assets.” The courts interpreted congressional intent as going beyond a mere transfer of assets between businesses. Even though Evelyn’s so-called “re-organization” followed the literal meaning of “a transfer of assets,” the exercise was unrelated to either of the actual businesses involved in the transaction, and thus should not be considered a true reorganization.

 

Substance over Form Doctrine: The Matter at (Learned?) Hand

So what does this mean for participants in a merger or acquisition? One scholar calls the substance over form doctrine “a lethal weapon in the IRS’s arsenal.”[3] The IRS uses Gregory v. Helvering and related rulings to challenge reorganizations and other cases where the economic substance of the transaction is inconsistent with its legal form. Although this doctrine is prominently used to challenge reorganizations, the IRS can use it challenge anything from leasing to employing independent contractors. Financial statements and disclosures should always represent the economic realities underlying the business transaction.

A deal should be properly structured with the IRS in mind to avoid the possibility of coming out on the wrong side of an IRS substance over form claim. Of course, best practice is to ensure that form and substance match as much as possible. Here are a few approaches that are less vulnerable to attack:

  1. Arms-length transactions between taxpayers and independent parties generally fare better than self-dealing transactions.[4]
  2. The parties involved have differing tax interests. That is, one party is more willing to pay a tax (e.g. because of an ability to deduct an expense).
  3. The Business Purpose Test: originated with Gregory v. Helvering, and requires the parties involved to prove that there was a purpose or a motive other than tax avoidance for carrying out the transaction.[5]
  4. Step-Transaction Doctrine: if the economic substances of several formally distinct steps in a transaction depend on each other to reach a particular result, it may be treated for tax purposes as a single transaction, instead of treating each step separately.[6] For an example of when this might be used, read our article on Reverse Cash Mergers and Reverse Triangular Mergers.

It is important to note that these approaches are not bulletproof, but they can help protect the parties involved in a merger or acquisition. Since the substance over form doctrine is subjective, it is best to consult with a tax adviser to help structure a deal that adheres to the substance over form doctrine as much as possible. Taking initiative on this issue as a business owner can prevent headaches, in the form of challenges by the IRS, in the long run.


[1] Helvering v. Gregory, 69 F. 2d 809 (2nd Cir. 1935).

[2] Gregory v. Helvering, 293 U.S. 465 (1935).

[3] Knight, Ray A. and Knight, Lee G. (1991) “Substance Over Form: The Cornerstone of Our Tax System or a Lethal Weapon in the IRS’s Arsenal?,” Akron Tax Journal: Vol. 8, Article 3, 92.

[4] Id. at 98.; Campana Corp. v. Harrison, 114 F. 2d 400 (7th Cir. 1940).

[5] Knight, supra at 99.

[6] Knight, supra at 100; See Penrod v. Commissioner, 88 T.C. 1415, 1427-29 (1987).

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