Judicial Doctrines Relevant To Tax Fraud Schemes

The following judicial doctrines have been developed by the courts to analyze the
economic substance of a transaction and then determine its tax consequences.
Tax Evasion vs. Tax Avoidance
Unfortunately, the terms "tax evasion" and "tax avoidance" are often used
interchangeably.
Tax evasion involves fraudulent or criminal behavior, conduct involving deception,
concealment, or destruction of records.
Tax avoidance generally denotes non-criminal modes of conduct by the taxpayer
which minimize or avoid tax liability, but that he is prepared to disclose fully to the
IRS. If a transaction does not establish a tax liability in the first place, the taxpayers
motive to avoid tax is irrelevant.
The classic description of tax avoidance was written by Judge Learned Hand
in Helvering v. Gregory, 69 F. 2d 809, 810 (2nd Cir, 1934), affd 293 U.S. 465 (1935).
[A] transaction, otherwise within an exception of the tax law, does not lose its
immunity, because it is actuated by a desire to avoid, or, if one choose, to evade,
taxation. Any one 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; here is not
even a patriotic duty to increase ones taxes.
In contrast, tax evasion occurs when the taxpayer fraudulently or criminally avoids the
payment of taxes otherwise due and owing under the tax laws. There are many tax
crimes under the Internal Revenue Code. In that regard, in Spies v. U.S. 317 U.S. 492,
497 (1943) the Supreme Court observed:
singly or in combination [in income tax crimes] were calculated [by Congress] to
induce prompt and forthright fulfillment of every duty under the income tax law and
to provide a penalty suitable to every degree of delinquency.
The criminal violations cover the same territory as the civil fraud penalties, although
the government has a higher burden of proof in the criminal cases. The criminal cases,
however, reach a far greater spectrum of potential defendants. Unlike the civil
penalties which target only the taxpayer, the criminal penalties reach anyone engaging
in the defined offense, including employees, accountants, lawyers and tax preparers.

For example, in Tinkoff v. U.S., 86 F. 2d 868 (7th Cir., 1936), an accountant who
prepared fraudulent returns for clients was convicted of tax evasion.
Under IRC Sec. 7206(2), a person is guilty of a crime if he willfully:
aids or assists in or procures, counsels, or advises the preparation or presentation of
a return, affidavit, claim or other document, which is fraudulent or is false as to any
material matter, whether or not such falsity or fraud is with the knowledge or consent
of the person authorized or required to present such return, affidavit, claim or
documents.

Substance Over Form

In applying the income tax laws, with few exceptions, the substance of the transaction,
rather than its form, determines the tax consequences. U.S. v. Phellis, 257 U.S. 156,
168 (1921); Weinerts Est. v. CIR, 294 F. 2d 750, 755 (5th Cir. 1961).
The "form" of a transaction is generally the label the parties attach to their
arrangement; for instance, they might call an arrangement a compensation agreement,
a loan, a lease or a sale. There might be documents that support the form, but the
courts are not concerned with these labels or documents that purport to govern the
transaction the courts focus on the substance of the transaction, regardless of the
labels used by the parties.
According to Bittker and Lokken, Federal Taxation of Income, Estates and Gifts, 2
Ed. (Hereafter "Bittker and Lokken"), the substance over form analysis is often used
to dissect transactions between related parties, including loans to family members and
transactions between related corporations and their shareholders:
The substance-over-form doctrine is invoked by the government with greatest success
with respect to transactions between related persons, since in these circumstances the
form used often has minimal, if any non-tax consequences and is often chosen solely
to reduce taxes. Id. at 4-36.
Loans to members of the lenders family are also grist for the substance-over form
millThe same can be said of loans by controlling shareholders to their own
corporations and, conversely, of loans by their corporations to them, especially if the
advances are proportionate to stock ownership. Id. at 4-37.

Transactions between parent and subsidiary corporations and among other members
of an affiliated corporate group provide another set of tempting targets for legislative,
administrative, and judicial marksmen armed with the substance-over-form
weapon. Id. at 4-37.
Related party transactions provide fertile territory for self-dealing and the form of the
transaction is often secondary to achieving a tax result. In contrast, arms length
transactions with independent third parties are far less vulnerable to substance over
form attack. Independent third parties usually express their transaction in writing and
are concerned about the non-tax ramifications of the transactions; consequently, the
form of the transaction usually embodies the actual substance as well.

Sham Transactions
The sham transaction concept embodies two separate theories:
o A sham in fact which is a fictional transaction that never actually
occurred.
o A sham in substance is a transaction that actually occurred but which
lacked the substance the form allegedly represented. Kirchman v. Cm,
862 F. 2d 1486 (11th Cir, 1989).
A sham in substance occurs when the taxpayer draws up papers to characterize a
transaction contrary to the objective economic realities and which have no economic
significance beyond the expected tax benefits. Falsetti v. Cm, 85, TC 332 (1985).
A transaction is considered a sham in substance if it effects no real change in each
partys economic position. For example, a sale that fails to transfer beneficial
ownership of property in which the payments circulate among various parties in
ways that cancel themselves out would be considered a sham in substance.
In Rices Toyota World, Inc. v. Cm. 752 F. 2d 89, 91 (4th Cir, 1985), the Court of
Appeals described the sham-in-substance rule as follows:
To treat a transaction as a sham, the court must find that the taxpayer was motivated
by no business purpose other than obtaining tax benefits in entering the transaction,
and that the transaction has no economic substance because no reasonable possibility
of profits exists.

In Jacobson v. CM, 915 F. 2d 832 (2nd Cir, 1990), the Court of Appeals confirmed the
Tax Courts description of the sham transaction doctrine:
The Tax Court summarized the sham doctrine as follows:
Transactions that are entered into solely for the purpose of obtaining tax benefits and
that are without economic substance are considered shams for Federal income tax
purposes and purported indebtedness associated therewith will not be recognized.
[A] sham transaction [is] a transaction that is lacking in objective economic reality
and that has no economic significance beyond expected tax benefits.
In deciding whether transactions lack economic substance, we consider such factors as
the lack of arms-length negotiations, inflated purchase prices, the structure of the
financing of the transactions, and the degree of adherence to contractual terms.

Business Purpose
Courts will not recognize a transaction that lacks any business or corporate purpose,
but is a mere device for dodging the taxpayers taxes. Helvering v. Gregory, 69 F. 2d
809, 811 (2d Cir. 1934); Gregory v. Helvering, 293 U.S. 465, 469 (1935); CIR v.
Transport Trading & Terminal Corp., 176 F. 2d 570, 572 (2d Cir. 1949), cert. Denied,
338 U.S. 955 (1950).
In Helvering v Gregory, the taxpayer, a sole shareholder, wanted to receive
marketable securities from her corporation, but a direct distribution would have
constituted a dividend (taxed as ordinary income) to her.
The taxpayer formed another corporation, transferred the marketable securities to the
new corporation, then promptly liquidated the new corporation, receiving the
marketable securities in the process as a liquidating distribution of property from the
newly-formed corporation (thus receiving favorable capital gains treatment on the
liquidation). The transaction literally conformed to the liquidating distribution
provisions of the tax code. In other words, instead of receiving a dividend of
marketable securities from her original corporation, she received the same securities
tax-free by forming a second corporation, transferring the securities to that
corporation, then liquidating the second corporation.
The Supreme Court decided that the transaction lacked any business purpose and
violated the tax laws, notwithstanding the fact that it literally complied with the
liquidation provisions:

Putting aside the question of motive in respect of taxation altogether, and fixing the
character of the proceeding by what actually occurred, what do we find? Simply an
operation having no business or corporate purpose a mere device which put on the
form of a corporate reorganization as a disguise for concealing its real character, and
the sole object and accomplishment of which was the consummation of the
preconceived plan, not to reorganize a business or any part of a business, but to
transfer a parcel of corporate shares to the petitioner [taxpayer].
Judge Learned Hand, in Cm v. Transport Trading & Terminal Corp., 176 F. 2d 570,
572 (2nd Cir, 1949), cert. denied, 338 U.S. 955 (1950) summarized the business
purpose doctrine as follows:
The doctrine of Gregory v. Helvering means that in construing words of a tax
statute which describes commercial or industrial transactions we are to understand
them to refer to transactions entered upon for commercial or industrial purposes and
not to include transactions entered upon for no other motive but to escape taxation.

Step Transactions
The step transaction doctrine, especially pronounced in the corporate-shareholder
area, requires that interrelated steps of a transaction may be analyzed as a whole if
they in substance are interdependent and focused on a particular end result. Bittker
and Lokken at 4-47 states the rule as follows:
If the parties have agreed to a series of steps, no one of which will be legally effective
unless all are consummated, application of the doctrine is ordinarily assured.
In Manhattan Bldg. Co. v. CIR, 27 TC 1032, 1042 (1957), citing American Bantam
Car Co. v. CIR, 11 TC 397 (1948), affd per curium,, 177 F. 2d 513 (3d Cir. 1949),
cert. denied, 339 U.S. 920 (1950), the court stated the step transaction doctrine as
follows:
The test is, were the steps taken so interdependent that the legal relations created by
one transaction would have been fruitless without a completion of the series?
The Supreme Court, in Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938),
observed that:
A given result at the end of a straight path is not made a different result because
reached by following a devious path.

When the step transaction doctrine is used to eliminate transitory steps, it overlaps
with the business purpose doctrine (the step is disregarded because lacking in business
purpose) and the substance-over-form principle (the step is disregarded as a formality
that obscures the substance of the transaction).

Assignment of Income Doctrine

The "assignment of income" doctrine states that income is taxed to the one who earns
it a taxpayer cannot avoid tax by assigning his income to another party or entity.
Gross income derived from property must be included in the income of the person
who beneficially owns it. Blair v. Cm., 300 U.S. 5 (1937); Lucas v. Earl, 281 U.S. 111
(1930). The assignment of income doctrine is judicial in its origin and adds to IRC
Sec. 61 (the definition of gross income) an implicit requirement that gross income
must be included in the return of the appropriate taxpayer.
A corporation is acting as an agent of its shareholder when a taxpayers income is
assigned to the corporation, unless the corporation conducts substantial business
activities. Cm v. State-Adams Corp, 283 F. 2d 395 (2nd Cir, 1960), cert denied, 365
U.S. 844 (1961). In Parish-Watson & Co. v. Cm, 2 BTA 851 (1925), the court held
that income from property held by a corporation as agent of its sole shareholder was
included in the shareholders gross income.
This doctrine becomes relevant when a taxpayer attempts to deflect income to another
entity, such as by assigning an installment obligation or compensation earned by him,
to his wholly-owned corporation.

Distribution to Shareholders and Constructive Dividends

The courts have often found a constructive dividend when a corporation transfers
money or other property, without an expectation of reimbursement, to or for the
benefit of one or more of its shareholders, and the transaction is not characterized or
reported as a dividend. The transfer must be made with respect to the corporations
stock. It is not necessary that either the corporation or the shareholder intend a
dividend distribution for constructive dividend treatment to result. Crosby v. U.S., 496
F. 2d 1384 (5th Cir, 1974). Actually, in almost every case, the constructive dividend
was improperly characterized as a loan, business expense or consideration for the
purchase of an asset.

The basic inquiry regarding the true nature of the corporate transfer is whether there is
an actual loan, business expense or asset purchase to support the transfer to the
shareholder. A transfer to a shareholder from the corporation for a purpose other than
to satisfy its corporate obligations or to acquire a corporate asset is usually a dividend.
For example, in Kings Court Mobile Home v. Cm, 98 TC 511 (1992) funds diverted
by the shareholder were constructive dividends, not wages, when the transfer was
characterized as wages long after the diversion occurred and there was no evidence
that the purported compensation was reasonable in amount.
To be characterized as a constructive dividend, the distribution or transfer by the
corporation must also primarily benefit the shareholder. Loftin & Woodward v. U.S.,
577 F. 2d 1206 (5th Cir. 1978). The benefit may be conveyed through a distribution by
a corporation to a third party for the benefit of a shareholder, to satisfy the
shareholders purpose, or through a distribution of corporate earnings or assets for the
private purpose of the shareholder. Dean v. Cm, 57 TC 32 (1971); Sparks Nugget, Inc.
v. Cm, TC Memo 1970-74, affirmed, 458 F. 2d 631 (9th Cir, 1972).
In cases where there are distributions to the controlling shareholder, the IRS usually
issues a Notice of Deficiency, treating the distributions as constructive dividends.
Given the IRSs presumption of correctness in most cases, the burden of proof usually
falls to the taxpayer to show by a preponderance of the evidence that the distribution
was made in connection with a valid corporate purpose.
Under IRC Sec. 301 (c) (3) and 316 (a), dividends are taxable to the shareholders as
ordinary income to the extent of the earnings and profits of the corporation, and any
amount received in excess is considered as a nontaxable return of capital to the
shareholders basis in the stock. Any amount received in excess of the corporations
earnings and profits and the shareholders basis in his stock is considered gain from
the sale or exchange of property (usually capital gain). Truesdell v. CM, 89 TC 1280
(1987).
In DiZenzo v. Cm, 348 F. 2d 122, 127 (2nd Cir, 1965), reversing in part and remanding
TC Memo 1964-121, the court held that the burden of proof is generally on "taxpayers
to establish that the corporation did NOT have earnings and profits equal to the funds
diverted" with respect to deficiencies (emphasis in original). Taxpayers must then
establish that the corporation did not have earnings or profits; otherwise, distributions
to shareholders will be considered dividends and taxed as ordinary income. DeLeo v.
CM, 96 TC 42 (1991).