Substance over Form in Criminal Tax - Wendell Odom

Substance over Form: SCOTUS Decision Guides Tax Practice

Business owners conduct various transactions throughout the year. These transactions often involve changes in asset ownership, expense payments, loan payments, and salary payments. Each of these transactions are material to the tax calculations at the corporate and individual levels. It is well understood in criminal law that a distinction exists between tax avoidance and tax fraud. It is accepted that taxpayers can use the tax code to their benefit. No citizen is required to pay more taxes than the code demands. However, there is a fine line between accepted avoidance and deception. This line is often hard to define in the criminal tax space. However, there is an overarching rule that guides that analysis – substance over form. In 1934, the Supreme Court of the United States delivered their opinion in *Gregory v. Helvering, *293 U.S. 465 (1934) discussing the economic realities of specific transactions. While the holding in *Gregory *is not often cited in current case law, the principles of this opinion are important. These principles flow through the tax code and criminal statutes.

This blog will review the Supreme Court’s decision in Helvering and provide real world examples and commentary on its ongoing impact in the world of criminal tax.

Facts of the Case

In *Helvering, *a stockholder organized a new corporation, Averill Corporation, and transferred 1,000 shares to the new corporation. The Averill Corporation was dissolved in that same year and distributed its assets to the stockholder. The stockholder then immediately sold the shares.

The purpose of the transaction was to lower the stockholders tax liability. If the shares were distributed directly from the original holding company, the dividend rules would have triggered a substantial tax liability. The stockholder was able to access a lower tax rate by routing the stock through Averill prior to distribution. Pursuant to Section 112 of Revenue Act of 1928, a stockholder would not recognize gains from the sale of stock if the distribution was done in pursuance of “a plan of reorganization” as long as the stockholder did not “surrender” the stock or security. Reorganization was defined as a transfer of all of the assets by a corporation to another corporation if the stockholders are immediately in control of the transferee corporation’s assets.

The government sued the stockholder in Tax Court for the reorganization scheme and the resulting decrease in tax liability. The Internal Revenue Service argued the transfer of the stock to Averill was not a true reorganization as there was no intent to continue operations. The stockholder had no valid business purpose for transferring the shares outside of the tax benefits. The stockholder argued her intent was irrelevant if the elements of “reorganization” under § 112 were met. The Court was asked to decide whether a transaction that met the elements of § 112 was invalid for tax purposes when the activity served no real business purpose.

The Court acknowledged that the intent or purpose behind the transaction was irrelevant – “the legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means the law permits, cannot be doubted.” However, the Court still had to analyze whether the substance of the transaction fit within the intent of the statute.

The line the Supreme Court drew fell between tax avoidance (as outlined in the quote above) and economic substance. The Court leaned into the lack of business purpose behind the transaction. The facts showed the stockholder did not transfer the stock for a valid business purpose, reorganization or otherwise. The only purpose of the transaction was to avoid the tax liability. This was clear when the history of Averill was reviewed as “when the limited function” of the corporation “had been exercised, it immediately was put to death.”

The Supreme Court found that the conveyance of the stocks to Averill was nothing more than a devious conveyance that masqueraded as a § 112 reorganization. The Court held that the transactions did not fit within the purpose of § 112 and thus, that section did not apply to the distribution of the shares. At first blush, the Court appeared to deliver a limited holding related to the proper use of § 112. However, the core tenets of the holding have permeated through the entire tax code, including the criminal provisions of Title 26.

Criminal Tax and Helvering

In the criminal tax arena, it is rare that the Department of Justice (DOJ) brings a case that is tied to a complicated area of the tax code. Unlike civil inquiries, the DOJ needs an easy-to-understand rule that is clearly violated. The elements of tax fraud and tax evasion require the government to prove that the defendant acted willfully. Willfulness can only be shown if the jury believes the taxpayer knew the rules and chose to violate them.

Tax Fraud and Economic Substance

The willfulness element drives DOJ to focus on tax fraud that involves underreporting income. Most taxpayers know that they must report all their income. Most taxpayers know whether they have omitted income from their return prior to filing. An underreporting case offers an easy route to show willfulness before a jury.

While DOJ primarily focuses on easy to prove tax theories, they will venture into more complicated areas at times. In these cases, the intricacies of the individual tax sections become part of a defense attorney’s arsenal. For example, our firm represented a client out of the Western District of Texas in 2019. The client was charged with filing a false return and tax evasion for not reporting income as a shareholder in his company. The business owner had control and personal use of millions of dollars and declared nearly no income on his personal tax return. While this seemed like an easy underreporting case, the business owner had set up a system of loans from the corporation to breathe life into his defense.

Under the tax code, a shareholder in a S-Corporation may take loans from the corporation up to his basis in the company. The basis in the company will be calculated by determining the total amount of value the shareholder has transferred to the corporation. In the weeks leading up to trial, the government began to realize that the disagreement between the parties did not relate to simple underreporting, but rather, it involved an analysis of the shareholder client’s basis in the asset to substantiate the loan structure. We had gone from a simple underreporting case to a complex tax code equation. The government quickly realized the difficulties in proving willfulness in such an environment. Not only did they need to prove the payments were more than the stockholder’s basis, they needed to show that the stockholder knew 1) the rules surrounding the basis loan provisions and 2) armed with that knowledge, chose to violate federal law. This case was dismissed a month before trial based upon the willfulness element and the complexities of proof.

The reason this defense worked is the stockholder’s transactions were done for a legitimate business purpose. While the transactions did lower tax liability, there is nothing improper about a stockholder classifying currency transactions as loans from the corporation. Stockholders often use loan structures to prevent the need for new shares (injections to the corporation) or control cash flow (shareholder loans). Under the tax code, a taxpayer cannot reclassify income as loans once the IRS knocks on their door. In our client’s case, the loans from the corporation were clearly delineated in the books and supported by documentation prior to the tax filings. If the client had not provided a document trail supporting the loan position, the case would have likely gone to trial. At that point, the prosecutors could argue the stockholder had no intent to repay the money to the corporation and was merely using the tax provisions to justify classic underreporting activity after the fact.

Tax Evasion and Helvering

Tax evasion has two forms under Title 26 – 1) evading the assessment of taxes and 2) evading the payment of taxes. The difference between the two forms stems from timing. A person will evade assessment if they take actions that obfuscate the government’s ability to properly assess tax liability. These actions would include moving money to a dummy corporation in an underreporting scheme or creating a nominee entity to justify invalid expenses. These acts are normally done before a return is filed. Evasion of payment occurs after the tax liability has been assessed. These actions would include putting assets in someone else’s name to avoid collections or lying on civil forms about asset ownership.

In 2021, our firm represented a taxpayer charged with evasion of payment. The taxpayer failed to file a tax return for multiple years. During this period, the taxpayer made substantial income from her professional practice. The civil division of the IRS calculated an outstanding tax liability and began the process of collecting against the client’s assets. During the collection process, the taxpayer bought various pieces of property under the name of her LLC. The LLC did not operate as an asset holding company at any time prior to the IRS collection activity. The purpose behind the client’s decision to place the assets in the LLC after collection efforts began was the focus of the trial.

The government believed the only purpose of the LLC’s asset ownership was to keep the assets out of the IRS’ reach. This theory had weight because the client’s tax liability stemmed from her personal taxes. Assets held in an LLC were not subject to collection for her personal tax liability. In the client’s defense, we had to show the placement of the assets had a valid business purpose that did not envision IRS collections. Under the evasion statute, the client will meet the intent element if avoiding collections was even one of many reasons for the transaction.

The economic reality behind the transaction became paramount. Our job was to convince the jury of a business purpose that was strong enough to overcome the government’s theory. A weak or unsound purpose for the transaction would leave the door open for the improper purpose that we needed to avoid.

While the tax evasion statute does not overtly cite to Helvering, the principles underlying the Supreme Court’s decision directly impact the evasion analysis. Criminal tax cases are built on the foundation of intent. If a taxpayer conducts business activity for a valid business reason, the elements of tax evasion become more difficult to prove. In the inverse, the more disconnected the activity is from a coherent business practice the more likely the government, and a jury, is to view the transaction with skepticism.

Substance is the Key

In the United States, there is no requirement that a taxpayer conducts business to increase their tax burden. There is no requirement that a taxpayer avoids conducting business that diminishes the IRS’ wallet. Tax avoidance is acceptable at all levels.

However, the game becomes far more dangerous when business decisions have no purpose other than tax avoidance. Decisions that lack any business purpose or economic substance will often run afoul of civil tax code rules. When sufficiently egregious, those decisions can become a sword for the government to show intent in a criminal case. The Supreme Court’s decision in *Helvering *lays a foundation from which practitioners should view all criminal tax issues. To understand Title 26, a lawyer needs to mold their brain into the reasoning elicited in *Helvering. *Once complete, the pivoting points in all criminal tax cases become obvious. That pivot must happen before a client’s position can be adequately sold before a jury.