Kornfeld v. Commissioner and the Step Transaction Doctrine

Step Transaction Doctrine Legal Theory Tax Deduction

The Step Transaction Doctrine

We will look at one more case before returning to our article series on the sixteenth amendment. This is a case every HTW reader should become very well acquainted with: Kornfeld v. Commissioner (1998). Though it’s primarily an income tax case, it contains a plethora of other important topics and subtopics, and it presents a message which every HTW reader should commit to memory.

In the past, we’ve learned that whether a transaction be taxable is dependent on its substance, and that courts apply the “substance over form” doctrine to determine the true nature of a business transaction. The substance over form doctrine is not the only tool utilized by courts to review a transaction, however; the so-called “step transaction doctrine” is another tool commonly used by courts to clarify the nature of a transaction for tax purposes. Under the step transaction doctrine, multiple “steps” may be classed together and regarded as a single transaction; in this way, steps which may have been taken simply for the specific goal of altering tax liability can be overturned. The step transaction doctrine does not exist to create tax liabilities where none should exist, but to assess tax liability properly by viewing a transaction with the greatest level of accuracy.

In other words, the step transaction doctrine imposes a sort of coherence to a multistep transaction so that it can be properly adjudicated. This is very common in law: legal theories often condense or codify reality so that it can be interpreted using preexisting categories. But the rationale for theories such as the step transaction doctrine is not only about simplicity; there is also the aim of viewing a matter according to its true nature. Even though the step transaction doctrine may “condense” things for the sake of simplicity, many contend that this theory (and other similar theories) portrays matters in a more accurate way, that it provides a clearer sense of what actually occurred. Let’s look at the details of the Kornfeld case to get a better sense of this doctrine and its rationale.

Facts

The facts of this case are a bit complicated. Kornfeld, a highly experienced tax attorney, established a revocable trust which he intended to use to purchase bonds. He entered into an agreement with his daughters in order to claim an amortization deduction on the bonds; the agreement was that Kornfeld would transfer funds (from the trust) to the bond issuing institution equal to the value of a life estate in the bonds and then the daughters would pay the balance on the bonds. The agreement also held that Kornfeld would deliver checks to the daughters for the exact amount which they paid to cover the balance.

Kornfeld and his daughters executed this initial agreement and Kornfeld obtained the bonds. Subsequently, the tax code was changed so that the amortization deduction sought by Kornfeld was made unavailable in situations involving related parties. In response, Kornfeld and his daughters made another agreement which included Kornfeld’s secretary; the second agreement held that the daughters would take a second life estate interest in the bonds following Kornfeld’s death, and that the secretary would have the final remainder interest upon the death of the daughters. Importantly, Kornfeld used IRS valuation tables to create his estimates for the value of his life estate interest. Kornfeld claimed amortization deductions on the bonds and then the IRS assessed a deficiency after they declared that the transaction had failed to produce a genuine life estate in the bonds.

Law

Under U.S. code – specifically section 167 – taxpayers may claim a depreciation deduction of a reasonable amount based on wear and tear for property held primarily for the production of income (such as a bond). IRC subsection 167(d) pertains to life tenants and beneficiaries of trusts. Under these rules, life estate interests in bonds – or “term interests” or limited interests – are considered amortizable (or depreciable) and thus taxpayers may claim a deduction for such an interest. Also see 26 CFR 1.167(a)-1.

Ruling

Applying the step transaction doctrine, the court rejected the argument made by Kornfeld that the payments made to his daughters (and secretary) had no real connection to the bond transaction, and that a genuine life estate interest had been created for tax purposes. The court based its decision on the fact that the seemingly disparate actions of the case were patently interdependent and all served to produce a single, underlying purpose. Kornfeld thought that he had devised a near foolproof scheme to completely avoid any tax liability on the bond transaction, but the court realized that a genuine limited interest had not been created and that Kornfeld had acquired total ownership of the bonds.

The Kornfeld case is a prime example of the step transaction doctrine at work. All HTW readers need to be aware of how the step transaction can affect their tax liabilities; if you aim to acquire a particular kind of tax treatment, you need to understand that your actions preceding any given transaction, as well as your actions which occur after a given transaction, can impact the tax treatment you ultimately receive. In the future – after a few more installments on the sixteenth amendment – we will look at a few more examples of how the step transaction doctrine has been used to alter the tax classification of a series of events.

Image credit: Investment Zen

Gruen v. Gruen: A Lesson on Gift Delivery

Painting Gift Tax Expensive

Expensive Gift

When we think of gift giving we tend to conjure a predictable set of ideas and images: we think of Christmas, birthdays, graduation ceremonies and other occasions in which gifts are exchanged. Seldom do we think of legal ramifications which may be triggered by the delivery of a gift. But when a gift is of exceptionally high monetary value, the act of gift giving can sometimes become a bit more complicated than normal. Gruen v. Gruen (1986) is an interesting case which involved the transfer of an extremely valuable piece of art from a father to his son; the ruling of the case clarified some of the uncertainty on the question of what constitutes proper or “valid” delivery of a gift. If you or someone you know is thinking about giving a gift of similar value, Gruen v. Gruen may be essential reading!

Facts

The father, Victor Gruen, attempted to make a gift of an oil painting by Gustav Klimt to his son, Michael Gruen, in 1963. The father wrote his son a letter in which he explained that, although he wished to transfer title of the gift, he wanted to retain physical possession of the painting for the duration of his life (in other words, retain a life estate in the painting). After being advised against this by his lawyer and accountant, the father wrote another letter to his son regarding the gift and omitted reference to his continued physical possession of the painting. The issue of the case is whether a valid transfer of title of the painting occurred given the fact that the son never took physical possession of the painting while his father was alive.

Ruling

The court (the Supreme Court of New York, upholding the decision of the appellate court) ruled in favor of the son. The son was attempting to establish ownership of the painting against another relative (Michael Gruen’s stepmother). The court found that the father had made a valid transfer of ownership despite the fact that he retained a lifetime interest in the painting. If someone wishes to transfer ownership of property specifically after their death, a will is required; the court reasoned that in this case present transfer of ownership occurred because there was a clear donative intent to bestow ownership upon the son.

Lessons

At the time the case was being tried, the painting by Klimt was worth approximately 2.5 million dollars – quite a birthday gift! The father was afraid that his son would have had to pay inheritance taxes on the gift if he (the father) continued to hold possession of it for the remainder of his life. As it turns out, his fear was without basis: Gruen v. Gruen shows that it is possible to make an inter vivos gift even without physical delivery of the property. As long as there is donative intent, physical or constructive delivery, and acceptance by the receiving party, a valid gift has been made.

Image credit: Bill Damon

The next time you plan to make a gift of an expensive item, don’t be worried about gift tax laws and instead be thankful your situation isn’t nearly as tricky as the one faced by the Gruen family!

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