The sixteenth amendment, says “Congress shall have the power to lay and collect taxes on incomes, from whatever source derived without apportionment among the several States, and without regard to any census or enumeration.” This amendment was ratified in 1913 and revised in 1992. It gives Congress the power to collect taxes.
In 1998 however, one accountant effectively challenged the 16h Amendment in what became Kornfeld V Commissioner.
In the past, 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 “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 common in law as 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) portray matters in a more accurate way.
Kornfeld v Commissioner: The Case
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.
Kornfeld 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.
Critically, 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.
What’s The Law Say?
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 Against Kornfeld
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 and it’s a good lesson in how a step transaction affect your tax liabilities. If you seek 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.