Nebraska Refuses to Apply Sham Transaction to Deny Special Capital Gains Exclusion

Nebraska ruled that a taxpayer’s transactions to meet the requirements of a special capital gains exclusion were legal.

By Jeff Glickman, SALT partner

When a tax authority reviews a transaction, it not only makes sure that the taxpayer’s tax position meets the requirements of the statute, but it may also determine whether the transaction itself has economic substance and is not a sham. Tax advisors often discuss with their clients the concepts of business purpose, sham transaction, economic substance and others. There concepts were initially established by federal courts addressing federal income tax issues. Over time, however, states began applying them, albeit inconsistently, and this creates uncertainty for taxpayers when trying to analyze how a state might view a particular tax position. Recently, the Nebraska Supreme Court (the “Court”) issued an opinion refusing to apply the economic substance/sham transaction doctrines to a transaction that the taxpayer admitted was structured in a way to specifically take advantage of a favorable tax rule. [1]

Nebraska has a special rule that allows an individual to make an election, once in his or her lifetime, to exclude capital gains from the sale of stock in a corporation that the individual acquired either “on account of employment by such corporation” or “while employed by such corporation.” [2] In addition, at the time of the first sale or exchange for which the election is made, the corporation must have (i) at least five shareholders and (ii) at least two shareholders (or groups of shareholders) who are not related and who each own at least 10 percent of the stock. [3]

Under the facts of the case, the Stewarts, a married couple, owned stock in a corporation with one other unrelated shareholder. The three shareholders had agreed in writing to sell all of their stock to another company (the “sale”). In order to take advantage of the special capital gains exclusion rule, Mrs. Stewart sold one share of her stock to each of three officers of the purchasing company a few days before the closing of the sale. By doing so, the Stewarts made sure that just prior to the sale, the ownership of the company met the five shareholder rule in order to qualify for the special capital gains exclusion. The sale contract explicitly described the pre-sale transaction and that it was being done with the specific intention of satisfying the statutory language for the capital gains exclusion.

The Court first examined the statutory language which it found to be plain and unambiguous, and it did not address any transactions that came before the sale giving rise to the capital gains exclusion election. The state argued that the Court should deny the taxpayers the exclusion on the grounds that the sale to the three officers lacked business purpose and economic substance. In particular, the state pointed out that these judicially-created doctrines are not intended to modify or alter the statutory language, but are instead applied to effectuate the purposes of the statute even where the transaction satisfies its literal language.

However, the Court determined that where the language of the statute is clear and unambiguous, it is precluded from looking beyond the words and applying additional meaning or requirements (such as business purpose or economic substance). The Court also noted that the state legislature was well aware of these doctrines at the time it enacted the special exclusion, and the fact that it did not impose any of those requirements into the statute is significant.

In tax law, there is a natural tension between the taxpayer’s position that as long as it meets the literal requirements of a tax statute that it should qualify for the tax treatment as set forth in that statute versus the government’s view that tax statutes are subject to interpretive tools to carry out their intended purposes and that engaging in transactions without business purpose or economic substance thwart those purposes.

While the taxpayer was victorious in this case, state administrative and judicial courts are applying these doctrines with more frequency in all areas of state tax (e.g., income tax, sales and use taxes, property tax, etc.). As such, state tax authorities have more incentive to review transactions on audit and apply these doctrines to deny the taxpayer’s intended tax benefits. Therefore, taxpayers must be careful to properly document the business purposes behind their transactions and make sure that those transactions are carried out with economic substance (e.g., if a parent is lending money to a subsidiary, there should be a written note, arm’s-length interest and payments should actually be made).

Aprio’s SALT team has experience assisting taxpayers with properly structuring their transactions in order to ensure that they are not denied due to the application of business purpose, economic substance or other similar tax doctrines. We constantly monitor these and other important state tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the November/December 2016 SALT Newsletter. To view the newsletter, click here.

[1] Stewart v. Nebraska Department of Revenue, 294 Neb. 1010 (Neb. Sup. Ct., Oct. 14, 2016).

[2] Neb. Rev. Stat. § 77-2715.09.

[3] Neb. Rev. Stat. § 77-2715.08(2)(c).

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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