On September 21, 2023, the U.S. Court of Appeals for the Federal Circuit clarified the boundary between the step transaction doctrine and the economic substance doctrine in a precedential opinion in GSS Holdings (Liberty) Inc. v. United States, 81 F.4th 1378 (Fed. Cir. 2023). The courts have long acknowledged that the soft doctrines – including the step transaction, business purpose, and substance over form doctrines – tend to "overlap and it is not always clear in a particular case which one is most appropriate[.]" King Enterprises, Inc. v. United States, 418 F.2d 511, 516 n.6 (Ct. Cl. 1969). In GSS Holdings, the Federal Circuit issued a rare decision placing limits on mixing and matching between the doctrines, specifically finding that the Court of Federal Claims had inappropriately "applied a hybrid legal standard conflating the step transaction doctrine and the economic substance doctrine." The Federal Circuit vacated judgment entered for the government at the Court of Federal Claims and remanded for further proceedings under the proper legal standard for the step transaction doctrine specifically.
In GSS Holdings, the IRS asserted that the step transaction doctrine applied to integrate (1) a partnership's 2011 sale of an investment asset to a bank through exercise of a put option with (2) amounts the partnership was required to pay to that bank under a separate loss sharing agreement. If the transactions were collapsed under the step transaction doctrine, then the partnership's payment to the bank would be an adjustment to the sales price received from the bank for the sale of the investment asset. For tax purposes, the bank was a majority partner in the partnership. Under section 707(b)(1), no deduction would be allowed for any loss incurred by the partnership from the related party sale of the investment asset. However, if the court respected the transactions as separate, then a deduction arising from the partnership's standalone payment to the bank may have been permissible under section 165.
The taxpayer and the government agreed that the "end result test" should be deployed to determine whether the step transaction doctrine applied to collapse the transactions. Under the end result test, the court analyzes whether multiple transactions "were really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result." Falconwood Corp. v. United States, 422 F.3d 1339, 1349 (Fed. Cir. 2005) (internal quotation marks omitted). The partnership had entered into the put option in 2006 and had established the loss sharing agreement in 2007, with that loss sharing agreement originally involving an unrelated third party. Rather than assessing the taxpayer's intention at the start of the series of transactions, the Court of Federal Claims examined the taxpayer's intentions at the time of the 2011 option exercise that triggered the claimed loss. Specifically, the court invoked case law under the economic substance doctrine to conclude that it should evaluate the taxpayer's intent at the time of the "transaction giving rise to the alleged tax benefit." The Federal Circuit ruled that this "hybrid legal standard" constituted "legal error" and remanded for a decision under the proper standard of assessing the taxpayer's intention at the outset of the series of transactions.
Notably, the Federal Circuit declined to address when the relevant transactions began in this case. The parties dispute whether the series of transactions started in 2006 or a later date connected with subsequent amendments of the put option or the transfer of the loss sharing agreement from the original third party to the bank. With the Federal Circuit directing the trial court on remand to "determine the outset of the series of transactions," it remains possible that the government prevails in disallowing the loss.
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