Benjamin M. Willis (@willisweighsin on Twitter; firstname.lastname@example.org) is a contributing editor with Tax Notes. He formerly worked in the mergers and acquisitions and international tax groups at PwC and with the Treasury Office of Tax Policy, the IRS, and the Senate Finance Committee. Before joining Tax Analysts, he was the corporate tax leader in the national office of BDO USA LLP. The views expressed here are his own.
In this article, Willis examines why Treasury’s inclusion of business purpose requirements in regulations defies congressional intent and misinterprets the law.
In this series of articles on the validity of Tax Cuts and Jobs Act regulations, I have yet to connect the dots on an essential point: Regulatory principal purpose tests defy Congress’s choice to omit a business purpose requirement.1
A principal purpose test imposes a business purpose requirement. A principal purpose test is the flip side of a business purpose requirement. A nontax business purpose is needed to show a taxpayer’s principal purpose was not tax avoidance, of course. It is the imposition of a congressionally unauthorized and unintended business purpose requirement that will cause a regulation using a principal purpose test to be invalidated. When a regulation uses a principal purpose requirement to defy the plain intent of the statute, such as giving tax incentives to encourage investment decisions, it is a patently improper interpretation of the law.
Congress intentionally includes business purpose requirements, and the IRS’s attempts to superimpose them aren’t permitted.2 This is true for tax-free basis-reducing distributions from corporations and partnerships and for deductions. Treasury’s respect for the law ensures that tax rates for specific entities or activities, such as domestic production and exports, align with congressional intent.
The extraordinary increase in frequency of Treasury’s decisions to incorporate principal purpose tests, and therefore business purpose requirements, in statutory provisions that clearly don’t intend this raise many questions. For example, are superficial antiabuse rules poison pills designed to ensure that the regulations will likely be invalidated? Would Treasury do this to follow executive orders requiring that regulations reduce costly tax burdens? After all, no TCJA regulation would be complete without a principal purpose test, right?
The Principal/Business Purpose Coin
In Gregory, the Supreme Court explained that “the rule which excludes from consideration the motive of tax avoidance is not pertinent to the situation, because the transaction upon its face lies outside the plain intent of the statute.”3 (Emphasis added.) In other words, a nontax business purpose is needed if the plain intent of the statute requires it. In Rev. Rul. 76-363, 1976-2 C.B. 90, the IRS ruled that when a corporation was formed and the “principal purpose for the organization of X was to secure the benefits of subchapter S,” those tax benefits, including the immediate flow-through of losses, would be respected because, as in Gregory, Congress's intent must be followed.4
While Gregory is well-known for distilling the business purpose requirement for reorganizations, it is often neglected that it merely interpreted the statute and thus, determined whether the required economic substance existed for what was found to be a sham transaction. As Stephen S. Bowen explained when describing the relatively narrow role of business purpose:
Gregory, fundamentally, is an economic substance case, not a business purpose case. Judge Hand certainly had no interest in evaluating Mrs. Gregory’s motive or purpose. Rather, as he stated, “if what was done . . . was what [the statute] intended, it is of no consequence that it was all an elaborate scheme to get rid of income taxes, as it certainly was.”5
The Supreme Court in Gregory found the need for a nontax purpose to reorganize business as follows: “When subdivision (B) speaks of a transfer of assets by one corporation to another, it means a transfer made ‘in pursuance of a plan of reorganization’ [section 112(g)] of corporate business, and not a transfer of assets by one corporation to another in pursuance of a plan having no relation to the business of either, as plainly is the case here.” And while the analysis could have been clearer, which ultimately led to the creation of many substance over form principles, there is no doubt that the goal was statutory interpretation. Shortly after Gregory, the court in W&K Holding Co. distinguished corporate reorganizations from section 351 transfers, which it found had no business purpose requirement.6 Although section 357(b)(1) demonstrates Congress’s intent for a principal purpose test and a business purpose requirement for contributions of liabilities.
In fact, most of the IRC contains mechanical rules for determining tax liability for which no subjective intent or purpose-based determination is required. In other words, a taxpayer’s intent generally is irrelevant.7 Yes, most of the IRC’s provisions don’t require a nontax business purpose or, said differently, prevent one from having a purpose to reduce tax, be it a substantial or principal purpose.
The nature of a tax item generally has no inherently good or bad qualities until other provisions cause that item to be taxed at a rate that reflects the burden or benefits Congress intends to be placed on the taxpayer or otherwise alters its treatment. A regulation cannot ignore Congress’s intent to bestow beneficial treatment on taxpayers by imposing a business purpose requirement when one hasn’t been intended, which is precisely what including a principal purpose test inside a tax regulation does.
A business purpose requirement or principal purpose test would render much of the IRC useless. Its provisions both give and take. Some get refunds, while some pay. Credits, deductions, and expensing, for example, are intended to offer economic incentives for specific behavior. Of course, the code is filled with penalty taxes that are designed to discourage behavior and that use principal purpose or substantial purpose thresholds. Others are purely mechanical, such as section 304, which isn’t concerned with taxpayer purposes to trigger its penalizing provisions that can convert a stock sale with no built-in gain or income to an entirely taxable dividend. A section 707 disguised sale can have a similar effect by converting an otherwise tax-free transaction into a taxable sale on built-in gain property based on substance, as specifically authorized by Congress.
We will explore in a future article the weight the unauthorized inclusion will be given in determining the validity of a regulation package and possibly integrated packages that constitute a tax regime. When Treasury demonstrates a clear lack of understanding of the tax laws or disrespect for the congressional intent of their provisions or the process for creating valid regulations, the courts won’t look favorably on such attempts to defile the Constitution and ignore the proper role of any branch of government. Specifically, courts will not be complicit in allowing any branch of government to ignore the Constitution; doing so would only allow for the encroachment upon its own judicial authority.
Business Purpose Thresholds Are Rare
The code has many provisions that use principal or substantial purpose thresholds, which are most often designed as penalty taxes to eliminate standard benefits or impose additional taxes and payments. Principal and substantial purpose thresholds ensure specific benefits are limited to those with business purposes that outweigh tax purposes to the requisite degree. But courts don’t easily deprive an accused of life, liberty, or property simply because of their thoughts. A code filled with such ambiguities would not be a code at all but a license for enforcement agencies to punish at will.
While some rules may use a requirement to have a nontax business purpose only under narrow circumstances, others may use it more broadly, such as in sections 269 or 7701(o). But of the thousands of pages of federal tax laws and their plethora of effective dates and expiration dates, the vast majority impose no business purpose requirement. Much of the code is based on choices or elections to fall within one regime or another based on slight differences in mechanics and entitlements.
If someone failed to fall within the $500 million gross receipts test of the base erosion and antiabuse tax of section 59A, they wouldn’t be penalized for not making enough income — even if the provision’s mechanical cliff effect was implicated by a taxpayer’s choice to earn a bit fewer taxable dollars to save it millions in tax. Let’s face it, whether it’s a mechanical control test or a tax bracket and holding period that alters one’s decision to trigger gain or otherwise earn income, the code taxes actions and transactions; motives don’t cause tax for most of the code. Taxpayers should be able to interpret the law, which is why Congress is thoughtful in crafting rules that look to a taxpayer’s thoughts before they are stripped of the rights the law provides. I wish Treasury had shown similar respect for taxpayers and the law in drafting regulations under the TCJA.
Of course, some of the business purpose requirements Treasury is imposing through principal purpose tests have statutory support in varying degrees. The problem is that regulations are intended to clarify ambiguities, not create them. In doing so, the new regulations arguably are designed to fail, and perhaps that is the goal.
Why Will Treasury Lose?
Overreach. Treasury will lose many principal purpose battles because many of the regulatory tests lack a basis in law and don’t satisfy procedural requirements. We’ve discussed procedural requirements before, and in an upcoming article we’ll talk about the weight accorded to several factors for this and determining when a sufficient basis in law exists to impose a business purpose requirement in a regulation. But it is important to remember that Congress drafts the law and courts respect the benefits Congress gives, regardless of how generous Treasury might think Congress has been.
In United Dominion,8 the Supreme Court explained that “in cases such as this one, in which the complex statutory and regulatory scheme lends itself to any number of interpretations, we should be inclined to rely on the traditional canon that construes revenue-raising laws against their drafter.” In Gitlitz, the Court held that cancellation of indebtedness income (COD) excludable under section 108 is an “item of income” that increases an S corporation shareholder’s stock basis under section 1367(a)(1)(A).9 The Court rejected the IRS’s argument that COD income under section 108 isn’t an “item of income,” noting that section 61(a)(12) lists COD income among the items of gross income and that section 108 is an exception to section 61(a)(12).
While the IRS relied on the narrow Ilfeld10 consolidation limitation and Treasury regulations applicable to S corporations, Justice Clarence Thomas said that a shareholder’s stock basis is increased by the amount of COD income under “a plain reading of the statute.” Thus, even though the item of income was excludable, the law still provided a generous basis bump.
It is clear when Congress imposes a limitation based on the subjective intent of a taxpayer. While section 269’s principal purpose test has been interpreted to be more of a mind-reading exercise and thus has been less effective, Treasury’s interpretation of section 355’s business purpose requirement has received great praise largely because the regulations clearly spell out detailed objective factors for determining whether a transaction was undertaken with a substantial business purpose. Section 7701(o) codified the economic substance doctrine in a similar fashion, ensuring a substantial business purpose is determined in conjunction with a meaningful change in economic position; although these are often one and the same because business purposes are usually intended to change economic positions.
In addition to often having little to no authority for intent-based limits under the TCJA provisions, Treasury added insult to injury by drafting regulations that rebuffed Congress’s laws on clear and proper rulemaking by designing them to be ambiguous, unlike the clearer section 355 regulations that implement Congress’s intent-based requirements. The ambiguity of Treasury’s new principal purpose tests is attributable to their lack of criteria or guidelines as well as the vague examples that taunt by merely stating, as a fact, that the legal principal purpose test hasn’t been satisfied. Could Treasury have really expected any deference would be given to these clear overreaches and the administrative impossibilities they present?
But let’s briefly go back to the intent of Congress. Courts have repeatedly invalidated unauthorized principal purpose thresholds. In Mayo Clinic,11 the court held that the regulatory requirement that the institution’s “primary function” be education in reg. section 1.170A-9(c)(1) exceeded Treasury’s statutory authority. The court explained that “there is no grammatical or textual reason to think that less frequent variants like ‘principal function’ or ‘primary purpose’ have a different meaning” than principal purpose and invalidated Treasury’s unauthorized attempt to insert this threshold and alter the plain meaning of the law.
Similarly, in Stephenson Trust, the Tax Court held that a subchapter J regulation was “invalid because it adds restrictions not contained in the statute nor contemplated by Congress.”12 The court explained that “Congress had not enacted a provision making tax-avoidance motive the touchstone of tax liability in the trust area although it had done so in other areas such as sections 269, 306, 482, 532 and 1551.” The Tax Court concluded by holding that the “regulation specifically states that forming multiple trusts for the principal purpose of obtaining these deferral and minimum tax benefits is forbidden. Sec. 1.641(a)-0(c)(3), Income Tax Regs. The regulation disallows benefits allowed by the statute and thus conflicts with the plain intent of Congress. Therefore, the regulation is invalid.”13
The courts have continually made it clear that tax benefits won’t be withheld from the taxpayer even if Treasury thinks the benefits are too good to be true.14 Ultimately, when Treasury attempts to insert an unauthorized business purpose requirement into a statute it has failed.15 TCJA regulations with unauthorized business purpose requirements found in principal purpose tests will also fail.
1 Benjamin M. Willis, “Carried Interest Regs Resurrect Kisor’s Altered Auer Deference,” Tax Notes Federal, Aug. 10, 2020, p. 1043; Willis, “TCJA International Regulations: Deference for Expertise and Interest,” Tax Notes Federal, Aug. 3, 2020, p. 863; Willis, “TCJA International Regulations: Uncertain Validity,” Tax Notes Federal, July 20, 2020, p. 451; Willis, “TCJA International Regulations: Certain Invalidity,” Tax Notes Federal, July 6, 2020, p. 103; Willis, “TCJA International Rules: Complete Uncertainty,” Tax Notes Federal, June 29, 2020, p. 2293; and Willis, “When Policy Doesn’t Support a Principal Purpose,” Tax Notes Federal, June 15, 2020, p. 1879.
4 In Modern Home Fire & Casualty Co. v. Commissioner, 54 T.C. 839 (1970), the Tax Court held that denying the benefits of an S corporation election because of a U.S. federal tax avoidance purpose would thwart “the intent of Congress to allow shareholders of electing small business corporations to ‘be taxed directly on the corporations earnings’ and to report ‘corporate income (whether or not distributed) as their own for tax purposes.’”
5 Stephen S. Bowen, “Whither Business Purpose,” 80 Taxes 275 (2002).
6 W&K Holding Co. v. Commissioner, 38 B.T.A. 830 (1938).
7 See section 7701(o) and the codification of the relevancy requirement, which merely reflects this fundamental tax principal. See, e.g., Joint Committee on Taxation, “Technical Explanation of the Revenue Provisions of the ‘Reconciliation Act of 2010,’ as Amended, in Combination With the ‘Patient Protection and Affordable Care Act,’” JCX-18-10 (Mar. 21, 2010) (providing the codification of the economic substance doctrine under section 7701(o) is “not intended to alter the tax treatment of certain basic business transactions” including “the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C”).
8 United Dominion Industries Inc. v. United States, 532 U.S. 822, 839 (2001); see also Steve R. Johnson, “Should Ambiguous Revenue Laws Be Interpreted in Favor of Taxpayers?” Nev. Law. 15-16 (Apr. 2002) (stating that Thomas’s and Stevens’s opinions in United Dominion support the long-standing preference principle of taxing provisions).
9 Gitlitz v. Commissioner, 531 U.S. 206 (2001); see also Security Bank Minnesota v. Commissioner, 994 F.2d 432 (8th Cir. 1993) (holding “because the application of section 1281 to these loans is ambiguous, we follow the venerable rule that ‘in the interpretation of statutes levying taxes . . . [courts must not] enlarge their operations so as to embrace matters not specifically pointed out. In case of doubt they are construed most strongly against the Government, and in favor of the citizen.’”) (Emphasis added.).
13 Willis, “Principal Purpose: Treasury’s Disappointment in the TCJA,” Tax Notes Federal, Oct. 28, 2019, p. 617.
14 Willis, “Executive Overreach Burdens Taxpayers,” Tax Notes, Jan. 28, 2019, p. 407; see also Transco Exploration Co. v. Commissioner, 949 F.2d 837 (5th Cir. 1992) (providing that when the “benefit claimed by the taxpayer is fairly within the statutory language and the construction sought is in harmony with the statute as an organic whole, the benefits will not be withheld from the taxpayer though they represent an unexpected windfall”).
15 Robert Willens, “Phantom Business Purpose Requirement: Laid to Rest?” Tax Notes, May 6, 2013, p. 683 (“an additional reason to doubt the existence of a business purpose requirement in the section 351 context is the Service’s own concession to that reality, Rev. Rul. 84-71”). Willis, “The Phantom Business Purpose Requirement,” Tax Notes, Apr. 29, 2013, p. 523.