The U.S. Tax Court recently issued an opinion in Parkway Gravel Inc. v. Commissioner, Docket No. 10819-21, respecting the structure of a gravel company's sale of a land parcel known as the Freeway Pit. In finding for the taxpayer, the Tax Court rejected the IRS argument that either the common law "conduit" doctrine or the "sham transaction" doctrine should apply to recharacterize the transaction.

Judicial Tax Doctrines

Federal courts have developed several anti-abuse doctrines to deny the tax benefits of a tax-motivated transaction. Many of the doctrines overlap in significant ways, and the courts are often imprecise in their terminology. The sham transaction doctrine has two variations: 1) a factual sham, which is a transaction that did not occur, and 2) a sham-in-substance, which is a variation of the economic substance doctrine. The economic substance doctrine was codified by the U.S. Congress in 2010.

The conduit doctrine is a separate judicial doctrine that provides that a sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title.

The IRS is increasingly raising these judicial doctrines to disregard tax planning in real business transactions.

Parkway Gravel

In Parkway Gravel, two family members owned a road construction company taxed as a C corporation for income tax purposes (Parkway), and a separate real estate development partnership (V&N). Parkway granted an option to V&N to buy the Freeway Pit for $6.9 million. In exchange, the Option Agreement required V&N to undertake rezoning efforts to prepare the property for development.

After V&N's rezoning efforts were successful six years later, the owners sold the Freeway Pit to a third party for $11.1 million. The sale was structured such that the purchaser directly paid V&N the excess over the $6.9 million option amount ($4.2 million) to assume V&N's option to purchase the property from Parkway, which the purchaser then exercised. Parkway received the remaining $6.9 million proceeds and shortly thereafter entered into a tax-deferred exchange of property under Section 1031 of the Internal Revenue Code. V&N reported the $4.2 million as long-term capital gains.

The IRS challenged the structure of the sale under two primary theories. First, the IRS argued that V&N operated as a conduit for the sale to avoid the full $11.1 million proceeds being allocated to Parkway. The Tax Court rejected this theory due to the fact that V&N participated in the sale through its rezoning efforts that increased the marketability of the Freeway Pit.

Alternatively, the IRS argued that the Option Agreement was a factual and economic "sham" that should be disregarded for tax purposes based on the common control of both entities. The Tax Court easily held that the Option Agreement was not a factual sham because Parkway and V&N entered into a written agreement that was performed by both parties. Further, the Tax Court found that the Option Agreement was not an economic sham because V&N had downside risk if the Freeway Pit diminished in value below the $6.9 million option price. Therefore, the IRS could not disregard the Option Agreement and attribute the full $11.1 million sales price to Parkway.

Conclusion and Takeaways

The Tax Court's holding is a victory for taxpayers and their ability to structure ordinary business transactions. Despite the taxpayer's victory, the IRS will continue to raise judicial doctrines to tax planning in business transactions, particularly when they involve related parties. However, well-documented and carefully structured transactions can still pass muster despite attempts by the IRS to expand the scope of judicial tax doctrines.