It is important to understand the step doctrine and how it applies to IRS audits and state tax investigations, including California tax audits. The "step doctrine" is a concept not directly found in federal or California law, but that has been borne out of Court decisions since the great depression, beginning with Gregory v. Helvering, 293 U.S. 465 in 1935.

Generally speaking, the step doctrine says you can't avoid the tax burden associated with going from point "1" to point "4" by taking the additional step(s) of going from point "1" to point "2" to point "3" and ending up at point "4." The step doctrine may seem a bit complex, but the principles underneath it are highly fact and case-specific.

U.S. Courts have devised several tests to apply to any series of transactions to determine whether the individual steps were warranted or if the separate transactions should be considered as one. The two most common tests include the "interdependence" test and the "end-result" test.

The interdependence test generally questions whether each transaction in a series of transactions makes sense and would and could stand on its own. If there is no profit, purpose, or value (often referred to as "fruit") in the individual steps, and they cannot make sense unless the series of transactions is completed, the interdependence test would suggest the step doctrine applies.

Likewise, if the separately structured transactions were intended (from the start) to achieve the final step, the end-result test can result in the application of the step doctrine.

However, a taxpayer victory in Orange County, California several years ago demonstrates the importance of a strong accounting and tax strategy for any entity conducting business here in California, across the U.S., or internationally.

In this California tax case, an individual wished to acquire a pizza business, a transaction that would have triggered a substantial tax event. The party first acquired 50% ownership of the business (non-assessable), then liquidated the company while maintaining the 50% ownership of the property (also not generating an assessable event). Finally, the taxpayer completed the acquisition of the pizza business through a buy-out of the remaining 50% interest of the other party - a taxable event, but much less than the total tax that would have resulted by simply purchasing the business directly.

In this case, the Orange County assessor asserted (successfully at the trial level) that the buyer had attempted to avoid the tax assessment through the combination of steps above. Thus, a violation of the "step doctrine" had occurred. The taxpayer, however, was able to convince the Court of Appeals through extensive documentation, accounting, supporting tax documentation, and argument of the facts that the assessor did not have the right to invoke the step doctrine in this case.

It is absolutely possible to stand up to state and federal tax agencies and their personnel when you have a properly structured transaction or series of transactions supported by strong accounting records and tax filings.

How does this apply to most of us? Federal law, California law, and the laws of any state here in the U.S. must be observed and followed. Structuring transactions, developing schemes, or taking actions to avoid the payment of appropriate taxes will result in serious financial and, in some cases, potential criminal exposure and consequences.

Recent technological advances, the integration of Artificial Intelligence (AI), and the cooperation between state tax agencies, the IRS, foreign financial institutions (FFIs), and sovereign tax authorities under FATCA have made conducting business and investment and all associated transactional details much more transparent from the government's point of view.

Transactional and account-level information flows into the IRS from sources within the U.S. and worldwide. In the past, the agency didn't possess the workforce necessary to comb through all of the information and tie it back to individual or entity-level U.S. tax returns.

Recent events have substantially changed this equation. Substantial funding, the acquisition of advanced data processing systems and software and the application of AI have provided the IRS with the ability to efficiently and effectively dissect massive streams of information, searching for patterns and schemes as well as information that is "missing" (read: unreported income) from U.S. tax returns.

However, both transactional planning and tax planning are legal and effective. Structuring transactions, investments, and businesses in a strategic manner is legal and can substantially reduce tax burdens at every level of the transaction itself, as well as downstream. Working with experienced professionals who provide integrated tax, legal, accounting, and business advisory and consulting services is important when structuring complex business and personal transactions.