Tax Law | Expert Legal Commentary
July 19, 2010
Klauer v. Commissioner: Step Transaction Doctrine Does Not Apply to Multi-Step Bargain Sales to Charity
William R. Klauer v. Commissioner of Internal Revenue
H. Jacob Lager of Zuber Lawler & Del Duca
The Tax Court has held that the step transaction doctrine did not apply to a series of bargain sales from a family-owned S Corp. to a charitable organization. As a result, the shareholders were entitled to charitable contribution deductions related to the sales. In William R. Klauer v. Commissioner of Internal Revenue, T.C. Memo 2010-65, 2010 WL 1293209 (U.S. Tax Court 2010), the Tax Court considered the three prevailing tests to determine whether the step transaction doctrine applied: The “binding commitment” test, the “end result” test, and the “interdependence” test. Because none of these tests applies to the series of transactions at issue, the step transaction doctrine did not apply.
The Klauer family owned an Iowa Subchapter S corporation named Klauer Manufacturing (“Klauer”). Between 1919 and 2001, Klauer acquired about 9,800 acres of land adjacent to Taos, New Mexico, including 2,581 acres known as the Taos Valley Overlook (the “Taos Overlook”).
In 1999, the Trust for Public Land (the “Trust”) approached the Klauers about purchasing the Taos Overlook. Because the Trust had no funding at the time, it was not able to enter into a legally binding contract to purchase all of the property. Instead, on January 23, 2001, the Trust and Klauer executed three options that would allow Klauer to convey one-third of the Taos Overlook to the Trust each year over a period of three years at a bargain price. Each sale would be dependent upon the Trust obtaining funding for the purchase; the Trust was not obligated to purchase any of the property. Moreover, the Trust would have to purchase exterior portions of the Taos Overlook first, so that if they did not purchase all three sections, Klauer would retain ownership over the interior.
The Trust did obtain funding and did exercise their options to purchase the property each year, in 2001, 2002, and 2003, for a total of $15 million. Klauer obtained appraisals for the fair market values of the conveyed land each year – the total value each year was substantially higher than the bargain sale price. Klauer issued a K-1 to the shareholder, who claimed their share of the charitable deductions resulting from the sale each year.
The IRS audited all shareholders and denied the deduction. The IRS claimed that the original option agreement created a binding sale contract on the entire Taos Overlook, thus requiring application of the step doctrine and denial of the charitable contribution deduction.
The Series of Transactions Did Not Qualify as a Step Transaction
The step transaction doctrine holds that a series of separate but related transactions may be viewed as a single transaction for tax purposes. If the step transaction doctrine applies, tax liability applies to the entire integrated transaction, rather than to each separate transaction. William R. Klauer v. Commissioner of Internal Revenue, T.C. Memo 2010-65, 2010 WL 1293209, *19 (U.S. Tax Court 2010).
As it did in Klauer, the Tax Court has three different tests to apply to determine whether a series of transactions qualifies for the step transaction doctrine (See Penrod v. Comm., 88 T.C. 1415, 1429 (1987)):
1) The “Binding Commitment” test: This test inquires whether, at the time the first step, or transaction, is executed, a binding commitment is made to undertake the next step. Klauer, 2010 WL 1293209, *19
2) The “End Result” test: This test asks whether the “series of formally separate steps are really pre-arranged parts of a single transaction intended from the outset to reach the ultimate result.” Id.
3) The “Interdependence” test: This test considers whether the steps were “so interdependent that the legal relations created by one transaction would have been fruitless without a completion of the series” of transactions. Id.
In Klauer, the Tax Court determined that none of these applied. The IRS argued that the option contract created a binding commitment because the contract fixed the value of the sale price in advance. In the alternative, it argued that the sales were “interdependent transactions,” and therefore denied the deduction.
The Tax Court rejected the IRS’ claim of a binding commitment because the Trust had no legal obligation to purchase any of the property. If the Trust could not obtain funding, it could not purchase that portion of the tract and ownership would remain with Klauer. The Trust was not required to exercise any or all of its options, and its acquisition of one section of the property did not obligate it to purchase any additional sections. Accordingly, the series of transactions failed both the binding commitment and end result tests for a step transaction. Id. at **20-24.
The Tax Court also rejected the interdependent transaction argument, finding that the individual transactions in the series had independent significance – the exercise of any single option had value to the Trust regardless of whether the Trust exercised the other options. Moreover, the parties had contemplated that all of the options would not be exercised, as evidenced by Klauer’s insistence on retaining the interior portion of the tract if the Trust did not exercise all of its options. Id. at ** 25-27.
Because none of the step transaction doctrine tests applied, the Tax Court held that the charitable contribution deductions were allowed.
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