The Step Transaction Doctrine

by Joe on May 6, 2013

I love getting and answering questions. Often, it’s too late, a reader already did something, and enough time has passed that there’s little to be done. When I’m contacted first and can save a reader from a potential mistake, that’s a good day for me.

I found this one particularly intriguing. First, the question from my reader at JoeTaxpayer.com:

Thanks for all of the great information you have provided! I have a question that I’m hoping you can shed some light on. My father passed and left his IRA to my brother and me, each of us inheriting a 50% share of the account. My brother is proposing to sign over his share to my name, and then have me cash out his 50% amount because I’m in a much lower income income tax bracket and live in Florida with no state income tax. Then he suggests that I write him a check for the amount I receive, after proper taxes are withheld according to MY residency and tax bracket. My question is, is this even legal? What are the implications of doing this? He says his tax attorney says it’s completely legal, but something doesn’t seem right about it to me, I somehow feel like this is backdoor way at tax evasion. Thanks for your help!

My response – sorry for your loss. Forgive me, I’m forgetting the exact word here. The meaning is that when one looks at the whole picture, what do they see?

a) disclaim IRA inheritance – no problem
b) withdraw more than RMD at your rate – no problem
c) gift (up to $14,000 per year with no paperwork required) – no problem

Three separate transactions each being fine, but when strung together are in fact, tax evasion. I am not a lawyer, nor a CPA. I am self-educated in this field and an author with passion. I’ve read enough to know that in the case of an audit, these events clearly come together with the intent to defraud. In fact, (a) the disclaimer, while legal, wasn’t a true disclaimer, it came with strings and an expectation that you’d give the money back. The advice I’d give a family member, friend, or reader is to avoid such transactions. Your Spidey-senses told you this can’t be the right thing to do, and it really isn’t. I’m afraid your brother will inject “but Joe said ‘audit’ and we’d never get audited.” I have a 14 year old and my advice to her has always been if you are wondering what the odds are are of being caught, you know you’re doing something wrong. On a lighter note, the attorney is actually proposing tax evasion, and should be disbarred. I’d say jailed as well, but I don’t wish to pay for this guy’s room and board.

This was my response, and I was confident of its accuracy. But the word I was missing was driving me crazy. Fortunately, an online request at the Usenet group I frequent and am a moderator, misc.taxes.moderated, resulted in a response. Step Transaction Doctrine. Indeed, I got it right, the definition at USLegal.com shows “In short, the tax liability should be determined by viewing the transaction as a whole, disregarding one or more non substantive, intervening transactions taken to achieve the final result.” To put it into layman’s words – “They think they are taking a series of legal steps that, if done all at once, would result in underpayment of tax. The idea is that the IRS has the ability to ignore the middle steps and look just at the result.”

Simply put, these three transactions combined as suggested form one larger transaction that is tax evasion. As I wrote the response to my reader, what I found remarkable is the suggestion from the Tax Attorney whom you’d expect to be knowledgeable on such matters. It took me a few hours to track down the right principle that applies in this matter, shouldn’t a legitimate tax attorney know this as well? In my post “Let’s Kill All the Lawyers,” it seemed a lawyer stepped out of his area of expertise, but in this case, this was something a tax attorney should get right, period.

{ 3 comments… read them below or add one }

Honolulu Aunty May 6, 2013 at 12:20 pm

Aloha Joe and reader,
Indeed that tax attorney sounds sleazy! The brother too, imo. Basically he gets an inheritance gift from his father and looks to get the most out of it by shuffling around the cards.
Question: If the will or trust specifies that the 2 brothers get 50% each of the IRA (I guess it isn’t a Roth IRA or no tax consequences, correct?), even if one brother gifts his portion over to the other brother, isn’t he still responsible for the tax liability since the original transaction was his receipt of 50% of the father’s IRA?
Interesting case, mahalo for sharing,
Aunty

Reply

Joe May 21, 2013 at 3:17 pm

Aunty – a beneficiary of a retirement account or will can disclaim his inheritance. Say my mom left me and my sister each 50% of an account. I decide sis needs the money more than I do, and I tell the broker or trustee of the estate that I will disclaim my share. She is then treated as sole beneficiary, and it’s as if I were never listed.

In the above situation, one brother would like to figure out how to pass on most of the tax bill, but still get his share.

Reply

Dolly Z. Dunlap January 9, 2014 at 1:41 am

Yesterday, the Tax Court issued a decision that illustrates what happens when the taxpayer has engaged in fraud. (Joseph B. Williams III v. Commissioner, 2009 TNT 72-11). Because the court found that fraud was established by the taxpayer’s plea to tax evasion, the court ruled that the IRS could recover for liability dating back to 1993-2000, more than six years before the IRS’ notice of deficiency to the taxpayer.

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