After I wrote The Step Transaction Doctrine at my companion site, RothMania, I received a number of emails asking about situations where this might apply. Here’s an example of another disallowed series of transactions:
A) A son and wife are in a high tax bracket. Enough so the AMT effect causes there long term capital gain to be taxed at 22.5% (really 15% plus extra due to AMT). They gift the son’s parents $50,000 in appreciated stock.
B) The parents, who are in a low bracket, sell the shares and have no tax due as there’s no cap gain tax if you are in the 10 or 15% bracket.
C) Parents then gift their son and his wife $50,000, the proceeds of the sale.
In a Q&A a few years back my favorite IRA author Ed Slott offered a definition of the Step Transaction Doctrine:
The step transaction doctrine can be a bit complicated, but essentially, when applied it treats what are actually several independent steps as if they were a single transaction for tax purposes.
There are three different tests which have been used to determine if the step transaction doctrine should apply. One test, commonly referred to as the “binding commitment test” applies when there is a commitment to complete a later step in an overall transaction at the time the first step is made. Since an IRA contribution (deductible or not) does not require that one convert the contribution to a Roth IRA, this test is a non-factor here.
Another test that is used to determine if the step transaction doctrine should be applied is the “mutual interdependence test.” This test looks at each step in an overall series of steps and determines if a specific step is meaningless unless the later step(s) actually occurs. Since a non-deductible IRA contribution is clearly beneficial (read “not meaningless”) on its own, this test is also a non-factor.
The third and final test, known as the “end result test,” is the most applicable for this discussion. Under the end result test, the steps in a transaction are looked at to see whether the series of steps were really just predetermined steps of a single, overall transaction, aimed at achieving a specific outcome. Do clients make IRA contributions with the idea that they will later convert them? Sure. So is it possible for IRS to raise issues with this strategy in the future? Yes, but it’s not a likely scenario.
You can see that each of these events, taken alone, is perfectly legitimate. It’s only when they are combined in this way that the IRS combines the transactions and would go back to our Yuppie couple along with a tax bill.
The key thing to ask yourself is whether each event was legitimate, and in this case, there’s really no bona fide gift to anyone, the transactions are simply tax avoidance. Will you get caught? That’s the wrong question. You see, once you start asking what your chances are, it’s a slippery slope. Best to avoid deals that look like this regardless of what your ‘advisor’ tells you. At RothMania, a reader’s brother has a tax attorney who was encouraging him to skirt this rule, either that or the lawyer was completely ignorant of it. In either case, I’d stay clear of any advisor who makes such proposals. If it sounds too good to be true, it might just be tax evasion.