The Stock Sale as a Sham Transaction

Taxpayers are continually seeking ways to avoid or minimize their tax liabilities. And rightfully so, as taxes take a significant amount of profit or gain from any deal or effort.

Take the case of a lawsuit award. You sue someone and settle or win the case. There are nuances, but generally, you are usually taxed on the full settlement award or judgment. You are even taxed on the portion that is used to pay your attorney’s fees.

But what if instead of settling the case with the defendant, you have them purchase your stock? You then treat the payment you receive as a capital contribution which is not subject to tax.

That is the setup in the Acqis Technology v. Commissioner, T.C. Memo. 2024-21 case. The taxpayer seems to have had a reason for this type of transaction, independent of the tax savings. The IRS did not agree and asserted that it was a sham transaction.

Facts and Procedural History

The taxpayer was a business founded in California in 1998. In 2004, after selling its computer hardware business, the taxpayer transitioned into a nonpracticing patent licensing model.

The company acquired seven U.S. patents related to modular computer systems and sought to collect licensing fees from other companies infringing on those patents.

The taxpayer hired lawyers, sent notice letters to companies regarding the patents, and started preparing to file patent infringement lawsuits against numerous large tech companies. The taxpayer started with one lawsuit against 11 tech companies.

After two years, the taxpayer had reached settlements with all of the defendant companies. A few of the larger settlements were structured as stock purchases, where the defendants paid sums to the taxpayer designated as purchases of newly issued “Settlement Shares.” The taxpayer treated these amounts as equity investments, not taxable income, on its 2010-2012 tax returns. The defendants also paid a smaller license fee, which was reported as taxable income.

After an audit by the IRS, the IRS determined in 2017 that the stock purchase payments should have been treated as taxable income for the taxpayer. It assessed deficiencies against the taxpayer for tax years 2010-2012. The taxpayer petitioned the U.S. Tax Court, arguing the payments were properly characterized as nontaxable stock purchases and not settlement payments or license payments.

Tax Treatment of Settlements

In assessing the tax treatment of settlement payments, the fundamental inquiry is: in lieu of what were the damages awarded? This is often referred to as the origin of the claim.

These rules usually arise in the context of the income tax exclusion for damages received by individuals on account of physical sickness or injury. That is not what we have in this case, but the concepts still apply.

The tax consequences of a settlement payment depend not on the validity of the underlying claim but on the nature of the claim that was the basis for the settlement. To determine the nature of the claim, courts focus on the intent of the payor at the time of settlement.

If the settlement agreement lacks express terms specifying the purpose of the payment, courts look beyond the agreement itself to other evidence of the payor’s intent. Relevant evidence includes the amount paid, communications between the parties, and the circumstances leading up to the settlement.

The ultimate question is what was the payor’s dominant reason for making the payment? With that said, even seemingly clear payment allocations in settlement agreements may be disregarded if the evidence shows the payment actually represented something else.

The Sham Transaction Framework

The key issue in this case was whether the stock purchases were shams lacking economic substance.

The court summarizes the law as follows:

Two relevant forms of sham transactions exist: factual shams and economic shams. Krumhorn v. Commissioner, 103 T.C. 29, 38 (1994). Factual shams are purported transactions that never took place, while economic shams are transactions that lack economic substance. Id. In examining economic shams the U.S. Court of Appeals for the Ninth Circuit focuses on (1) the subjective inquiry of whether the taxpayer intended anything other than acquiring tax benefits (business purpose) and (2) the objective inquiry of whether the transaction had any practical economic effects beyond avoiding taxation (economic substance).

Thus, for economic shams, the court considers the business purpose and economic substance. They have applied these rules to a number of different types of transactions, such as intercompany transfers.

Business Purpose Analysis

The business purpose analysis focuses on whether the taxpayer had a subjectively genuine business purpose for entering into the transaction apart from tax avoidance.

Under this analysis, transactions executed solely to produce tax deductions, without any expectation of economic profit, are generally treated as shams.

Courts evaluate the taxpayer’s assertions regarding business motivations objectively, looking at the facts known or reasonably discoverable by the taxpayer when entering into the transaction.

This is just one of two aspects of this analysis. Even if the taxpayer intended some business purpose, the absence of any reasonable expectation of pre-tax profit may still indicate lack of economic substance.

Economic Substance Analysis

Closely related to the business purpose analysis is the economic substance analysis, which asks whether the transaction had any practical economic effects apart from tax savings.

This involves an objective analysis of whether the transaction was likely to confer actual monetary benefits on the taxpayer, corresponded to realistic economic losses/gains, and appreciably changed the taxpayer’s financial position.

Factors considered include the relationship between the price paid and fair market value, whether the parties negotiated prices at arm’s length, subsequent adherence to contract terms, financing arrangements, and whether traditional burdens and benefits of ownership actually shifted.

If a transaction lacks either a business purpose or has no economic substance, the courts may disregard the form and assess taxes based on the underlying economic reality.

Were the Stock Purchases a Sham?

In this case, the tax court analyzed whether the settlement share purchases were shams lacking business purpose and economic substance.

Regarding business purpose and the taxpayer’s motivations, the court made the following observations:

During settlement negotiations, petitioner offered D1, D2, D3, and D4 discounts to structure the settlements as stock purchases rather than as licensing agreements. Chu testified that he understood at the  time that petitioner would not have to pay taxes on the payments if structured as stock purchases. Petitioner, however, asserts that the financial incentive to have defendants settle through stock purchases was to enlist the large technology firms as “partners.” Per petitioner, it expected that the defendants, as shareholders, would provide the company with credibility and validity, while retaining a passive interest in Acqis’s future success.

The court found the taxpayer’s assertions of wanting to partner with large tech firms unconvincing. This was primarily due to restrictions in the settlement agreements that barred the taxpayer from disclosing the new “partnerships.” Also, the taxpayer only offered stock purchase structuring discounts to larger settlement payments, contrary to the taxpayer’s claim about wanting stature from big tech firms as partners.

As for economic substance, the court held the Settlement Shares themselves had no actual value because they lacked any meaningful ownership rights and conferred no ability for shareholders to profit from the taxpayer’s success. The terms of the share purchases also resembled the licensing fee settlement structure used with other defendants.

For these reasons, the court held that the stock sales were a sham to avoid taxes on the litigation settlement payments. The result is that the taxpayer had to pick up the capital contributions as taxable income. For the investors, the court opinion is not all that clear, but hopefully, they deducted the payments and, if not, filed protective claims pending the outcome of this litigation.

The Takeaway

This court case demonstrates the courts’ willingness to prioritize its view of what counts as the economic reality over strict adherence to transactional forms when applying federal tax law. This type of hindsight analysis by the courts can be troubling for businesses.

A court and its staff are not in business. They often do not appreciate the realities of business. The pressure from having to do what you have to do to make payroll or pay payroll taxes or fire loyal staff members, to constantly fend off profiteers and others who have motivations that go beyond just bilking the business for money, employees who underperform intentionally and even those who steal from the business, etc. are everyday considerations for businesses. These are often the types of motivations that drive transactions that courts are apt to miss or not fully appreciate.

The economic substance doctrine allows courts to scrutinize transactions like those in this case. This can reverse the tax treatment for valid business transactions.

As evidenced by this case, taxpayers should ensure any transactions have concrete business motivations and real economic effects beyond anticipated tax benefits. This includes documenting motivations that a court might be able to understand and appreciate.