Don't Put the Cart Before the Horse (State Tax Planning vs. Business Purpose)

I published this post two years ago, but the idea still applies today; therefore, I thought I would re-post it as a reminder on how to, or how NOT to, implement state tax planning.

CASE: HMN Financial, Inc. and Affiliates v. Commissioner of Revenue, Minnesota; docket No. 7911-R; May 27, 2009 (State of Minnesota County of Ramsey Tax Court)

Summary of Case

This case involved, as the Court stated:

“a sophisticated tax avoidance plan involving a captive real estate investment trust (REIT), a holding company and the transfer of loans and loan proceeds in a circular pattern through the taxpayer’s entities.”

The taxpayer argued that it met the requirements of a foreign operating company (FOC) under Minnesota statutes; therefore, it must be afforded the favorable tax treatment the statute allows. The taxpayer argued the state has no authority to set its transactions aside as a sham because the taxpayer met the definitions of an FOC.

The state maintained that one cannot simply look to the status of a taxpayer to determine whether deductions will be allowed or disallowed; one must look at the transactions to determine whether deductions will be allowed.

The state argued, and the Tax Court agreed, the only true purpose of the taxpayer’s transactions was to avoid Minnesota taxes. Thus, because the state has the authority to disregard sham transactions, the transactions must be disallowed.

Summary of Conclusions Stated in Support of Courts Finding:

1. Accounting firm marketed same plan to other businesses.
2. Accounting firm stressed state tax savings in its materials.
3. Accountants knew the taxpayer needed a business purpose other than tax savings.
4. Accountants provided taxpayer with several sample business purposes.
5. Taxpayer did not follow through on achieving any non-tax business purpose.
6. Non-tax business purposes did not have economic substance, risk, or effect.
7. There was no increase in income, no lessening of expenses, no business, other than the avoidance of taxes.
8. Only business purpose achieved was state tax savings.

So What?

This is not the first time a state and/or court has disallowed a transaction because it determined the transaction lacked economic substance or business purpose (and it won't be the last time).

Therefore, when conducting any type of state tax planning (especially complex restructuring), make sure the “horse is in front of the cart.” Meaning, figure out what your business goals and objectives are, and then figure out what state tax planning can be done to minimize the state tax ramifications of achieving those business goals.