Nebraska Supreme Court Rejects Department Of Revenue’s Application Of The Federal “Economic Substance” And “Sham Transaction” Doctrines To Nebraska’s Special Capital Gains Exclusion

by Matt Ottemann

Ottemann, Matthew
(402) 341-3070

In Stewart v. Nebraska Department of Revenue, the Nebraska Supreme Court rejected the Department of Revenue’s application of the “economic substance” and “sham transaction” doctrines, which were developed under federal tax law, to Nebraska’s Special Capital Gains exclusion. The net result of this decision is a big win for both the Stewarts and for owners of Nebraska corporations.

Nebraska’s Special Capital Gains Exclusion

Nebraska’s Special Capital Gains Exclusion allows owners of many Nebraska-based corporations to avoid Nebraska income tax on the sale of their corporate stock. The Legislature’s goal in enacting the Exclusion was to keep corporate shareholders from leaving Nebraska before the shareholders sold their corporate stock. Many owners of Nebraska based corporations had been leaving Nebraska for non-income tax states to avoid paying Nebraska income tax on the capital gain from that sale.

There are a number of requirements that corporate shareholders must meet to qualify for the Exclusion. Each individual may elect to claim the Exclusion for one corporation in his or her lifetime. The shareholder must have acquired his or her shares while employed, or on account of employment, at a corporation with Nebraska operations. Another key requirement, which was at issue in the Stewart case, is that the corporation must have at least five shareholders “at the time of first sale or exchange for which the election [to claim the Exclusion] is made.”

Department’s Contention Regarding The Special Capital Gains Exclusion

The Department has recently been contending that both the “economic substance” and “sham transaction” doctrines from federal tax law should be applied to the Exclusion. Pursuant to those doctrines, even if a corporation had five shareholders at the time of the first sale of corporate stock, the Department contended that it could look through that ownership to determine if the ownership of the corporate stock by each of the five shareholders had “economic substance.” If the Department judged that such ownership did not have “economic substance,” or that ownership was acquired only to qualify for the Exclusion (and thus was a “sham transaction”), the Department often contended that the Exclusion was not available for a given sale.

Stewart Case Facts

Brenton and Mary Stewart owned a significant majority of Pioneer Aerial Applicators, Inc. Along with one other shareholder, they entered into a contract to sell their stock in the company to an outside corporation. Because Pioneer did not have five shareholders, Mary Stewart entered into a contract to sell one share of Pioneer stock to three officers of the purchasing corporation before the transaction with the purchasing corporation closed. Payment for the shares was made pursuant to a nonrecourse note.

After the transfer to the three officers was completed, the Stewarts completed the sale of the remaining shares to the purchasing corporation. The Stewarts contended that such sale was eligible for the Exclusion. The Department disagreed and issued a tax assessment to the Stewarts. The appeal of that tax assessment ultimately reached the Supreme Court.

Supreme Court’s Decision

The Supreme Court soundly rejected that the “economic substance” or “sham transaction” doctrines from federal law could apply to the Exclusion. Instead, the Court took a plain reading of the statute and determined that the date on which corporate ownership was measured was the date of the first sale of corporate stock. Pursuant to this rationale, the Supreme Court disregarded the transactions prior to the date of sale that allowed Pioneer to reach five shareholders. The Supreme Court decided instead that, because Pioneer had five shareholders when the Stewarts’ sale closed, the Stewarts were eligible for the Special Capital Gains Exclusion.

Effect Of Decision

The Department of Revenue has been assessing many corporate shareholders who attempted to qualify for the Exclusion by adding shareholders to their corporation to reach five before a stock sale closed. The Department’s rationale for these assessments was often based on the “economic substance” or “sham transaction” doctrines. The Department may now have to drop many of those assessments (except where the Department has other contentions of fact or law supporting the assessment). This is a big win for Nebraska’s corporate shareholders.

What The Decision Does Not Say

This decision reflects the Supreme Court’s rejection of the “economic substance” or “sham transaction” doctrines to interpret one specific statute which the Supreme Court believed was plain and did not need interpretation. So, we don’t believe that the decision is a widespread rejection by the Nebraska Supreme Court of the “economic substance” or “sham transaction” doctrines in all tax areas. We urge readers and their advisors not to view this decision too broadly (both as applied to the Exclusion itself and to other Nebraska tax issues).

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