Substance Versus Form, Part II: The Step Transaction Doctrine – How Tax Works
Mar 02, 2026
In episode 47 of How Tax Works, Matt Foreman continues his discussion of substance versus form issues, focusing on the Step Transaction Doctrine, discussing the three tests and how they’re used and misused.
Listen to the episode here:
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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.
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Transcript:
**This transcript has been prepared automatically by AI and may contain inaccuracies**
Matthew Foreman [00:00]
Hello and welcome to the 47th episode of *How Tax Works*. I’m Matthew Foreman. In this episode, I’m going to talk about the economic substance doctrine and the step transaction doctrine. In this episode, I’m probably going to largely focus on tax-related investments, but this is really about substance versus form. In the last episode, 46, I talked about economic substance. This one, I’m going to focus on step transaction doctrine. If you’ve ever talked about these with anyone, you’ll see that not only are they very closely related,
They have a lot of overlapping concepts. They can substitute for each other at times, and they can dip in and out. So it’s really important.
How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Hire your own attorney. *How Tax Works* is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions that we all make. Administrative stuff: new episodes every two weeks. The next one will be on unrelated business taxable income, UBTI—a totally different but important topic.
And what I run into more often than I thought I would: nonprofits really exist in the world, kind of outside of what I do, but at the same time, they just keep bumping into structuring issues, which is always really interesting. Anyway, last time I talked about a lot of substance versus form stuff, went through the economic substance doctrine. This one, I’m talking about the step transaction.
Matthew Foreman [00:01:57]
The step transaction doctrine, in my view, is more complicated, which is probably why this ended up as two episodes. If I had gone really fast with economic substance, I could have covered step transaction in about half an episode. But I added more details because I want to talk about it in depth.
At its core, the step transaction doctrine permits a series of formally distinct steps to be combined and treated as a single transaction if the steps, in substance, are integrated, interdependent, and focused toward a particular result. That’s from *Penrod 88*, a tax court case, 88 TC 1415—the quote part: “integrated, interdependent, and focused toward a particular result,” SpotSight 1428 for those looking it up.
There are really three parts to it: one, distinct steps combined into a single transaction; two, if integrated, interdependent, and focused toward a particular result. Importantly, you can have steps that are not problematic at all in a large transaction that meet these criteria. I have seen PLRs written where the structuring is overt and obvious, intended to get a tax result the IRS is aware of, and they approve it.
Matthew Foreman [00:03:40]:
Usually I turn my phone off, but yes, I do have an actual phone—hope you didn’t hear that. Anyway, the point is: you can meet all three of those criteria and still not have a transaction collapsed by the step transaction doctrine. There’s more that goes into it than just that. *Penrod* is a really good case to start with because it opens up a lot of the core concepts you encounter with the step transaction doctrine.
If the goal is to go from A to B, you can’t add steps from A to Z and ignore B through Y. Steps that exist between A and Z may be collapsed under the doctrine. Taxpayers are stuck with their chosen form, but the IRS can reinterpret or recharacterize things. The key point: the taxpayer must follow the chosen form unless there is a reason otherwise.
Matthew Foreman [00:06:06]:
What we have is a mesh of inconsistent formulations of the step transaction doctrine. *Penrod* talks about the different ways to apply it. Unlike economic substance, this is all case-law driven—no statutory basis—so the rules vary by circuit. Tax court may treat things differently than appellate circuits, so be careful.
As a general rule, if you meet all three criteria, you’re fine. If only two, you need to check the rules in the relevant circuit. Some cases settle, some go to court, so you see a lot of complex fact patterns.
Matthew Foreman [00:07:29]
Now, let’s discuss the three formulations of the step transaction doctrine: one, the binding commitment test; two, the end result test; three, the interdependent test. They overlap a lot, so it’s important to understand each.
The binding commitment test says that a series of transactions will be stepped together if, at the time of the first step, there is a binding commitment to undertake later steps. You don’t literally need a signed commitment—case law shows that understanding or implied commitment can suffice (*Revenue Ruling 91-47*).
The*end result test is broader: transactions are stepped together if they are pre-arranged parts of a single transaction intended from the onset to reach an ultimate result. Intent and timing matter, but starting points may vary.
The interdependent test focuses on whether transactions are so interdependent that one would be fruitless without the completion of the series. The emphasis is on relationships between steps, not the ultimate outcome.
Matthew Foreman [00:14:28]:
Sometimes adding unnecessary steps can trigger the doctrine. But if extra steps have a valid business purpose or regulatory reason, they may not be problematic. Analysts should review all three tests and check applicable circuit rules. Cases like *McDonald’s of Zion* show courts may apply different tests depending on jurisdiction.
Factors to consider: intent at each step, temporal proximity (time between steps), and overall business purpose. Temporal proximity alone does not collapse steps. Business purpose, reasonableness, and shareholder votes also matter. Public and private companies may have different implications.
Matthew Foreman [00:20:28]
Revenue rulings such as *79-250* and *96-29* show the IRS often respects separate economic motivations, even when steps are close in time. Courts reinforce that the IRS cannot invent steps—they can only evaluate existing steps (*Grove, 2nd Circuit*). Taxpayers can choose the lowest-tax option if it meets the law’s requirements. Real and meaningful shareholder votes can limit the application of the doctrine.
Matthew Foreman [00:27:24]:
A common example of inapplicability: pre-reorganization partnership elections and F-Re-orgs (*Revenue Ruling 2008-18*). Steps may appear multiple but effectively accomplish the same outcome without triggering the doctrine. Understanding alternatives is key.
Matthew Foreman [00:29:45]
Always evaluate tax alternatives, potential IRS challenges, and the purpose of each step. Combining step transaction doctrine with economic substance analysis helps assess risk. Tax professionals are limited to advising on likely outcomes in audits or litigation (CIRC 230).
Matthew Foreman [00:32:08]
This episode turned into two due to complexity. That was the 47th episode of How Tax Works. The next episode, 48, will cover UBTI—unrelated business taxable income. Thank you for listening, and I hope you learned something valuable.
