A business transaction is an interaction between a business and a vendor, a customer, or another business. The transaction may simply be buying or selling, or it may be something more complex. These transactions generate tax liability for the business.

What Is a Sham Transaction?

A sham transaction is a business transaction done for the purpose of avoiding taxes on a profit.

How Does This Type of Transaction Work?

An example of this kind of transaction is when a company buys stock. The company purchases the stock for $800. The dividend pays $200. Later, the company sells the stock for the market value of $800. The transaction appears to be a capital loss, but it is not. The company waited until after it collected the $200 dividend to make the transaction. Thus, in reality, the company made a $200 profit from the stock purchase. 

The IRS will likely deny the company’s claim for the withholding tax and capital losses. This is because, according to the IRS, the transaction was a sham. However, the company will contend that it only bought the right to make money from the dividend, and may challenge the IRS’s decision in court.

What Is a Two-Prong Test for Sham Transactions?

Some courts apply a two-prong test to a transaction to make sure the transaction is not a scam. The first step is to see whether the transaction has any economic benefit, or substance, other than creating a tax benefit. This step is referred to as the objective economic substance test.

The second step in the test is called the subjective business purpose test. It examines whether the transaction was motivated by a business purpose other than obtaining a tax benefit.

Other courts use a sham analysis test. This test is based on whether the transaction had any economical benefit other than generating an income tax loss. 

Should I Contact an Attorney If I Am Accused of a Sham Transaction?

Yes. The burden of proving you did not commit a fraudulent transaction depends on your proof. It is highly recommended that you talk to a business attorney to understand more about sham transactions and possible defenses.