In Stewart v. Nebraska Dep't. of Rev.,¹ the Nebraska Supreme Court (Court) held that common law economic substance and sham transaction doctrines did not apply to a special statutory capital gains election on sales of qualified capital stock. The Court concluded that the taxpayers, all individuals, met the statutory requirements for the election and that the lack of express language in the statute invoking the tax avoidance doctrines evidenced the legislature's intent that those doctrines should not apply.

In February 2010, the three shareholders, including a husband and wife (the Stewarts), of Pioneer Aerial Applicators, Inc. (Pioneer) entered into an agreement to sell their shares of capital stock to a buyer. The agreement set a closing date of March 1, 2010. Before that closing date, one of the existing shareholders of Pioneer sold one share of stock to each of three officers of the buyer. This brought the number of Pioneer shareholders to six prior to the closing date.

The pre-closing transaction was done so that the sale of Pioneer would qualify for a special, once-in-a-lifetime, statutory election under Nebraska law allowing an individual to exclude from state income tax the capital gains arising from the sale of stock of a corporation acquired by the individual either on account of employment by that corporation or while employed by that corporation.² To qualify for the election, the corporation must, at the time of the sale or exchange, have at least five shareholders and at least two of those shareholders, who are not related to each other, each of whom owns at least 10% of the stock.³ The purchase agreement expressly provided that the pre-closing restructuring was intended to make the sale eligible for the statutory election. On their 2010 Nebraska individual income tax return, the Stewarts elected to exclude the capital gains on the stock sale from tax under this provision.

The Nebraska Department of Revenue disallowed the Stewarts' election on the grounds that the capital stock was not issued from a qualifying corporation. The Stewarts filed a petition for redetermination. The Nebraska Tax Commissioner's (Commissioner) redetermined that, at the time of the sale, Pioneer only had three shareholders, which did not qualify for the statutory election. The Department's position was that the pre-closing transaction resulting in the three additional shareholders was not respected through application of the federal common law "economic substance" and "sham transaction" doctrines. A Nebraska district court affirmed the Commissioner's determination and the Stewarts appealed to the Court, which accepted their petition.

Nebraska Supreme Court rules common law tax avoidance doctrines do not apply

The Court reversed the Commissioner's determination. In so doing, the Court first considered the statutory language, noting that it should not resort to interpretation to ascertain the meaning of a plain, direct and unambiguous statute. The Court reviewed the statute's definition of a qualified corporation and found that it only set forth the requirements for the shareholders at the specific point in time when the election was made. The statute contained no language requiring a business, or other, purpose for taking actions to comply with the statute. Accordingly, the Court found no support for the Commissioner's decision to not respect the pre-closing transaction.

The Court then rejected the Commissioner's determination that the common law economic substance and sham transaction doctrines required a business purpose or economic substance in the creation of the qualified corporation. The Court did not apply the common law doctrines since the language of the statute was "clear and unambiguous." The Court further noted that these common law doctrines had been in existence long before the creation of the special election. Had the legislature wanted to add such requirements, according to the Court, it could have done so and, in fact, expressly did so in other Nebraska tax statutes.⁴ Accordingly, the Court found the omission of such language in the special election statute "significant."

Implications

While it is always a best practice to document business purpose and economic substance for any transaction, the Court's decision may serve as an example of how a state court could restrict application of a "clear and unambiguous" statute to its plain language and preclude a state tax authority from requiring a business purpose. This may especially be true when the state legislature has invoked the federal common law doctrines in some areas of state tax law but not in others.

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ENDNOTES

¹ Stewart v. Nebraska Dep't. of Rev., 294 Neb. 1010 (Neb. S. Ct. Oct. 14, 2016).

² Neb. Rev. Stat. Section 77-2715.09.

³ Neb. Rev. Stat. Section 77-2715.08(2)(c).

⁴ See e.g., Neb. Rev. Stat. Section 77-4931(6), 77-5540(6), 77-5724(6).