Handshake Deals

Informal arrangements may be good for business, but they are bad for tax enforcement

By Alex Raskolnikov

Summer 2011

Order, as Robert Ellickson reminded us more than a decade ago, can and does exist without law. Ellickson’s meticulous study of everyday life in rural Shasta County revealed that its farmers and ranchers build their relationships not by reference to their legal rights and obligations, but by relying on long-standing and pervasive norms of neighborliness. Neighbors help neighbors build, inspect, and repair fences, retrieve stray cattle, maintain the water supply, staff volunteer fire departments, 
and so on.

They do not ask each other for payments, they do not enter into contracts, and they reject out-of-hand the idea of calling lawyers every time they do not like something their neighbors have done. Shasta County’s system of social control is built on shared understandings that are always unwritten, almost always unstated, and frequently unsupported by (or even contrary to) the relevant legal rules.

Shasta County is anything but unique. Researchers studying everyday commercial interactions found similar informal practices everywhere they looked: among grain and feed merchants, cotton traders, diamond dealers, garment workers, lobster fishermen, beekeepers and orchard growers, shippers and rail carriers, and many others. Virtually every scholar who took time to ask businesspeople how they actually conduct their business reported that the informal arrangements were at least as important as the formal ones. Businesspeople hire lawyers, enter into elaborate contracts, and then avoid calling their lawyers at all costs and (largely) ignore their contractual rights and obligations. Sometimes, entrepreneurs sign agreements that they (and even their lawyers!) know to be unenforceable. They strongly prefer to do deals on a handshake and to resolve disputes “simply by horse-trading over the phone.”

All of these informal arrangements fall under the somewhat overused, extremely broad, and fairly ambiguous rubric of social norms. Social norms scholarship is vast, and its prevailing attitude toward its object of study is mostly favorable. Scholars argue that for a variety of reasons social norms are more efficient than legally binding written contracts, perhaps even Pareto superior.

Yet what if, to take Shasta County as a classic example, we considered some of the interactions described by Ellickson with an eye toward the tax law? It would quickly become apparent that Shasta inhabitants routinely engage in all sorts of commercial transactions that, if formalized, would produce tax consequences for one or both parties. Neighbors borrow (“rent” in tax-speak) each other’s equipment. They help each other with chores such as fence building and maintenance (i.e., they provide services to each other). Occasionally, one neighbor supplies the other with building materials for a joint project. For tax purposes, this transfer may be characterized as a sale, depending on the circumstances.

Even this cursory analysis suggests that in this world of neighbors helping neighbors, one thing neighbors may help each other do is reduce their tax liabilities. Rental and services income, if actually paid to lessors and service-providers, would be clearly taxable to them. The amount realized from a sale of property is also taken into account in computing taxable income. While there may be an offsetting deduction for the lessees and service recipients, it will not always be available immediately, or 
even at all.

Nothing in Ellickson’s story suggests that Shasta County’s dominant social norm of “live and let live” has any connection to tax planning. Most likely, a suggestion that neighborly habits exist to lower their tax bills would outrage the county’s old-timers. If the same is true of all informal interactions, if the biggest concern is that some tacit understandings occasionally give a few cooperative taxpayers a modest tax break, the situation is not exactly dire.

Unfortunately, not all social norms are as innocuous as those that exist in Shasta County. More broadly, taxpayers avoid all sorts of tax liabilities through what I have called relational tax planning—a form of tax minimization that relies on relational contracts. This tax planning occurs whenever taxpayers deliberately avoid formalizing certain aspects of their transactions in order to avoid undesirable tax results.

While the analysis of relational tax planning is still in early stages, it is already quite clear that the problem is widespread, extending well beyond the relatively well-understood phenomenon of intrafamily tax structuring and neighborly interactions. Relational tax planning is key to major tax avoidance strategies developed by financial markets in recent years. Variable delivery prepaid forwards, actively traded cross-border swaps, and structured loans by offshore hedge funds are just some examples. Charitable organizations and wealthy benefactors have relied on relational tax planning for years. And it is no secret that the entire tax shelter industry flourished in the late 1990s and early 2000s due in large part to numerous tacit understandings among various participants.

Case law analysis provides further evidence. A significant portion of hundreds of cases invoking tax anti-abuse doctrines involves relational tax planning. These cases, no doubt, represent just a small tip of the proverbial iceberg. It is remarkable how easily various relational tax planning strategies come to mind once one grasps the basic concept. These strategies cost the government billions of dollars in lost revenues.

Relational tax planning is possible (and likely) whenever the tax law relies on the so-called risk-based rules. These rules pervade the Internal Revenue Code, the Treasury Regulations, and the tax common law. But their sheer number does not determine the magnitude of the problem. Most importantly, risk-based rules defend major fault lines of our income tax system. The realization requirement, double taxation of corporate income, worldwide taxation of U.S. residents, U.S. taxation of (certain) U.S.-source income of foreign taxpayers, tax ownership, the distinction between risky and riskless returns, as well as between capital and labor income, are all protected by risk-based rules. All of these doctrines and distinctions are vulnerable to relational tax planners.

Regulatory warnings about implicit understandings and tax common law anti-abuse doctrines don’t come close to being effective. Academics have done little to assist policymakers with devising alternative approaches. While my recent work has started to remedy this deficiency, it also made clear that the problem has no easy solutions.

This essay was reprinted from the Sesquicentennial Essays of the Faculty of Columbia Law School. © 2008 Alex Raskolnikov