Sham Transaction Law and Legal Definition

A sham transaction is a business transaction that is entered into for the sake of avoiding tax. Since the 1930s, courts have used what is known as "the sham transaction doctrine" to invalidate deals designed solely to skirt income taxes. The question whether or not a transaction is a sham is primarily a factual one, on which the taxpayer bears the burden of proof in the abatement process.

Some courts apply a two-prong test, The first prong of the inquiry examines whether the transaction has economic substance other than the creation of a tax benefit, which has been labeled the "objective" economic substance test. The second prong examines whether the transaction was motivated by any business purpose other than obtaining a tax benefit, which has been labeled the "subjective" business purpose test.

Other courts have rejected a rigid two-step analysis, using traditional sham analysis; that is, whether the transaction had any practical economic effects other than the creation of income tax losses.