IRS Codification of the Economic Substance Doctrine Imposes New Penalties

Taxpayers seeking the tax benefits of a transaction that the IRS deems to have no economic purpose, aside from reduction of tax liability, will face stiff penalties under the new 2010 Revenue Reconciliation Act. Under the auspices of attempting to “codify” the economic substance doctrine, the act attempts to crack down on tax shelters by imposing new penalties.

The doctrines of “sham transaction,” “economic substance” and “business purpose” have been applied by the courts for over fifty years to deny tax benefits from certain transactions. However, because these doctrines were developed by the courts, there has been no uniformity in their application. Congress has stated that the codification of economic substance in new IRC § 7701(o) will provide consistency in applying the doctrines. However, it seems more likely that the draconian penalties, and the revenue it will generate, are the real reasons for passing the legislation.

Under new IRC § 7701(o), the economic substance doctrine will be applied using a two part test. Under this two part test, the transaction will be respected as having economic substance only if both the following two tests are met:

1. There has been a meaningful change in the taxpayer’s economic position (apart from federal income tax effects); and,
2. The taxpayer has a substantial non-federal tax purpose for entering into the transaction.

In evaluating the taxpayer’s business purpose, any state tax benefits or financial accounting benefits that are related to a federal income tax effect cannot be considered. Moreover, profit potential can only be taken into account if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits.

A particularly harsh aspect of the new law is the new strict liability penalty. The new law applies a twenty percent penalty to underpayments that are attributable to a transaction lacking economic substance under IRC § 7701(o). The penalty is increased to forty percent if the transaction is not disclosed. Importantly, there is no reasonable cause exception to the penalty. Therefore, a tax opinion letter from a tax lawyer will not protect a taxpayer from the penalty.

In short, Congress has given a powerful weapon to the Internal Revenue Service in its quest to close the mythical “Tax Gap.” Hopefully, the courts will curtail the worst of the potential IRS abuses of this new weapon.