When is the Economic Substance Doctrine Applicable?
Liberty Global, Inc. v. United States, 174 F.4th 1208 (10th Cir. 2026); Patel v. Comm’r, 26-60180 (5th Cir.)
The Economic Substance Doctrine, an erstwhile common-law creation, is currently codified at 26 U.S.C. § 7701(o)), and provides as follows:
- In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if—
- the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and
- the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.
The Economic Substance Doctrine is a powerful tool. It allows the IRS to deny the tax benefits of a taxpayer’s transactions that ostensibly comply with the relevant provisions of the Internal Revenue Code.
Why is there Current Litigation Regarding the Economic Substance Doctrine?
Currently, there is a substantial question in federal tax litigation regarding the meaning of the introductory clause of section 7701(o)(1) (i.e. “In the case of any transaction to which the economic substance doctrine is relevant….”) (emphasis added). This prefatory language appears to require a threshold relevancy determination as to whether the Economic Substance Doctrine is even applicable to the transaction at issue. Under this interpretation, the commonly litigated “two prongs” of economic substance (section 7701(o)(1)(A) & (B)) are only analyzed after satisfaction of this threshold “relevancy” analysis (somewhat akin to the now-defunct Chevron “Step Zero” analysis).
This issue is currently pending before the Fifth Circuit in Patel v. Comm’r, 26-60180 (5th Cir.), where the Tax Court unanimously determined that section 7701(o) requires a relevancy determination before the two-part economic substance test analysis. Patel v. Comm’r, 165 T.C. 171 (2025). In finding that a threshold relevancy analysis was necessary, the Court noted that the legislative history clearly envisioned situations when the economic substance doctrine should not be used.[1] Id at 189-90. The Patel court purported to meet the relevancy threshold requirement by finding an application of the economic substance doctrine in the “insurance context.” Id at 190. In the Fifth Circuit, there are (at present) three amicus briefs on this issue, from the National Taxpayers Union Foundation [D.E. 66], the Chamber of Commerce of the United States of America and National Association of Manufacturers [D.E. 68], and the American Forest & Paper Association [D.E. 71]. All three generally support the threshold relevancy requirement of section 7701(o). The amicus briefs seemed particularly aimed to counter the Tenth Circuit’s decision in Liberty Global, Inc. v. United States, 174 F.4th 1208 (10th Cir. 2026).
In Liberty Global, the district court found there was no relevancy test, and collapsed[2] any “relevancy” finding into the two pronged analysis of 7701(o)(1)(A) & (B) (i.e. (1) whether there was a meaningful change in the economic position, and (2) whether there was a substantial nontax purpose for the transaction). The Tenth Circuit did not explicitly overrule this finding, but called the relevancy test issue a “red herring” in the context of the case because the district court “concluded the doctrine was relevant because [the transaction at issue] was an attempt by [Liberty Global] to mechanically utilize the provisions of the TCJA to obtain a benefit not intended by Congress.” Liberty Global, 174 F.4th 1208 at fn6. The amicus briefs in Patel generally argue that a relevancy analysis is needed to encourage legitimate business planning, and generally argue that the Fifth Circuit should require a more in-depth analysis than even the Patel Tax Cout gave.
Background of the Economic Substance Doctrine:
The Economic Substance Doctrine was derived from a long line of cases wherein federal courts (including the United States Supreme Court) looked not only at the tax effects of a transaction, but also compared the intent of the statute with the taxpayer’s intent in entering into the transaction. As stated by the Supreme Court:
The whole undertaking, though conducted according to the terms of subdivision (B), was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else. The rule which excludes from consideration the motive of tax avoidance is not pertinent to the situation, because the transaction upon its face lies outside of the plain intent of the statute. To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.
Gregory v. Helvering, 293 U.S. 465, 470 (1935). Courts have historically recognized other similar “doctrines” (or, arguably, different names for the same doctrine) to undo transactions that do not promote the legitimate aims of the Internal Revenue Code, for example, the Substance Over Form Doctrine (see e.g., Benenson v. Comm’r, 910 F.3d 690, 699 (2d Cir. 2018)); the Sham-Transaction Doctrine (see e.g., Acqis Technology, Inc. v. Comm’r, T.C. Memo 2024-21, 2024 WL 578148 at *10 (2024)); and the Step-Transaction Doctrine (see e.g., Associated Wholesale Grocers, Inc. v. United States, 927 F.2d 1517, 1521-22 (10th Cir. 1991)). IRS regulations have also been promulgated to allow the IRS to recast or disallow tax benefits that were not intended under the Internal Revenue Code. See e.g., Treas. Reg. § 1.701-2[3](b)(“…the Commissioner can recast the transaction for federal tax purposes, as appropriate to achieve tax results that are consistent with the intent of subchapter K”); Treas. Reg. § 1.165-1 (“Only a bona fide loss is allowable. Substance and not mere form shall govern in determining a deductible loss.”).
The common-law Economic Substance Doctrine was developed over years, with a “split” developing amongst the Circuits regarding the “motives” of the taxpayer. See Klamath Strategic Investment Fund v. United States, 568 F.3d 537, 544 (5th Cir. 2009) (describing development of the doctrine and the circuit “split”). This led to the codification of the Economic Substance Doctrine in section 7701 of the Internal Revenue Code in 2010. See Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, section 1409.
What Relevancy Determination Does section 7701(o) Require?
However, circling back to the original issue, the language of the statute, on its face, requires a “determination” (see 26 U.S.C. § 7701(o)(5)(C)) as to whether the doctrine is applicable to the transaction at issue. This “determination” is to be made “in the same manner as if [section 7701(o)] had never been enacted” (i.e. the codification was not meant to change the current common law standards in determining when to utilize an economic substance analysis).[4] Id. However, this does not helpfully clarify how to use this threshold relevancy determination, as there is not a vast reservoir of pre-statute common law that specifically opines on this relevancy standard. As Judge Eid noted in her dissent in Liberty Global:
In other words, [the statute requires that] we determine whether the doctrine is relevant in the same way courts have always done when invoking the common law doctrine. The problem is that prior to codification, courts did not explicitly engage in a relevancy determination. In fact, no case decided prior to the enactment of § 7701(o) used the term “relevant” in analyzing whether to apply the economic substance doctrine in a particular case. They either applied the doctrine or did not, never explaining when the common law doctrine was relevant.
Liberty Global, Inc. 174 F.4th at 1228 (J. Eid dissenting). Nevertheless, Judge Eid posited that the correct approach would be to apply the economic substance doctrine “when the favorable tax treatment provided by another provision’s text turns on the ‘objective economic realities of a transaction’ or the taxpayer’s economic motive.” Id. Put another way, the economic substance doctrine should be applied “only when there is a dispute about whether the taxpayer actually has done in substance what a Code provision—from an economic perspective—requires.” Id.
Judge Eid’s approach seems consistent with the legislative history regarding section 7701(o), which stated that the purpose in passing section 7701(o)(1) was to prevent taxpayers from “gaining unintended tax relief and [undermining] the overall integrity of the tax system.” H.R. Rep. No. 111-443, pt. 1 at 122 (emphasis added). However, “[i]f the tax benefits are clearly consistent with all applicable provisions of the Code and the purposes of such provisions, it is not intended that such tax benefits be disallowed if the only reason for such disallowance is that the transaction fails the economic substance doctrine as defined in this provision. Id at 124 citing Treas. Reg. sec. 1.269-2
What is the Government Position on this Matter?
The Government has generally contended that the prefatory language in subsection 7701(o) does not require a preliminary threshold analysis, but rather a factual “case-by-case” analysis. See IRS Notice 14-58, pg. 4 (“Whether the economic substance doctrine is relevant and whether a transaction should be disaggregated will be considered on a case-by-case basis, depending on the facts and circumstances of each individual case.”). Clearly, the government does not want to provide a “safe harbor” of transactions which the government will not challenge on economic substance grounds – likely fearing that if it does, the transactions will become more and more (allegedly) abusive. While the government’s position allows it considerable flexibility in its litigation strategies, it will likely hamper taxpayers’ efforts to effectively plan legitimate business transactions, fearing that they will be forced to litigate their “business purpose” for years in court.
Can the Economic Substance Doctrine be Used in Criminal Prosecutions?
While it may seem at odds with both (1) the mens rea generally required for criminal tax prosecutions (i.e. “willfulness”[5]), and (2) the standard of proof required for guilt (i.e. “beyond a reasonable doubt”[6]), there are a limited number of cases where criminal jury instructions have included instructions based on the economic substance doctrine. See e.g. United States v. Manko, 979 F.2d 900 (2d Cir. 1992); United States v. Parse, 789 F.3d 83 (2d Cir. 2015). These cases generally involve sophisticated actors who designed and implemented the schemes at issue. Unless these conditions are present, the government would face an uphill battle trying to show criminal liability. See e.g., United States v. Daugerdas, 837 F.3d 212 (2d Cir. 2016)(“For a jury to conclude that [defendant] had the necessary mens rea to commit tax evasion, mail fraud, and obstruction of the IRS on the basis of violations of the economic substance rule, they would have to find both that he knew the rule and knew that the transactions lacked economic substance.”). Indeed, an attempt to impose criminal liability on a Defendant may very well violate the constitutional guarantee of due process (as the charge against the taxpayer would be void for vagueness), unless the Defendant clearly knows (or has reason to know) the transaction lacks economic substance. See e.g., United States v. Pirro, 212 F.3d 86 (2d Cir. 2000).
Takeaways
Currently, there is disagreement between the courts, the government, and the private bar over the application of the Economic Substance Doctrine of section 7701(o) (and whether a “relevancy determination” is required). While, to some, this may seem an esoteric point of law, it can have real-world consequences. For example, should the government attempt to disallow the tax benefits of the investment/energy credit of IRC § 48, it could argue that the taxpayer only entered into the transaction because of the tax benefits (violating section 7701(o)(1)(B)). The taxpayer would counter that the energy tax credit is an intended tax benefit[7], and as such the economic substance doctrine fails at the relevancy determination.
Knowing the answer to whether or not the Economic Substance Doctrine is even applicable, in advance, would assist businesses before they spent considerable funds on the investment and compliance obligations required to obtain such credits, or enter into similar transactions.
[1] The legislative history lists several examples of “basic transactions” that confer tax benefits, but have been respected after “longstanding judicial and administrative practice”: (1) the choice between capitalizing a business enterprise with debt or equity; (2) a U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; and (4) the choice to utilize a related-party entity in a transaction, provided that the arm’s length standard of section 482 and other applicable concepts are satisfied. H.R. Rep. 111-443(l) at 228-29.
[2] “At the risk of tautology, I proceed with the conclusion that the economic substance doctrine applies when a transaction lacks economic substance. The question of whether the doctrine lacks economic substance is equivalent to the question of whether the tax benefits achieved in the transaction violate congressional intent and is analyzed using the enumerated statutory prongs – which are in turn elaborated and informed by the ‘red flags’ that courts have long described. There is no ‘threshold’ inquiry separate from the statutory factors.” Liberty Global, Inc. v. United States, 2023 WL 8062792 (D. Colo. 2023) (internal citations omitted).
[3] Treas. Reg. 1.701-2(a) generally requires that, for partnership transactions to be respected, (1) the partnership must be bona fide and the transactions be entered into for a substantial business purpose; (2) the form of each partnership transaction must be respected; and (3) the tax consequences to each partner must accurately reflect the partner’s economic agreement and clearly reflect the partner’s income. See also Treas. Reg. 1.701-2(e).
[4]See H.R. Rep. No. 111-443(l), at 293-95 (2010) as reprinted in 2010 U.S.C.C.A.N. 123-224-228.
[5] See e.g., 26 U.S.C. §§ 7201; 7202; 7203
[6] In re Winship, 397 U.S. 358 (1970).
[7] See Illinois Cereal Mills, Inc. v. Comm’r, 789 F.2d 1234 (“…the purpose of the ITC is to promote investment.”) citing Comdisco v. United States, 756 F.2d 569, 577 (7th Cir. 1985) (“The legislative history indicates that Congress intended that the tax credit provisions [section 48] should be broadly construed.”); Schuyler Grain Co., 411 F.2d 649, 652 (7th Cir. 1969) (“it is clear that basic to the statutory purpose is the desire to provide stimulant to the economic growth of this country, to increase the profitability of productive investment by reducing the net cost of acquiring new equipment, and thereby to stimulate investment incapacity expansion and modernization, contribute to growth of our productivity and output and increase the competitiveness of American exports in world markets.”); see also A.C. Monk & Co., Inc. v. United States, 686 F.2d 1058, 1060 (4th Cir. 1982) (“Congress enacted the investment tax credit provisions to create incentives that would increase employment and spur productivity and output by the formation of capital equipment.”); Kleinsasser on Behalf of Kleinsasser v. United States, 707 F.2d 1024, fn3 (9th Cir. 1983) (“One of the stated purposes of the investment tax credit is to make capital acquisition less expensive; to the extent the [Petitioners] desire to use their income to make capital purchase, they will purchase more if they are allowed an investment tax credit.”).
