What is the Economic Substance Doctrine?
The economic substance doctrine has long been a part of tax law. Although it was only codified in the Internal Revenue Code in 2010, the doctrine has been used by the IRS and courts for years to disregard non-compliant transactions. This post provides a brief primer on the economic substance doctrine, the interplay between the statute and the case law that predates its codification, and the potential penalties related to the economic substance doctrine. (For prior posts from Freeman Law on related subjects, see Is “Form” “Substance” When it Comes to Law? The Future of the Doctrines of Economic Substance and Substance Over Form.)
This common law judicial doctrine disallows tax benefits for a transaction if the said transaction has no economic substance nor business purposes. Essentially, this doctrine states that in order for a transaction to be valid, it must have an economic purpose other than reducing tax liability, and it also must have an effect other than its tax effect. The economic substance doctrine exists so that the Internal Revenue Service (IRS) can determine tactics used to reduce tax liability (also known as tax shelters) are abusive or not.
Under this doctrine, in order for a transaction to be accepted, the taxpayer’s economic position must be impacted in a significant way by this transaction, aside from any effects from Federal income tax. The individual must have had a substantial reason for going through with the transaction, aside from the tax effects. For these reasons, many view the economic substance doctrine as divisive and contentious, even if its goal is a good one.
The Statute, Case Law, and Potential Penalties
The IRC defines the economic substance doctrine as “the common law doctrine under which . . . transaction[s] are not allowable if the transaction does not have economic substance or lacks a business purpose.” Under the Code, the doctrine only applies to transactions “in connection with a trade or business or an activity engaged in for the production of income.”Even though the doctrine has been codified in IRC § 7701(o), the common law principles that developed well before its codification remain relevant because those common law principles – even under the statute – determine whether or not economic substance exists.
Economic substance exists only if: “(A) the transaction changes in a meaningful way (apart from [Federal, State, and Local]income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from [Federal, State, and Local] income tax effects) for entering into such transaction.”The elements for finding economic substance in the IRC parallel those from case law, and the case law should be consulted to analyze whether or not the two prongs of § 7701(o) have been met under any given facts.
If tax benefits are disallowed by the IRS for lack of economic substance under § 6662(b)(6), the traditional 20% penalty for an underpayment of tax may be applicable.However, if “the relevant facts affecting the [economic substance of the transaction] are not adequately disclosed” on the return or an attachment to the return, the penalty jumps from 20% to a 40% penalty.That can be a steep price to pay.
While the economic substance doctrine has recently been codified, the principles underlying § 7701(o) have been developing for decades. When taxpayers claim the effects of transactions on their tax returns, they and their tax professionals should evaluate whether the transaction will pass muster under the economic substance doctrine or they may face substantial penalty exposure.
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The roots of the economic substance doctrine date back to as early as 1935. See Gregory v. Helvering, 293 U.S. 465 (1935).
Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1352 (Fed. Cir. 2006) (“[T]he economic substance doctrine [requires] disregarding, for tax purposes, transactions that comply with the literal terms of the tax code but lack economic reality.”).
I.R.C. § 7701(o)(5)(A).
Id at (o)(5)(B).
Id at (o)(5)(C) (“The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.”).
Id at (o)(3).
Id at (o)(1).
See Bank of New York Mellon Corp. v. C.I.R., 801 F.3d 104, 115 (2d Cir. 2015) (citing to Gilman v. Comm’r, 933 F.2d 143, 147–48 (2d Cir.1991)) (ruling on transactions that predated the IRC section, but stating that under the common law principles of economic substance, the prongs of the test are still “1) whether the taxpayer had an objectively reasonable expectation of profit, apart from tax benefits, from the transaction; and 2) whether the taxpayer had a subjective non-tax business purpose in entering the transaction.”); see also ACM P’ship v. C.I.R., 157 F.3d 231, 247 (3d Cir. 1998).
I.R.C. § 6662(a), (b)(6).
I.R.C. § 6662(i)