Codified Economic Substance: 5 Things To Know

In 2010, Congress codified the economic substance doctrine and enacted a 40% strict liability penalty for undisclosed transactions that lack economic substance (economic substance penalty). In 2022, the IRS relaxed internal procedures and removed the requirement for executive approval before raising the codified economic substance doctrine and imposing the economic substance penalty. Since then, IRS disallowance of tax benefits based on the codified economic substance doctrine appears to be on the rise. Here are five things taxpayers should know about the current state of play in this area:

1. The economic substance doctrine is codified in Section 7701(o). Section 7701(o)(5)(A) defines the term “economic substance doctrine” to mean the common law doctrine under which income tax benefits with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. Section 7701(o)(1) provides that when the doctrine is relevant, a transaction will have economic substance only if the transaction changes the taxpayer’s economic position in a meaningful way (apart from federal income tax effects) and the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction.
2. Section 6662 generally imposes a 20% accuracy-related penalty that can be waived or abated if reasonable cause applies. In stark contrast, the law codifying the economic substance doctrine included a 40% strict liability penalty (meaning the penalty applies even if there is reasonable cause) under Section 6662(b)(6) for underpayments attributable to disallowed tax benefits from undisclosed transactions that lack economic substance under Section 7701(o) or that fail the requirements of any similar rule of law.
3. In 2010, the IRS Large and Mid-Size Business (LMSB) Division issued a directive requiring executive-level approval to impose the economic substance penalty. A year later, the LMSB Division issued a directive requiring executive level approval before raising the codified economic substance doctrine, including a description of situations where the doctrine likely is not appropriate. In 2022, these directives were replaced with less restrictive procedures requiring IRS agents to consult attorneys in the Office of the Chief Counsel to determine the appropriateness of raising the doctrine and imposing the penalty.
4. Recently in Patel v. Commissioner, the U.S. Tax Court held that Section 7701(o) does not apply unless the economic substance doctrine is relevant to the transaction, leading to the implication that when the economic substance doctrine is not relevant, transactions are not subject to Section 7701(o) and the 40% strict liability penalty. In Liberty Global Inc. v. United States, the district court came to the opposite conclusion. The taxpayer has appealed the lower court’s decision.
   
   
   Crowe observation
   
   Though taxpayers long have requested a so-called “angel list” of transactions that are not subject to the codified economic substance doctrine, no such list has been published.
5. IRS staffing and resources have been reduced, meaning that there will be fewer audits in the near future. However, the risk of the IRS raising the codified economic substance doctrine and imposing the 40% strict liability economic substance penalty remains. The IRS continues to defend imposition of the economic substance doctrine and the economic substance penalty in court. Additionally, despite calls for its removal, Revenue Ruling 2024-14, which describes situations where transactions involving partnership basis shifting lack economic substance, remains in effect.

Looking ahead

Despite cuts to its resources, the IRS continues to perform audits. However, the overall audit rate will go down and the IRS’ ability to audit complex issues will be impaired. Nevertheless, the codified economic substance doctrine and the 40% strict liability penalty remain a tool in the IRS’ toolbox.

Furthermore, even though the IRS has limited resources today, it generally has three years to audit transactions, meaning that a 2026 transaction reported on a return filed in 2027 can be audited until at least 2030. By that time, the IRS could have received additional funding, increased its staffing, and improved its technology to support its audits. Accordingly, as part of its diligence, taxpayers engaging in complex transactions should work closely with their tax and legal advisers to evaluate the transactions under the economic substance doctrine.