Executive summary: The IRS may be increasing tax and penalty assessments based on economic substance grounds
Recent developments appear consistent with increased tax enforcement based on economic substance. Tax assessments based on lack of economic substance are often accompanied by tax penalty assessments.
Economic substance and tax penalties
A transaction’s tax benefits can be denied if the transaction lacks economic substance. Originally a judicial doctrine, Congress added codified economic substance rules in 2010.
Under those codified rules, transactions that are required to have economic substance will meet that requirement only if (1) the transaction changes in a meaningful way the taxpayer's economic position (apart from taxes), and (2) the taxpayer has a substantial non-tax purpose for entering into the transaction. However, not every type of transaction is required to have economic substance in order to produce tax benefits.
Congress added related tax penalty rules in 2010, too. Tax penalties of 20% or 40% of the tax deficiency may be assessed on transactions lacking economic substance.
Recent indications of economic substance-based tax enforcement
There has been no official announcement of an increased emphasis on economic substance by the IRS. Recent events nonetheless indicate that the IRS may be emphasizing economic substance enforcement to a greater extent. Even though it is infrequent for the IRS to make assertions of economic substance-based arguments and penalties, these developments substantiate that the IRS does consider making those arguments.
It has been reported that IRS Associate Chief Counsel (International) Peter Blessing stated at a recent bar association meeting that the IRS could look to assert economic substance-based tax assessments more often than in the past. Two recent court cases filed this year reflect IRS tax assessments on economic substance grounds. (United States v. Liberty Global, No. 22-cv-02622 (District of Colorado), Lewis, Kaufman, Reid, Stukey, Gattis & Co. v. Commissioner, No. 17924-22 (Tax Court). Recent email advice from IRS Chief Counsel (CCA 202240019) addresses potential routes to enforcement based on economic substance with respect to a particular transaction.
CCA 202240019 and Notice 2014-58
CCA 202240019 is emailed advice from IRS Chief Counsel in 2022 that discusses transactions that occurred about 12 years ago. The taxpayer addressed in the CCA entered into multiple transaction steps – some before the codified economic substance rules’ Mar. 30, 2010 effective date, and some after that date.
Chief Counsel advised that if the tax-motivated transaction steps were (a) entered into after the effective date, and (b) not necessary for accomplishing a non-tax purpose, the codified economic substance rules could be applied by the IRS. The IRS indicated that this approach is consistent with Notice 2014-58. The IRS concluded in that Notice that the economic substance rules could be applied to specific tax-motivated transaction steps within a series of transactions that together accomplished a non-tax purpose. The tax-motivated step this CCA focused on happened to be the creation of new insurance policies.
Recent developments indicated that the IRS may be increasing its focus on economic substance-based tax enforcement. The IRS indicated in CCA 202240019 that economic substance principles and penalties may apply to either a tax-motivated series of transactions or to a tax-motivated step in a series of transactions. Taxpayers should discuss transactions expected to result in tax benefits with their tax advisors and make sure that economic substance concerns are addressed where needed. if an as appropriate.