United States

IRS issues guidance on the codified economic substance doctrine

TAX ALERT  | 

The IRS recently provided additional guidance on the codified economic substance doctrine by issuing Notice 2014-58. Under section 7701(o), "in the case of any transaction to which the economic substance doctrine is relevant," a transaction is treated as having economic substance only if, apart from federal income taxes, it passes a two-prong test: (1) the transaction changes in a meaningful way the taxpayer's economic position (i.e., economic substance), and (2) the taxpayer has a substantial purpose for entering into the transaction (i.e., a business purpose).1 Transactions that are deemed to not have economic substance within section 7701(o) or a similar rule of law are subject to 40 percent accuracy-related penalties under section 6662(b)(6). However, "transaction" is not defined in section 7701(o), and "similar rule of law" is not defined in section 6662(b)(6). As a result, the IRS defined these terms in Notice 2014-58.

The IRS' definition of transaction is not unexpected. Transaction is defined as either a series of steps under a plan or a single step, determined based on the taxpayer's facts and circumstances. Therefore, if any step in a plan is determined to be unnecessary to achieve the non-tax objective, the economic substance doctrine (and its penalties) may be applied by the IRS to the specific step for purposes of section 7701(o).

Noticeably absent from the notice with respect to the definition of transaction is guidance on the threshold question as to when and whether economic substance is relevant. The Treasury has continually stated that it would not issue a so-called "angel list" of transactions that are not subject to the economic substance doctrine. However, it would seem reasonable for taxpayers to expect clarification on such a significant issue. The best guidance taxpayers have outside of prior case law is the Large Business and International Division (LB&I) directive (LB&I-4-0711-015), which directed that in applying the economic substance doctrine, "an examiner should evaluate whether the circumstances in the case are those under which application of the economic substance doctrine to a transaction is likely not appropriate." However, such guidance appears lacking in light of the issuance of Notice 2014-58.

Whereas the definition of transaction is not unexpected, the IRS' definition of similar rule of law has raised practitioner concerns. Notice 2014-58 defines similar rule of law to mean a rule or doctrine that applies the same factors and analysis that is required under section 7701(o) for an economic substance analysis even if a different term or terms are used to describe the rule or doctrine, and the notice specifically uses the sham transaction doctrine as an example. 

The sham transaction doctrine is the common law doctrine that requires a transaction have an economic reality apart from the creation of income tax losses in order for the courts to respect it.2 While many courts address the overlapping analysis required for the economic substance doctrine and the sham transaction doctrine, the sham transaction doctrine did not previously place a taxpayer in danger of being subject to the 40 percent penalty. Further, the 2011 directive limited, until further guidance, the penalties provided for under section 6662(b) to the economic substance doctrine and indicated they would not be imposed upon taxpayers due the application of any other similar rule or law, including the sham transaction doctrine. 

While Notice 2014-58 does go on to provide that the IRS will not apply the section 6662(b)(6) penalty "unless it also raises section 7701(o) to support the underlying adjustment," the inclusion of the sham transaction in the definition of similar rule of law still comes as a surprise as the "sham" terminology is used quite often in court decisions. 

The recent notice adds guidance on the applicability of section 7701(o) and the related penalties under section 6662(b)(6). New questions have arisen regarding exactly how a taxpayer's facts and circumstances will drive the IRS' decision to analyze either a series of steps under a plan or a single step for economic substance. Additionally, the notice's inclusion of the sham transaction as an example of a similar rule of law potentially expands the applicability of the 40 percent penalties, but only where a transaction also fails the two-prong test under section 7701(o). As a result, understanding how the sham transaction will be used by the IRS will be of interest to taxpayers, especially considering the inclusion is a reversal from the prior LB&I directive. Despite the remaining uncertainties, section 7701(o) and the notice are effective for transactions entered into after March 31, 2010. Taxpayers should consult with their tax advisors on economic substance concerns relevant to any current or planned transactions.

1 Section 7701(o)(1)
2 See Knetsch v. U.S., 6 AFTR 2d 5851 (1960), Sochin v. Commissioner, 61 AFTR 2d 88-926 (1988), Thompson v. Commissioner, 46 AFTR 2d 80-6107 (1980).

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