Thomas Wechter

Codification of the Economic Substance Doctrine’s Strict Penalty

Why it is necessary for the IRS to provide general administrative guidance.

June 9, 2011
by Thomas Wechter, JD, LLM

After more than 10 years, with no less than seven legislative proposals, the economic substance doctrine (ESD) was codified in the Health Care and Education Reconciliation Act of 2010 as section 7701(o) and signed into law on March 30, 2010. Enacted at the same time to provide compliance with the ESD was a significant strict accuracy-related penalty of 40 percent, reduced to 20 percent if adequate disclosure is made, on underpayments attributable to transactions lacking economic substance or transactions that fail the requirements of any similar rule of law. The penalty is not subject to any reasonable cause or good faith defense.

Codification of Economic Substance Doctrine

Section 7701(o)(5)(A) states that the ESD “means the common law doctrine under which tax benefits under Subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purposes.” Providing a conjunctive test, Section 7701(o) states that “[i]n the case of any transaction to which the ESD is relevant, such transactions shall be treated as having economic substance only if:

A. The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position and

B. The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.”

The enactment of a two-prong conjunctive test resolved the longstanding conflict among the circuit courts of appeal regarding how the doctrine should be applied. The first prong is sometimes referred to as the “economic substance” or the objective test, while the second prong is sometimes referred to as the “business purpose” or subjective test.

Profit Potential to Satisfy Either or Both Prongs

The statute provides a special rule in section 7701(o)(2) in which the taxpayer relies upon profit potential to satisfy either or both prongs of the ESD. In that case, the profit potential is taken into account only if the present value of the reasonably expected pretax net profits from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed, if, the transaction was respected. Fees and expenses are to be taken into account in determining pretax profits and regulations are to be issued requiring foreign taxes to be treated as expenses in determining pretax profits. See section 7701(o)(2)(B).

State and Local Tax Benefits and Financial Accounting Benefits

In determining what constitutes a substantial nontax purpose, any state or local income tax effect related to a federal income tax effect is to be treated in the same manner as the federal income tax effect. In other words, a taxpayer cannot use state and local tax savings from a transaction that otherwise lacks economic substance to satisfy either prong if the state and local tax savings are related to the federal income tax savings A financial accounting benefit will not be taken into account to satisfy the nonfederal tax purpose for entering into a transaction if the financial accounting benefit is as a result of the reduction of federal income tax. In other words, a taxpayer cannot argue that the alleged tax savings from a transaction that lacks economic substance results in savings for accounting purpose, which would be a nontax purpose for entering into the transaction.

Definitions and Special Rules

The statute provides a number of definitions and rules in applying the ESD. The application of the ESD depends on whether it is relevant to a transaction. Even though there are no cases dealing with the relevancy of the ESD to a transaction, the determination of relevancy is to be made in the same manner as if section 7701(o) had never been enacted.

The ESD does not apply defined as transactions not entered into in connection with a trade or business or an activity engaged in for the production of income to personal transactions. See section 7701(o)(5)(B). As a result gift and estate tax transactions that invariably lack a business purpose does not affect the ESD, but family limited partnerships (FLPs), charitable remainder trusts (CRUTs) and like transactions may be. In applying the ESD, the term “transaction” is defined to include a series of transactions. The narrower the term is defined, the less likely the transaction will have a business purpose or economic substance.

Legislative History Guidance

Although technically not legislative history, the Joint Committee on Taxation Report, Technical Explanation of the Revenue Provisions of the Reconciliation Act of 2010 (JCX–18–10) March 21, 2010, provides some guidance on the type of transaction to which the ESD is relevant:

  • The first type of transaction is a transaction in which the tax benefits are consistent with the congressional purpose or plan that the tax benefits were designed by Congress to effectuate and the taxpayer makes the type of investment or undertakes the type of activity that the tax benefit was intended to encourage.
  • The second type of transaction includes certain basis business transactions that are respected under longstanding judicial and administrative practice even though the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.

As examples of basic business transactions, the Technical Explanation lists debt vs. equity capitalization, foreign vs. domestic organizations for a foreign business, corporate organizations and reorganizations and intercompany transactions at arm’s-length prices. The few examples listed in the Technical Explanation are illustrative and not exclusive.

Notice 2010–62

Despite numerous requests from practitioners, the Internal Revenue Service (IRS) has consistently stated that it does not intend to issue administrative guidance or an “angels list” of transactions in which the ESD is not relevant. On September 13, 2010, Notice 2010–62 was issued to provide interim guidance on the ESD and related penalties. As expected, the Notice makes clear that the Treasury and the IRS “do not intend to issue general administrative guidance regarding the type of transactions to which the ESD applies or does not apply.” In addition, the Notice states that the IRS will not issue private letter rulings or determination letters regarding whether the ESD is relevant to any transaction or whether any transaction complies with the requirements of section 7701(o). In applying the statute, the Notice provides that the IRS will rely on relevant case law applying the common-law ESD. The remainder of the Notice provides guidance on how adequate disclosure is to be made to qualify for the reduced penalty of 20 percent for underpayments as a result of a transaction that lacks economic substance.

Following the issuance of the Notice, the IRS Large Business and International (LB&I) Division issued a directive requiring the directors of field operations to approve assertions of the economic substance penalties. LMSB–04–0910–024. The directive has been criticized as insufficient to ensure consistency in the application of the penalty because it only applies to LB&I taxpayers and there are 12 directors of operations.


There are a number of fuzzy terms used in the ESD codification, such as “relevant,” “meaningful,” “transaction,” “substantial” and “any similar rule of law” that need clarification in administrative regulations on which taxpayers can rely. In addition, guidance has to be issued relating to the determination of the profitability test, including guidance with respect to the computation of the present value of the pretax net profits and the present value of the tax benefits.

Guidance also needs to be issued regarding the term “any similar rule of law’ in the application of the strict accuracy related penalty. It is not enough for the IRS to refuse to issue guidance on the basis that practitioners will find ways around the guidance, that providing guidance is too big a job or that practitioners can take their clues from prior judicial decisions when there is the threat of the strict penalty and no assurance that the IRS will not challenge under the new statute transactions that the IRS has previously lost under the application of the common law doctrine.

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Thomas R. Wechter, JD, LLM, is a partner with Duane Morris LLP in the Chicago office, and concentrates his practice in tax planning for individuals, corporations and partnerships and in tax controversy matters in front of the IRS and before the Tax Court, U.S. Court of Federal Claims and the District Courts. Wechter was formerly a partner at Schiff Hardin LLP. He has an LL.M. degree in Tax from New York University and is a member of the Taxpayer Advocacy Panel.