By Joseph L. Wyatt,
Jr. Morrison & Foerster LLP
The Health Reform Act of
2010 [Health Care and Education Affordability Reconciliation Act of 2010]
occupies 2,377 pages, of which only one page, occupied by section 1409 of that
Act, enacts IRC § 7701(o) ("Codification of economic
substance doctrine [and penalties]"), aka "form versus substance," "business
purpose," "tax avoidance," or "step transaction." We can encounter this doctrine in the estate
planning field in various types of transactions, e.g., when business entities
are created and valuation discounts sought for gifts of fractional interests in
the entities; where installment sales involve promissory notes among family
members and the notes are not treated as valid debts; and where donors
contribute appreciated property to a charity with an understanding that the
charity will use the proceeds to purchase other assets from the donor.
What do health care reform
and economic substance reform have to do with each other? Why are they together? Answer:
Money. Health care reform will
cost a lot, despite its ultimate goal to save the cost of health care and
improve its efficiency. Taxpayers whose
transactions don't meet the strict rules needed to show economic substance can incur
stiff penalties. It is expected that
enough taxpayers will incur enough penalties for lacking economic substance ($4.5 billion
over ten years) to help defray the cost of health care reform.
This is how it works:
IRC section 7701(o) assertedly
clarifies the economic substance doctrine (ESD) not just by defining it but by
codifying two essential preconditions that must be met for a complying taxpayer
to be treated in a transaction as "having economic substance."
"7701(o)(1) APPLICATION OF DOCTRINE.-In the
case of any transaction to which the economic substance doctrine is relevant,
such transaction 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.
. .
.
Then it imposes strict
liability penalties if the taxpayer's transaction fails to have economic
substance. Those penalties seem to be a
very important feature of the Act because it carries a $4.5 billion
revenue estimate over ten years, and so it is expected to be used to bring down
the cost of the healthcare bill. In
other words, it would appear that the Congress expects that so many taxpayers'
transactions will not have economic substance that they will have to pay
$4.5 billion of penalties.
How then does it affect the
trust and estate planner and taxpayer?
Here's the statute's asserted
"exception" that would embrace individual trust and estate planning. IRC § 7701(o)(5)(B) states:
(B)
EXCEPTION FOR PERSONAL TRANSACTIONS OF INDIVIDUALS.-In the case of an
individual, paragraph (1) shall apply only to transactions entered into in
connection with a trade or business or an activity engaged in for the
production of income.
Thus,
in the case of an individual, the two-pronged provision of paragraph (1)
("Application of doctrine") applies only to transactions entered into in
connection with a trade or business or an activity engaged in for the
production of income.
Does subparagraph (5)(B)
mean that individuals can do whatever they want to? Or, instead, that individuals will not even
be able to enjoy any safe harbors that might be provided under paragraph
(1)? More likely it means that the new
section 7701(o)(5)(B) really doesn't protect individuals from the application
of any "common law of economic substance principles," resulting from case "common
law" developed over many years. The Joint Committee on Taxation's technical
explanation simply states in that respect [JCX-18-10, page 159]:
No
inference is intended as to the proper application of the economic substance
doctrine under present law. The
provision is not intended to alter or supplant any other rule of law, including
any common-law doctrine or provision of the Code or regulations or other
guidance thereunder; and it is intended the provision be construed as being
additive to any such other rule of law.
Therefore, subparagraph
(5)(B)'s "exception" affords no protection from the penalties for
noncompliance.
Penalty for underpayments
and understatements attributable to transactions lacking economic substance:
Section
6662(b)(6)
[20% accuracy related penalty] Any disallowance of claimed tax benefits by
reason of a transaction lacking economic substance (within the meaning of
section 7701(o)) or failing to meet the requirements of any similar rule of law."
(Emphasis supplied.)
The provision imposes a new
strict liability penalty under section 6662 for an underpayment attributable to
any disallowance of claimed tax benefits by reason of a transaction lacking
economic substance, as defined in new section 7701(o), or failing to meet the
requirements of any similar rule of law. The penalty rate is 20 percent (increased to
40 percent if the taxpayer does not adequately disclose the relevant facts
affecting the tax treatment in the return or a statement attached to the
return). An amended return or supplement
to a return is not taken into account if filed after the taxpayer has been
contacted for audit or such other date as is specified by the Secretary. No exceptions to the penalty (including the
reasonable cause rules) are available. Thus, under the provision, outside opinions
or in-house analysis would not protect a taxpayer from imposition of a penalty
if it is determined that the transaction lacks economic substance or
fails to meet the requirements of any similar rule of law. Similarly, a claim for refund or credit that
is excessive under section 6676 due to a claim that is lacking in economic
substance or fails to meet the requirements of any similar rule of law is
subject to the 20 percent penalty under that section, and the reasonable basis
exception is not available.
As described above, under
the provision, the reasonable cause and good faith exception of present law
section 6664(c)(1) does not apply to any portion of an
underpayment that is attributable to a transaction lacking economic substance,
as defined in section 7701(o), or fails to meet the requirements of any similar
rule of law. Likewise, the reasonable cause and good faith exception of present
law section 6664(d)(1) does not apply to any portion of a reportable
transaction understatement that is attributable to a transaction lacking
economic substance, as defined in section 7701(o), or fails to meet the
requirements of any similar rule of law.
The stiffer, and stricter, penalty
will apply whenever claimed tax benefits are disallowed because they lack
economic substance under section 7701(o) "or fail[] to meet the requirement of
any similar rule of law." That means that
cases that have rejected tax planning in estates and trusts because of a lack
of economic substance or collapsed as related step transactions or rejected by
reason of any other "similar rule of law," including estate planning, will be
unaffected by the new clarification of the economic substance doctrine; those
cases that have disallowed planning - whether of transfer tax or income tax-
will continue to lose their battles with the Internal Revenue Service. See, for example, Brown v. United States, 329 F.3d 664, 672 (9 Cir. 2003) [enhanced version available to lexis.com subscribers
/ unenhanced version available from lexisONE Free Case Law]
(estate tax case; step transaction document applied to determine who in fact
paid gift taxes, relevant under IRC § 2035); Blake v. Commissioner, 697 F.2d 473, 474 (2 Cir. 1982) [enhanced version] (step transaction doctrine
applied in charitable contribution case).
The latest instance is Suzanne J.
Pierre v. Comm'r, T.C. Memo
2010-106 [enhanced version], collapsing gift-and-sale
transfers into gift transfers with no tax-independent significance.
The only difference after
the new Act's enactment on March 30, 2010, is that any penalty will be stiffer
and will not allow for excuses based on reasonable cause. However, to ensure consistent administration
of the Section 6662(b)(6) accuracy-related strict penalty for transactions
lacking economic substance (or rejected under "any similar rule of law"), "any
proposal to impose the penalty at the examination level must be reviewed and
approved by the appropriate Director of Field Operations before the penalty is
proposed." (LMSB 20‑0910-024,
Sept. 14, 2010.)
The effect of the change in
political control after the 2010 election is impossible to predict. Administratively, we learn (since October, see
Notice 2010‑62,
2010‑40
I.R.B. 411-12, Oct. 4, 2010), that the IRS will not issue
private letter rulings or determinations on the application of the economic substance
doctrine to a particular transaction.
These rules are effective
for any transaction entered into on or after March 31, 2010.
Morrison
& Foerster's Trusts and Estates group provides sophisticated planning and
administration services to a broad variety of clients. If you would like additional information or
assistance, please contact Patrick McCabe at (415) 268-6926 or
PMcCabe@mofo.com.
©
Copyright 2011 Morrison & Foerster LLP.
This article is published with permission of Morrison & Foerster
LLP. Further duplication without the
permission of Morrison & Foerster LLP is prohibited. All rights reserved. The views expressed in this article are those
of the authors only, are intended to be general in nature, and are not
attributable to Morrison & Foerster LLP or any of its clients. The information provided herein may not be
applicable in all situations and should not be acted upon without specific
legal advice based on particular situations.
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