Penalties and Retainer Letters After the Enactment of Economic Substance

As mentioned a few times on this blog, Congress codified the economic substance doctrine last year as part of the Health Care and Education Reconciliation Act of 2010. One of the aspects of the new law is the introduction of a strict liability penalty for engaging in transactions that lack economic substance.  Before the enactment of the doctrine, usually, to avoid the 20% penalty under Sec. 6662 of the Code, funds either relied on "reasonable cause" or on "adequate disclosure."  However, newly amended Sec. 6662(b)(6) of the Code provides for a 20% penalty for "[a]ny 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." In turn, Sec. 6662(i)(1) increases this penalty to 40% for any nondisclosed noneconomic substance transactions.  In other words, a fund that does not make a disclosure for a particular transaction could be subject to a 40% penalty if the transaction is cast away based on economic substance doctrine grounds. To top this off, under newly amended Sec. 6664(c)(2) of the Code, the reasonable cause exception does not apply; thus, the fund cannot rely on legal tax opinions to abate the penalty.

Practitioners have started to amend their retainer letters to address these issues.  It seems that some retainers are trying to disclaim all liability for penalties that arise from transactions that are found to lack economic substance.  The logic seems to be that because the penalty is strict and cannot be avoided based on reasonable cause or reliance on advice, then the practitioner should not be responsible for any harm to the client.  Under some circumstances this may make sense, but not always.  For example, fund hires practitioner to opine whether a particular transaction has economic substance.  Practitioner determines that the transaction has economic substance.  Based on this advice, fund does not disclose the transaction.  The transaction is found to lack economic substance and the fund is subject to a 40% penalty.  It is true that the fund cannot avoid the penalty per se. However, the fund could have avoided the additional 20% penalty due to the lack of disclosure.  Assume now that the practitioner was negligent in making the economic substance determination.  I am not sure why the fund should be subject to a blanket disclaimer of liability under these circumstances.  

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View Ivan Mitev's opinion in its entirety on the Private Equity, Venture Capital and Hedge Fund Taxation site.

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