Tax Considerations for Taxpayers Applying the Economic Substance Doctrine

Tax Considerations for Taxpayers Applying the Economic Substance Doctrine

The Background

In 2010, Congress codified the economic substance doctrine, but left numerous unanswered questions for taxpayers on how to apply the doctrine. Along with codifying the economic substance doctrine, Congress also enacted strict liability penalties [IRC § 6662(b)(6) (20 percent strict liability penalty) and IRC § 6662(i) (40 percent strict liability penalty)]...

Since the codification, the Service has issued a notice and one somewhat useful directive [Notice 2010-62, 2010-2 C.B. 411; LB&I-04-0711-015 (July 15, 2011) (the Directive)]. The Notice left us with a large number of unanswered questions. The directive (directives, as you recall, are addressed to field examiners), while generally lacking in meaningful guidance, did provide a helpful insight into the Service's current perspective on the economic substance doctrine, as codified.

With no further guidance forthcoming, and significant penalty exposure for taxpayers who misapply the doctrine, taxpayers need to develop a practical framework as to how to approach the compliance with
IRC § 7701(o)...

...

Formation of a Business Corporation as a Basic Business Transaction - Part (A)

... [W]hen one forms a corporation, the first of the two statutory tests is whether the transaction changes "in a meaningful way the taxpayer's economic position." The answer to that question is almost universally "no". The reason for that answer is the same as the one behind the tax-free incorporation rule - the taxpayer owns the day after the incorporation the same assets (or, if you prefer, has the same net worth) as he did the day before.

So, right off the bat, we flunk the first of the two tests. The problem is that such an answer is nonsensical... As we know, in tax matters, just because an answer is nonsensical does not mean that it is wrong.

Formation of a Business Corporation as a Basic Business Transaction - Part (B)

Formation of a corporation, one of the most common of business steps, appears to be so simple and so standard that an economic substance challenge seems out of the question. Indeed, as suggested, the Directive seems to reflect that thought. But...  Caruth v. United States [688 F. Supp. 1129 (N.D. Tex. 1987), aff'd, 865 F.2d 644 (5th Cir. 1989)] and W. & K. Holding Corp. v. Commissioner [38 B.T.A. 830 (1938), nonacq., 1939-1 C.B. 69] are two cases in which the courts arrived at different results in this respect...

...

What those courts, and a host of others, tell us is that incorporation is not automatically free of any question about economic substance and business purpose.

In its administrative guidance, the Service typically required a business purpose for forming a corporation when it was determining whether to grant the
IRC § 351 non-recognition tax treatment for the taxpayer...

So, all of the foregoing leaves us with the practical question for the taxpayer of whether the economic substance doctrine is relevant to an incorporation transaction and, if so, whether to disclose the transaction on the taxpayer's tax return...

The Directive

The Directive suggests that the Service appears of the view that the economic substance doctrine should apply in all circumstances (indeed, to determine if the economic substance doctrine is relevant to the transaction in question, the Service's field agents must use various factors to analyze whether or not to raise the economic substance doctrine)...

Other Anti-Avoidance Principles

Formation of a corporation is subject to other statutory rules and anti-avoidance principles. For example, IRC § 269 provides an additional safeguard for the Service and generally denies certain tax benefits sought by taxpayers if the principal purpose for entering into the transaction, involving the acquisition of control, was to evade or avoid U.S. federal income tax by securing such tax benefit. Other U.S. tax (agency and conduit) principles can also be applied to disregard the existence of a corporation for claiming certain tax benefits...

Practical Considerations for Taxpayers

Based on the existing longstanding judicial and administrative practice, some taxpayers may decide to argue that the economic substance doctrine is irrelevant to the proposed formation of a corporation. Due to hefty penalties, however, that approach may not be the best approach.

... As a suggested rule of thumb, the more prevalent a tax advantage is to the incorporation, the more likely the incorporation is to lack economic substance (or, at the very least, to be scrutinized by the Service)...

... Essentially, what was once a "basic business transaction" has now become more complicated, at least with respect to the application of the economic substance doctrine.

...

This publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact Ernst & Young or another professional advisor to discuss these matters in the context of your particular circumstances. We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication.

...

LEXIS users can view the complete commentary HERE. Additional fees may apply. (Approx. 6 pages)

RELATED LINKS: For further discussion and information about the codification of the economic substance doctrine, see:

For additional discussion and insight on the economic substance doctrine, see:

 

Rhoades & Langer, U.S. International Taxation and Tax Treaties is also available in print at the LexisNexis® Store.

...

Discover the features and benefits of LexisNexis® Tax Center
For quality Tax & Accounting research resources, visit the LexisNexis® Store