Under the judicial economic substance doctrine, courts disregard an otherwise valid transaction and its related tax benefits when the transaction serves no economic purpose other than tax savings. Congress codified the economic substance doctrine and a related strict liability penalty under Secs. 7701(o) and 6662(i), respectively, in the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, for transactions entered into after March 30, 2010. This column discusses uncertainty surrounding the codification of the economic substance doctrine and explores selected areas of impact on CPAs’ professional obligations and practice. It also demonstrates that the doctrine must be understood by all practitioners, not simply those who work with, for instance, multinational companies.
Introduction to Secs. 7701(o) and 6662(i)
Courts have applied the economic substance doctrine when there was no meaningful change to the taxpayer’s economic position other than a purported reduction in federal income tax, despite technical compliance with the Code. However, there have been multiple common law tests for determining economic substance and business purpose. The Sec. 7701(o) two-prong test creates a uniform standard.
The test provides that where the economic substance doctrine is determined to be relevant, a transaction and its associated tax benefits will be respected only if (1) the taxpayer’s economic position changes in a meaningful way and (2) there is substantial business purpose. “Relevance,” “meaningful,” and “substantial” are not defined. In addition, federal, state, and local income tax benefits cannot be used to demonstrate a change in economic position or business purpose. The Joint Committee on Taxation’s (JCT) unofficial report states that this exclusion does not apply to tax provisions enacted to induce behavior (e.g., rehabilitation credits) (JCT, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010,” as Amended, in Combination with the “Patient Protection and Affordable Care Act” (JCX-18-10), p. 152 (March 21, 2010)).
The new Sec. 6662(b)(6) strict liability penalty applies to any transaction lacking economic substance under Sec. 7701(o) and “any similar rule of law.” There is no reasonable cause exception, and the penalty is a striking 40% if the transaction is undisclosed (Sec. 6662(i)) and 20% if adequately disclosed on Form 8275, Disclosure Statement, Form 8275-R, Regulation Disclosure Statement, or Schedule UTP, Uncertain Tax Position Statement, with additional requirements for reportable transactions.
“Similar rule of law” is also ambiguous. For instance, does this include the substance-over-form and step-transaction doctrines? The substance-over-form doctrine recharacterizes the tax treatment to reflect the transaction’s substance. Similarly, the step-transaction doctrine merges a series of formally separate steps into a single transaction and recharacterizes the transaction’s tax treatment. Conversely, when the Sec. 7701(o) test is not satisfied, the transaction is disregarded and tax benefits are disallowed. Despite these differences, the Sec. 6662(b) penalty may apply.
The IRS does not intend to provide substantive guidance on the codified economic substance doctrine (see Notice 2010-62). The JCT provided the following illustrative, nonexhaustive examples of where it is not relevant:
(1) the choice between capitalizing a business enterprise with debt or equity; (2) a U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; (4) the choice to utilize a related-party entity in a transaction, provided that the arm’s length standard . . . [is] satisfied. [JCT, Technical Explanation at 152–53]
Preparer Obligations Under Sec. 6694
Return preparers may be subject to penalties under Sec. 6694 unless positions on the covered return meet the relevant authoritative support tests. Although practitioners may rely in good faith on information provided by clients in preparing returns, considering the codified economic substance doctrine in detail in certain situations likely will be necessary to avoid Sec. 6694 penalties. For instance, when a transaction or investment appears tax motivated or depends significantly on tax benefits to explain the economics, further economic substance–related inquiry should be considered. This is critical when evaluating whether a transaction has a significant purpose of avoiding or evading federal income tax.
In some instances, clients may provide internally or externally prepared advice relating to the doctrine or a transaction where it is relevant. Practitioners may rely on this advice after performing adequate due diligence and determining that the advice is reasonable. In doing so, the following may be considered:
- The adviser’s competence;
- Whether the analysis appears reasonable on its face;
- Whether the adviser was aware of and considered all the relevant facts and made reasonable legal conclusions; and
- Subsequent legal developments.
The codification of the economic substance doctrine also affects the Sec. 6694 reasonable cause and good-faith exceptions. When a transaction is disregarded under the doctrine, the facts and taxpayer intentions matter more than technical merits. To demonstrate reasonable cause and good faith, a practitioner may have to show a documented understanding of the transaction. Further, if a practitioner knew or should have known that the doctrine was relevant, failing to recommend disclosure and document consideration of the Sec. 7701(o) two-prong test may not be considered good faith.
Finally, clients are in the best position to know of transactions that may lack economic substance. Practitioners should establish procedures to (1) inquire into the existence of these transactions, (2) document responses, and (3) analyze any affirmative responses to help satisfy their Sec. 6694 obligations.
Codification of the economic substance doctrine also affects practitioners’ Circular 230 obligations. First, Circular 230, Section 10.33, is an aspirational standard that urges the establishment of best practices when practicing before the IRS. Best practices include processes that allow the practitioner to identify relevant facts, appropriately apply facts to law, and reach proper conclusions. A better understanding of the facts and how they relate to the economic substance doctrine should allow practitioners to appropriately evaluate client transactions and thus provide quality representation.
Since the economic substance doctrine may result in disallowed tax benefits and significant penalties, evaluating the facts and circumstances of transactions or matters to which the doctrine may apply is necessary to satisfy the Circular 230, Section 10.22, due diligence obligations. The due diligence process should assist in identifying when the doctrine may apply and in discovering relevant facts and motivations, thus enabling practitioners to estimate risk and exposure associated with compliance.
These processes should also help practitioners satisfy their Circular 230, Section 10.34, obligations for positions taken in tax returns and all other documents submitted to the IRS on behalf of clients. These standards, effective August 2, 2011, prohibit practitioners from knowingly signing a return containing or advising on a position that:
- Lacks a reasonable basis;
- Is an unreasonable position under Sec. 6694(a)(2); or
- Is a willful attempt to understate tax liability or a reckless or intentional disregard of the Sec. 6694(b)(2) rules.
While practitioners may rely in good faith without verification upon information furnished by the client, they may not ignore the implications of incorrect, inconsistent, or incomplete information provided by the client. Further investigation would be necessary.
Understanding the facts underlying a transaction and the taxpayer’s motivations is also necessary to provide written tax advice under Circular 230, Sections 10.35 and 10.37. Relevant facts must be uncovered and applied to the applicable law(s) based on the scope of the advice. Reasonable assumptions of fact are permitted, but practitioners should not assume satisfaction of the Sec. 7701(o) two-prong test, since it is per se unreasonable under Circular 230 to factually assume business purpose or a transaction’s potential profitability apart from its tax benefits.
The Statements on Standards for Tax Services (SSTS) are enforceable standards that are part of the AICPA’s professional standards. The SSTS apply to all tax engagements undertaken by CPAs, not just federal tax matters. Although the SSTS create ethical obligations similar to those discussed above in the Circular 230 and Sec. 6694 subsections, they also provide significant additional guidance. SSTS No. 1, Tax Return Positions, paragraph 6 (tax return positions generally), and No. 7, Form and Content of Advice to Taxpayers, paragraph 3 (content and form of advice), contain requirements that practitioners advise clients on potential penalties and how to avoid such penalties, if possible, through disclosure. SSTS No. 3, Certain Procedural Aspects of Preparing Returns, similar to the Circular 230 and Sec. 6694 due diligence requirements, sets a standard of care for potential negligence, malpractice, or disciplinary actions. Interpretations 1-1 and 1-2 (currently under revision) provide additional guidance but do not explicitly address the codification of the economic substance doctrine. CPAs should carefully consider the economic substance doctrine in their practice guidelines for tax compliance and consulting engagements.
Considerations for the Practitioner
Here, the economic substance doctrine applies only to transactions or matters entered into in connection with a trade or business or an activity engaged in for the production of income. Thus, individual returns that contain Schedule C, Profit or Loss from Business, and Schedule E, Supplemental Income and Loss, are not exempt from the doctrine, nor is any individual return that includes items reported on a Schedule K-1. The economic substance doctrine is generally inapplicable to individual returns that report primarily salary income derived solely from W-2s and 1099 investment income reported on Schedules B and D.
Taxpayers can use Schedule C to deduct expenses that may not be “ordinary and necessary” or related to an activity that has a profit motive. Indeed, this is why the Code includes so-called hobby loss rules. As such, it has always been important for practitioners to challenge clients in this area, but now, with the Sec. 6662(i) strict liability penalty, it is vital that practitioners discuss potential economic substance doctrine penalties with their clients. To the extent possible, discussions surrounding economic substance and potentially relevant transactions should occur as early as possible, perhaps well before tax season begins in the case of existing clients. Information surrounding these activities can be reviewed before receiving final numbers to alleviate some of this additional burden.
Returns for Passthrough Entities
Because subchapter K already has anti-abuse rules, the codification of the economic substance doctrine may simply present an additional hurdle. For instance, Regs. Sec. 1.701-2(b) permits the IRS to recharacterize any passthrough entity transaction with a principal purpose of substantially reducing tax liability in a manner inconsistent with the intent of subchapter K, even if the transaction is otherwise compliant with tax laws and regulations. In recharacterizing a transaction, the regulation provides that statutory and regulatory principles of law can be considered. This now includes the codified economic substance doctrine, so transactions that previously satisfied the anti-abuse rules may fail under the doctrine.
The IRS may use the economic substance doctrine to challenge other partnership transactions, such as the allocation rules under Sec. 704 and the disguised sale rules under Sec. 707. It is unclear how the doctrine will affect these matters because the current rules are a mixture of mechanical rules that are deemed to have a form of economic substance. Further, consider the treatment of recourse debt under Sec. 752. A partner can increase basis by guaranteeing part of a nonrecourse liability in a manner that poses little economic risk. This guarantee may fail the Sec. 7701(o) test because the partner’s economic position has not changed in a meaningful way (see Cudd, “Recent Tax Law Changes and Consequences,” in Tax Law Developments Affecting Private Equity and Venture Capital (Aspatore 2011)).
These concerns do not exist in a vacuum and must be considered in the context of the entire return process. For example, practitioners should take into account the level of expertise of the party that is preparing the Schedule K-1. Less scrutiny can be given to K-1s prepared by specialists and experienced practitioners. Less deference is appropriate for and should be given to K-1 preparers with little or unknown experience. Further, there is frequently very little time for practitioners to receive a K-1 and prepare the client’s return. This crunch adds to the difficulty of satisfying professional obligations. Practitioners should consider requesting information on transactions where the economic substance doctrine may be relevant prior to receiving the K-1.
Requesting internal and external prepared tax advice memorandums is a good practice, especially in the corporate setting, because these memorandums can be reviewed for high-risk transactions. For instance, transactions without nexus to the client’s business are higher risk. Transactions offsetting large income items (e.g., distressed asset debt instruments) or involving tax-indifferent parties are most dubious. While helpful, these steps do not assist in determining the relevance of the economic substance doctrine to more common transactions.
Consider the conversion of a corporation’s wholly owned domestic subsidiary into a limited liability company (LLC). In the absence of a check-the-box election, the subsidiary would be viewed as having liquidated for federal income tax purposes. However, the liquidation is truly for tax purposes only because the business continues in the same manner it did before the election. There is no meaningful change to the taxpayer’s economic position. This would certainly fail the Sec. 7701(o) two-prong test; perhaps the proper conclusion is that the test is not necessary if it is determined that the doctrine is not relevant to check-the-box.
There is also the Sec. 338(h)(10) election where the buyer and seller both treat an entity sale as an asset sale. The election would likely fail the Sec. 7701(o) test because the election is purely tax motivated. Again, perhaps the proper conclusion is that the doctrine is not relevant. Finally, there are well-established corporate tax rules—e.g., the step-transaction and substance-over-form doctrines—upon which the application and effect of the doctrine are unknown.
Prudent Measures to Consider
A prudent measure would be to broach the economic substance doctrine with the client during engagement planning. Initially, clients may need general background regarding the doctrine, especially its broad scope, strict liability penalties, uncertainty, and some examples of when it may apply.
When contracting for engagements, consider whether the client should bear sole responsibility for the codified economic substance doctrine’s strict liability penalties. The client knows the facts and circumstance of each transaction. Sec. 6694 and Circular 230 have due diligence requirements, but neither imposes a duty to audit. Taking responsibility for such a penalty is a serious undertaking by the practitioner. Further, economic substance–related work may result in additional detail regarding engagement scope, as well as higher fees because the analysis can be complicated and time consuming and involve higher risk.
This is a different and tougher conversation, however, when a professional has structured the transaction. More so than in compliance, clients may believe that economic substance is the adviser’s responsibility because the planning and structuring is what the client paid the adviser to do. Nonetheless, a client should understand that such advice does not provide Sec. 6662(i) penalty protection.
Once commencing the engagement, a practitioner should determine whether the client is aware of any transactions that may implicate the doctrine by explaining it in more detail. Inquiries should focus on nonroutine transactions, with additional attention given to transactions without nexus to the client’s business operations and those proposed by advisers with whom the client does not have a standing relationship. As always, transactions that appear to provide significant tax benefits should be carefully evaluated. When available, practitioners should obtain copies of opinions, advice, and analysis provided by external and internal client advisers. Economic substance–related inquires should be documented in the practitioner’s working papers. If the practitioner finds that the economic substance doctrine is relevant to a particular transaction, the Sec. 7701(o) two-prong test should be applied to the transaction, with the results documented and communicated to the client.
There is significant uncertainty surrounding the codification of the economic substance doctrine because no further substantive guidance is expected, cases interpreting Sec. 7701(o) are years away, and the precedential value of existing economic substance doctrine case law is unknown. For now, practitioners should take a back-to-basics, prudent course. If the doctrine is potentially applicable to an engagement, practitioners should discuss the implications with their clients, consider the issues raised in this column, and seek additional assistance if necessary.
Thomas Purcell III is a professor of accounting and professor of law at Creighton University in Omaha, NE. Gregory Fowler is with PricewaterhouseCoopers LLP in Washington, DC. Andrew Mattson is with Mohler, Nixon & Williams in Campbell, CA. James Bresnahan II is with PricewaterhouseCoopers LLP in Washington, DC. Mr. Fowler is chair and Mr. Purcell and Mr. Mattson are members of the AICPA’s Tax Practice Responsibilities Committee.