On July 15, 2011, the IRS issued an important directive to its examiners on how the economic substance doctrine, which was codified by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, and the new penalty associated with it should be applied to cases in the field (LB&I-4-0711-015). Since the IRS’s Large Business and International Division (LB&I) is auditing more high-wealth clients, this directive will be important to more practitioners.
The economic substance doctrine has long been a judicial doctrine, and for transactions entered into after March 30, 2010, it is now codified in Sec. 7701(o). There is also a new strict liability penalty in Sec. 6662(b)(6) equal to 20% (or 40% for undisclosed transactions) on any underpayment attributable to the disallowance of claimed tax benefits resulting from the application of the economic substance doctrine. Taxpayers cannot use the reasonable cause exception (Sec. 6664) to avoid this penalty.
To apply the new economic substance doctrine and the associated penalty, IRS examiners must obtain the review and approval of their director of field operations (DFO). Before requesting DFO review, examiners should perform four steps:
1. Evaluate the 22 factors in the directive showing that the application of the economic substance doctrine to a transaction is likely not appropriate.
2. If the examiner still feels that the doctrine is warranted, evaluate whether the facts and circumstances in the case support the application of the doctrine.
3. Make additional inquiries consistent with the guidelines, including whether another judicial doctrine such as step transaction or substance over form more appropriately addresses the noncompliance. These other doctrines would then take precedence in application over the economic substance doctrine.
4. Review the logistical guidance for requesting DFO approval when the examiner and managers have concluded that the application of the doctrine is merited.
The importance of these guidelines is to ensure that the IRS is applying the economic substance doctrine and strict liability penalty consistently across taxpayers. It is important for tax practitioners to understand how the IRS is prioritizing this doctrine relative to other traditional judicial doctrines.
Valrie Chambers is a professor of accounting at Texas A&M University–Corpus Christi in Corpus Christi, TX. Mark VanDeveer is with Mark A. VanDeveer PC in Virginia Beach, VA. Prof. Chambers and the author are members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For more information about this column, contact Prof. Chambers at firstname.lastname@example.org.