IRS Gives Limited Guidance on Economic Substance

By James A. Beavers, J.D., LL.M., CPA

Procedure & Administration

The IRS has provided indications of its plans regarding the codified economic substance doctrine and the enhanced penalty for transactions lacking economic substance in formal guidance to taxpayers and its examiners, as well as in informal statements made by IRS representatives. However, in this guidance, the IRS has steadfastly refused to identify any specific types of transactions it will consider to have economic substance.


The courts originally created the economic substance doctrine to disallow a transaction’s tax benefits if the transaction lacks economic substance. It allowed courts to enforce Congress’s statutory intent in situations in which a literal reading of the Code would allow a taxpayer to circumvent this intent.

While the courts generally agree on the definition of the economic substance doctrine, they have applied a number of different tests to determine whether a transaction has economic substance. Some courts use a single-element test and some use a two-element test. Under the single-element test, a transaction has economic substance if, viewed objectively, there is a nontax business purpose for the transaction. The taxpayer’s subjective intentions regarding the transaction are not taken into account (see Coltec Industries, 454 F.3d 1340 (Fed. Cir. 2006)). Under the two-element test, a transaction has economic substance if (1) the transaction, viewed objectively, has economic substance and (2) the taxpayer has a subjective business purpose for the transaction.

Adding to the confusion, courts that use the two-element test for economic substance have not been consistent in applying it, in some cases requiring that both elements be satisfied, in others requiring that either one of the two elements be satisfied, and in others taking both elements into consideration as part of the determination of whether a transaction has economic effects other than those derived from its tax benefits (see, e.g., Pasternak, 990 F.2d 893 (6th Cir. 1993); Rice’s Toyota World, 752 F.2d 90 (4th Cir. 1985); IES Industries, 253 F.3d 350 (8th Cir. 2001); ACM Partnership, 157 F.3d 231 (3d Cir. 1998); James, 899 F.2d 905 (10th Cir. 1990); Sacks, 69 F.3d 982 (9th Cir. 1995)).

As it had long threatened to do, Congress enacted legislation to codify the economic substance doctrine in the Health Care and Education Reconciliation Act of 2010, P.L. 111-152. The act added new Sec. 7701(o), which adopts a two-prong test, providing that in the case of any transaction to which the economic substance doctrine is relevant, the transaction will be treated as having economic substance only if (1) the transaction changes the taxpayer’s economic position in a meaningful way (apart from federal income tax effects) and (2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction. For purposes of the Code, the term “economic substance doctrine” means the common law economic substance doctrine.

Sec. 7701(o) states that the determination of whether the economic substance doctrine is relevant to a transaction will be made in the same manner as if the section had never been enacted. With respect to individuals, however, the two-prong analysis in Sec. 7701(o)(1) applies only to a transaction (or series of transactions) entered into in connection with a trade or business or an activity engaged in for the production of income. A transaction’s potential for profit will be taken into account in determining whether the economic substance requirements are met only if the present value of the reasonably expected pretax profit is substantial in relation to the present value of the claimed net tax benefits.

The Health Care and Education Reconciliation Act also added Sec. 6662(b)(6), which provides that the accuracy-related penalty imposed under Sec. 6662(a) applies to any underpayment attributable to any disallowance of a claimed tax benefit because of a transaction lacking economic substance (within the meaning of Sec. 7701(o)) or failing to meet any similar rule of law. The accuracy-related penalty is increased from 20% to 40% for any portion of an underpayment attributable to one or more transactions lacking economic substance for which the relevant facts affecting the tax treatment are not adequately disclosed in the return or in a statement attached to the return. Certain amended returns or any supplement to a return will not be taken into consideration for these purposes.

Sec. 6664(c) was amended to provide that the reasonable cause exception for underpayments found in Sec. 6664(c)(1) will not apply to any portion of any underpayment attributable to a transaction that lacks economic substance. Sec. 6664(d) was amended to provide that the reasonable cause exception found in Sec. 6664(d)(1) does not apply to any reportable transaction understatement (within the meaning of Sec. 6662A(b)) attributable to a transaction that lacks economic substance. In addition, Sec. 6676 was amended to provide that any excessive amount (within the meaning of Sec. 6676(b)) attributable to a transaction lacking economic substance will not be treated as having a reasonable basis.

Notice 2010-62

In September, the IRS issued Notice 2010-62, its first guidance under Sec. 7701(o) (see News Notes). The most notable feature of Notice 2010-62 is its lack of a list of transactions to which the IRS considers the economic substance to apply or not apply and the IRS’s assurance in the notice that it does not intend to issue general administrative guidance on the application of the doctrine. The IRS also stated that it will not issue private letter rulings or determinations on the application of the doctrine to a particular transaction.


In a September 2010 directive (LMSB-20-0910-024), Heather Maloy, the commissioner of the IRS’s Large Business and International (LB&I) division, announced to LB&I examiners the division’s policy on the imposition of the Sec. 6662(b)(6) accuracy-related penalty for transactions lacking economic substance. According to the directive, to ensure consistent administration of the penalty, “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.”

Statements from IRS Officials

In informal discussions of the codified economic substance doctrine, several IRS officials (William D. Alexander, associate chief counsel (corporate), Deborah Butler, associate chief counsel (procedure and administration), and Bryon A. Christiansen, deputy tax legislative counsel (regulatory affairs)), have suggested that codification does not represent a radical change. According to these officials, the substantive law regarding the doctrine has not changed, the common law basis for the doctrine remains intact, and the IRS will continue to use its traditional methods in developing economic substance cases. They have also reiterated that the IRS will, as directed by Sec. 7701(o), apply the doctrine as if Sec. 7701(o) had not been enacted and have consistently expressed that the IRS wants practitioners’ input on how and to what transactions the IRS should apply the doctrine going forward.


As some commentators have suggested, the guidance about the codified economic substance doctrine and the related penalties has given taxpayers and practitioners little or no insight into how the IRS will apply the new law that could not be gleaned from the law itself. Before the codification of the economic substance doctrine, the IRS legitimately had no obligation to issue guidance regarding its application of the doctrine, despite the confusing state of the law. However, now that the doctrine has been codified and transactions that lack economic substance are subject to a large and inflexible penalty, the IRS should feel that it has a duty to provide truly useful guidance to taxpayers and practitioners so that they can know exactly what the IRS considers the scope of the doctrine to be and how they can avoid running afoul of it.

Notice 2010-62, 2010-40 I.R.B. 411

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