Economic Substance Doctrine

I’ve had a question from a student about the “economic substance doctrine.” This has been a club that the IRS used against people for years. However, the ObamaCare legislation beefed it up and actually made it a law.

The IRS has always argued, and the courts have bought off on the idea, that if something you do is done primarily to save taxes, the IRS can “undo” your transaction. The fact is lots of things people do are for the tax benefit.

In fact, tax laws are largely passed to “get the public to do something.” You get an energy tax credit if you insulate your house. You make investments in oil drilling, because you get tax credits.

When the courts have looked at the issue, they have asked questions like:

• Was there another reason, other than tax savings, for doing the deal?
• Was there a non-tax business purpose for doing the transaction?
• Was there a profit motive in the deal?

ObamaCare gave the IRS a lot bigger club, but the economic substance doctrine is something you should have been looking for all along.

The “window dressing” is important. For example, when you are moving assets out of creditors’ reach, you need to do estate planning (wills and trusts type stuff) at the same time. This isn’t the economic doctrine issue, but it is window dressing.

Did you transfer the property to get rid of creditors? If you don’t have a good answer to the question, the judge will slap you. But, if everything was done as part of your estate planning, that’s probably ok.

All of your estate planning, tax planning, and asset protection planning needs to be done with an “alternative” reason in mind. For example, if you show how a tax savings transaction was done for asset protection or estate planning needs, that will remove the “tax consequences” from the economic substance doctrine.

The issue comes up most in asset protection and tax planning, so think about your reasons for doing things, and it will help down the road. The primary target for the IRS is the guy who makes the investment deal knowing that it won’t make money, but for the tax savings.

If you can’t show a “non-tax” reason for your dealings, you’ll get caught in the trap, and the penalties are stiff. The tax savings will be disallowed, plus you’ll get a 40% penalty imposed by the IRS if you haven’t fully reported the deal in the past.