Business owners may have heard about economic substance from their business attorneys or tax attorneys. The Economic Substance Doctrine is a “test” by which the Internal Revenue Service will review certain transactions. As a Denver tax attorney John McGuire has dealt with the Economic Substance Doctrine first hand for a number of clients and this article may be used as general guidance regarding the doctrine. We recommend you contact your business attorney or tax attorney with any specific questions regarding a proposed transaction.
Section 7701(o) of the Internal Revenue Code provides that transactions after March 30, 2010, a transaction will be treated as having economic substance only if: 1) the transaction changes in a meaningful way, aside from federal income tax effects, the taxpayer’s economic position; and, 2) the taxpayer has a substantial purpose, other than federal income tax savings to enter into the specific transaction. The first part of the test is reviewed objectively and the second part of the test is reviewed subjectively.
The Internal Revenue Service has released a LB&I Directive, 4-0711-015 to be used by IRS examiners in determining whether the economic substance doctrine should apply to a transaction.
The directive provides the following factors and elements of which could cause the doctrine to likely apply:
1) Transaction is promoted/developed/administered by tax department or outside advisors
2) Transaction is highly structured
3) Transaction includes unnecessary steps
4) Transaction is not at arm’s length with unrelated third parties
5) Transaction creates no meaningful economic change on a present value basis (pre-tax)
6) Taxpayer’s potential for gain or loss is artificially limited
7) Transaction accelerates a loss or duplicates a deduction
8) Transaction generates a deduction that is not matched by an equivalent economic loss or expense (including artificial creation or increase in basis of an asset)
9) Taxpayer holds offsetting positions that largely reduce or eliminate the economic risk of the transaction
10) Transaction involves a tax-indifferent counterparty that recognizes substantial income
11) Transaction results in separation of income recognition from a related deduction either between different taxpayers or between the same taxpayer in different tax years
12) Transaction has no credible business purpose apart from federal tax benefits
13) Transaction has no meaningful potential for profit apart from tax benefits
14) Transaction has no significant risk of loss
15) Tax benefit is artificially generated by the transaction
16) Transaction is pre-packaged
17) Transaction is outside the taxpayer’s ordinary business operations.
If the Economic Substance Doctrine applies to a transaction, certain tax allocations and/or benefits received by the taxpayer could be changed and/or reallocated by the Internal Revenue Service. In short, the Internal Revenue Service can change the tax implications of certain transactions because the transaction lacked economic substance.
As a Denver tax lawyer and business lawyer John McGuire is experienced in this relatively new doctrine that can have a large affect and impact on certain transactions you or your business may be considering into. You can contact The McGuire Law Firm at anytime to schedule a free consultation and we would happy to meet with you.
Schedule your free consultation with a Denver tax attorney- Contact The McGuire Law Firm!