Client Alert from Tax Practice

October 4, 2010

Codification of Economic Substance Doctrine Brings Increased Penalties for Aggressive Tax Transactions

The 20% accuracy related penalty now applies to any underpayment of tax attributable to any disallowance of claimed tax benefits based on a determination that a transaction lacks economic substance.   The 20% penalty becomes 40% if the relevant facts about the tax treatment were not adequately disclosed on the tax return.  Unlike other penalties, there is no reasonable cause exception.

This change will have its greatest impact on tax products including products commonly referred to as tax shelters.   The Economic Substance Doctrine was developed by the courts to overturn various tax shelter transactions which might otherwise have passed muster.  It denies tax benefits from a transaction if the transaction lacks economic substance or a business purpose.  As now codified in the Internal Revenue Code, the Economic Substance Doctrine will treat a transaction as having economic substance only if: (a) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and (b) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.

Higher Tax Rates Will Apply to Individuals in 2011

Individuals Old Rates New Rates
10%, 25%, 28%, 33% and 35% 15%, 28%, 31%, 36% and 39.6%   Personal exemption phase out.  Limitation on itemized deductions.
Qualified Dividends 0% and 15% 39.6%
Long-Term Capital Gains 0% and 15% 20%


Individuals with a Long Period to Invest May Find Conversion to Roth IRA Beneficial

Prime candidates for Roth IRA conversions are taxpayers who have a long period of time before they need to withdraw money (so that there is plenty time for tax free inside buildup), anticipate being taxed at a high marginal bracket in the future and can afford to pay a tax now on the conversion.

Starting in 2010 there is no longer a $100,000 adjusted gross income limit for the conversion of traditional IRAs to Roth IRAs.  Unlike distributions from traditional IRAs, distributions from Roth IRAs are tax free if made after a five year taxable period has lapsed and after the owner attains age 59½.  The five taxable year period begins on the first day of the tax year in which the conversion occurs.  Roth IRAs are not subject to required minimum distribution rules. By contrast, annual distributions are generally required from regular IRAs beginning in the year following the year in which the owner attains age 70.