IRS Provides Guidance on Economic Substance Doctrine

August 24, 2011

Penalties apply to transactions without economic substance.

In July, the IRS gave direction to its examiners on when they can assert the 20% or 40% penalty that applies when a taxpayer’s transaction does not have economic substance.  There is no “reasonable cause” exception to these penalties.

40% penalty if there is inadequate disclosure.
The penalty provisions apply to transactions entered into after March 30, 2010, the date new Section 7701(o) of the Internal Revenue Code was enacted, where the IRS determines, and a court agrees, that the transaction did not have economic substance within the meaning the new statute.  In such a case, the taxpayer is strictly liable for a penalty in the amount of 20% of the underpayment of tax attributable to the disallowance of tax benefits as a result of the application of the economic substance doctrine.  If the transaction was not adequately disclosed on the taxpayer’s return, the penalty is 40% of the amount of the underpayment.

Lack of guidance.
The provisions have been highly controversial both because of their strict liability nature, and because there is no guidance in Section 7701(o), nor has any been provided by the IRS, on the types of transactions to which the penalties should or should not apply.  The July 2011 guidance helps to fill that void.

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