Litigation Considerations When Facing the Economic Substance Doctrine

The economic substance doctrine prevents taxpayers from subverting the legislative purpose of the Internal Revenue Code by engaging in transactions that are fictitious or lack economic reality simply to reap a tax benefit. In other words, the economic substance doctrine is a U.S. federal tax principle designed to disallow tax benefits from transactions lacking a genuine non-tax business purpose or meaningful change in economic position, even if they technically comply with the tax law. Originally a common law judicial concept, the economic substance doctrine was codified into Section 7701(o) of the Internal Revenue Code by the Health Care and Education Reconciliation Act of 2010. This article discusses important considerations that should be considered when dealing with a dispute involving the economic substance doctrine.

Common Law Definition of the Economic Substance Doctrine

Before Section 7701(o) was enacted, the economic substance doctrine was deemed a “cardinal rule of the Internal Revenue Code.” See Keeler v. Commissioner, 243 1212, 1215 (10th Cir. 2001). The number of federal cases involving the economic substance doctrine is immense and the federal courts have been interpreting the economic substance doctrine for almost a hundred years. Although Section 7701(o) codified the economic substance doctrine in 2010, case law that interpreted the economic substance doctrine is still very important for anyone currently involved in a dispute with the Internal Revenue Service (“IRS”) regarding the doctrine. We will therefore begin this article with a review of possibly the most important and relevant cases discussing the economic substance doctrine prior to the enactment of Section 7701(o).

We will begin our review of judicial cases analyzing the economic substance doctrine with Gregory v. Helvering, 293 U.S. 465 (1935). Gregory held that it is axiomatic that taxpayers may structure business transactions as they please, even though motivated by tax-beneficial considerations. However, under federal common law, a transaction must still have economic substance to be recognized for federal tax purposes. Though it may be proper in form, a transaction which lacks economic substance beyond the creation of tax benefits and which is not imbued with tax-independent considerations is an economic sham without effect for federal income tax purposes. The courts have distinguished “shams in fact,” in which the alleged transactions never actually took place, from “shams in substance,” in which the transactions actually took place and are genuine for general private law purposes, but for federal tax purposes nonetheless lack the substance their form represents. See Lerman v. Commissioner, 939 F,2d 44, 48 (3rd Cir. 1991); Brown v. Commissioner, T.C. 1992-279 (court noted that the investment in horse breeding tax shelter was not a factual sham, since it [did] not deal with phantom horses or other indices or fictitiousness; however, the court found the transaction to be economic shams).

Prior to the enactment of Section 7701(o), courts focused on two factors to determine whether a transaction would be deemed an economic sham for federal tax purposes:

1. The Economic Substance Factor Test. This test involved objective analysis regarding whether there was any realistic potential for profit or practical economic effect exclusive of tax benefits, and
2. The Business Purpose Factor Test. This test involved a substantive analysis of the taxpayer’s intent, regarding whether the taxpayer was motivated by business purposes other than obtaining tax benefits.

These two factors were examined in light of the facts and circumstances existing as of the time of the subject transaction, not in hindsight. The courts were not uniform as to the weight to give these factors. In Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985), the Fourth Circuit Court of Appeals held that a transaction was not a sham for tax purposes if the taxpayer satisfied either factor of this inquiry. However, the Tax Court considered the economic substance factor virtually determinative in the analysis and business purpose merely relevant. See Cherin v. Commissioner, 89 T.C. 986 (1987). According to the Tax Court, “[a] transaction imbued with economic substance will be recognized for tax purposes even in the absence of a business purpose. On the other hand, the existence of a subjective business purpose does not mandate the recognition of a transaction lacking economic substance.” See Dixon v. Commissioner, T.C. Memo 1991-614. In other cases, particularly older ones, the taxpayer’s intent had been disregarded entirely. See Knetsch v. United States, 364 U.S. 361 (1960).

In United States v. Consumer Life Insurance Co, 430 U.S. 725 (1977), the Supreme Court addressed whether, by virtue of two sets of reinsurance agreements, or “treaties,” the taxpayers maintained a sufficient proportion of life insurance reserve afforded to “life insurance companies” under Section 801. The government argued, among other theories, that treaties, which allocated unearned premium reserves between the taxpayers and other unrelated insurance companies, were sham transactions without substance.

The Court rejected this argument on the ground that the treaties, which were negotiated at arm’s length, served business purposes for the respective parties in addition to tax benefits. Under the first set of treaties, the taxpayers were reinsurers, and the ceding companies were required to hold the premiums until earned. The terms of those treaties permitted the ceding companies to invest the funds and keep all resulting investment income. The second set of treaties, under which the taxpayers were ceding companies, “served most of the basic business purposes commonly claimed for reinsurance treaties,” and in effect enabled each taxpayer to expand its business. Moreover, each taxpayer associated itself through the second treaty with a reinsurance company more experienced in the field, and under the terms each taxpayer was shielded against certain catastrophic losses. According to the Supreme Court, “tax considerations will have a good deal to do with the specific terms of the treaties, but even a ‘major motive’ to reduce taxes will not vitiate [the] transaction.” 430 U.S. at 738 [Emphasis added].

The Supreme Court Frank Lyon Co. v. United States, 435 U.S. 561 (1978). In Frank Lyon Co., Worthen Bank & Trust (“Worthern”) planned the construction of a multistory bank and office building to replace its existing facility. Worthern’s banking competitor also planned to construct a new building in which to relocate its operations, which placed pressure on Worthen to construct a new building in which to relocate its operations, which placed pressure on Worthen to follow through with its construction plans. Worthen initially hoped to finance, build and own the proposed facility by selling debentures and contributing the proceeds to a wholly-owned real estate subsidiary. As planned, the subsidiary would hold formal title and would raise the remaining $5 million by a conventional mortgage loan on the new premises. However, Worthen abandoned the plan for two reasons. First, the proposed obligation would be rendered unmarketable, because Worthen legally could not pay more interest than that specified under Arkansas banking law. Second, the Federal Reserve refused to grant Worthen the necessary permission to invest in banking premises in the planned amount. Worthen was thus forced to seek an alternative solution which would provide it with the use of the building, satisfy the state and federal regulators, and attract the necessary capital.

Consequently, after negotiations with various prospective investors, Worthen negotiated and consummated a sale-leaseback arrangement with the taxpayer, whereby the taxpayer took title to the Worthen building under construction, financing the acquisition through unrelated third parties and lease the building back to Worthen. The lease was a net lease; the rental payments were identical to the taxpayer’s mortgage payments. The lease granted Worthen an option to purchase the building after the primary lease, on other future dates, at predetermined amounts that would represent a 6 percent compound return on the taxpayer’s equity. The Internal Revenue Service (“IRS”) maintained that the taxpayer’s transactions in their entirety were shams for tax purposes, and all deductions, such as interest expenses and depreciation should be disallowed. According to the IRS, the taxpayer was in substance merely a conduit between Worthen and the lenders in an elaborate financing arrangement.

The Supreme Court rejected the government’s position. The Court found a host of business and regulatory purposes, rather than mere tax benefits, underlying the structure of the transaction. The Court regarded the taxpayer’s exposure to the “real and substantial” risk of the notes and the presence of a third party- a finance agency- in the transaction that the transaction as structured had substance. The Court made the following conclusion:

“In short, we hold that where, as here, there is a genuine multiple-party transaction with economic substance which is compelling or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties.” 435 U.S. at 583-584.

Rice Toyota World. Inc v. Commissioner, 752 F.2d 89 (4th Cir. 1985), aff’g and rev’g. 81 T.C. 184 (1983), was the first major case to construe Frank Lyon Co as requiring the two factor analysis under the sham transaction doctrine. The transaction was devoid of economic purpose for entering into the sale-leaseback transaction. The transaction was devoid of economic substance, and thus the entire arrangement, including the recourse note, was a sham for tax purposes. The Fourth Circuit Court of Appeals agreed that the taxpayer satisfied neither factor of the sham transaction analysis with respect to the computer sale-leaseback and affirmed the disallowance of the depreciation deduction and nonrecourse interest deduction. In concluding the business purpose inquiry – specifically, whether the taxpayer entered into the transaction with a profit objective – the Fourth Circuit Court of Appeals looked at three facts. First, the taxpayer did not seriously evaluate whether the computer would have sufficient residual value at the end of the existing lease to enable the taxpayer to earn a profit on its purchase and leaseback. The Court of Appeals held as follows:

“Residual value of the computer (either in selling or releasing) should therefore have been a crucial point of inquiry for a person with a business purpose of making a profit on this transaction. However, Rice’s principal officer knew virtually nothing about computers, and relied almost exclusively on the representations of a Finalco salesperson regarding expected residual value. Despite the Finalco representative’s frank concession that he was not an expert in predicting residual values, Rice did not pursue the representative’s offer to provide an expert appraisal of likely residual value. Rice’s accountant advised that the transaction appeared to be profitable, but the record does not reveal that the accountant’s opinion reflects anything more than the fact that the transaction, if successful, would generate large tax deductions. Although Rice had in its possession a report containing a chart that showed a possibility that the computer would have sufficient residual value to earn Rice a profit, the report warned of great risk in predicting residual values, and also showed a large possibility of losses on the transaction. See 752 F.2d at 92-93.

Second, the sales literature of the transaction emphasized the large deductions associated with the transaction, rather than the profit potential. Third, and most critically according to the court, the taxpayer willingly paid an inflated purchase price for the computer. The Court of Appeals went on to say that:

Considering that Finalco had a right to 30 percent of re-leasing or sale proceeds after five years, Rice can more accurately be said to have purchased only 70 percent of a computer, then worth less than $1,000,000. Because Rice paid so obviously inflated of a purchase price for the computer and financed the purchase mainly with nonrecourse debt, it was inferred by the Tax Court that Rice intended to abandon the transaction down the road by walking away from the nonrecourse note balance before the transaction ran its stated course.

The economic inquiry, according to the Fourth Circuit Court of Appeals, requires an objective determination of whether a reasonable possibility of profit from the transaction existed apart from the tax benefit. The appellate court accepted the Tax Court’s finding that the sale-leaseback carried no hope of earning a profit because the computer’s residual value was not sufficient to recoup the interest and principal paid to the seller on the recourse note less the $10,000 annual return under the lease. In substance, the taxpayer did not purchase or lease a computer, but rather, paid a fee to Finalco in exchange for claims for tax benefits. The court found the nonrecourse note associated with the sham investment similarly without economic substance. However, the Fourth Circuit Court of Appeals reversed the Tax Court on the disallowance of the interest deduction based on the recourse note, which it held was genuine and had independent economic substance. Citing Frank Lyon Co.,the Fourth Circuit Court reasoned that a transaction having economic substance must be respected for tax purposes even if the motive for the transaction was to avoid tax.

In ACM Partnership v. Commissioner, 73 T.C.M. 2189 (1997), aff’d in part and rev’d in part, 157 F.3d 231 (3rd Cir. 1998), cert denied, 119 S. Ct. 1251 (1999), the Tax Court was faced with assessing whether a series of complex financial transactions had the requisite economic substance to be respected for federal income tax purposes. ACM Partnership involved a foreign partnership engaged in the contingent installment sale of certain notes that shifted income to a foreign partner and generated a capital loss to its U.S. partner, Colgate-Palmolive, who incurred all the costs. The Tax Court found in a memorandum decision that at the time Colgate-Palmolive entered into the partnership, its only opportunity to earn a profit was through either an increase in the credit quality of the issuers of the notes or a 400-500 basis point increase in the 3- month LIBOR interest rate.

The Tax Court found it was impossible for the issuers’ credit quality to increase by the necessary amount because it was so highly rated at the time of the transaction. Moreover, a 6-year review of the 3-month LIBOR rate by the Tax Court failed to find an increase of even 300 basis points within that time frame. Thus, the Tax Court concluded there was no reasonable expectation of profit from the investment strategy undertaken by the taxpayer, and engaging in such strategy was not “consistent with rational profit-motivated behavior in the absence of expected tax benefits.” 73 T.C.M. 2189 (1997). In explaining its rationale, the Tax Court held “in this case .. the taxpayer desired to take advantage of a loss that was not economically inherent in the object of the sale, but which the taxpayer created artificially through the manipulation and abuse of the tax laws. A taxpayer is not entitled to recognize a phantom loss from a transaction that lacks economic substance.

The Tax Court also determined that, on the basis of the evidence presented, the investment strategy did not achieve the hedging effects and other non-tax commercial goals as the taxpayer contended. The Tax Court concluded that the strategy served no useful non-tax business purpose and held for the IRS. On ACM’s appeal, the Third Circuit Court of Appeal applied an economic substance analysis in its partial affirmation of the Tax Court’s holding, finding that ACM’s transactions had no effect on ACM’s net economic position or non-tax business interests and thus did not constitute an economically substantive transaction that could be respected for tax purposes. The Third Circuit Court of Appeals did acknowledge that it is “well established that where a transaction objectively affects that taxpayer’s net economic position, legal relations, or non-tax business interests, it will not be disregarded merely because it was motivated by tax considerations.” 157 F.3d 231 (3rd Cir. 1998). The Third Circuit Court of Appeals decision in ACM seems to imply that a taxpayer must not always pursue the most efficient and profitable means of accomplishing a transaction in order to avoid having it labeled as a “sham” for taxation purposes.

The Economic Substance Doctrine Codified in Internal Revenue Code Section 7701(o)

The economic substantive doctrine was codified into Section 7701(o) of the Internal Revenue Code in 2010. Under Section 7701(o) of the Internal Revenue Code, the economic substance doctrine requires that two prongs be satisfied. First, the transaction must change in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position; and, second, the taxpayer must have had a substantial purpose (apart from federal income tax effects) for entering into the transaction.

Penalties related to attempts to circumvent the economic substance doctrine are significant. Taxpayers may be penalized for underpayments of tax caused by transactions that lack economic substance. See IRC Section 6662(b)(6). The penalty is 20 percent of the underpayment of tax attributable to the transaction. Section 6664(c)(1) of the Internal Revenue Code establishes a “reasonable cause” safe harbor. But it specifies that the safe harbor “shall not apply to any portion of an underpayment which is attributable to one or more transactions described in Section 6662(b)(6) of the Internal Revenue Code. Therefore transactions that lack economic substance are not eligible for an abatement under the reasonable cause exception. In addition, under Section 6662(i), the penalty is increased to 40 percent on any portion of an underpayment that is attributable to nondisclosure of the noneconomic substance transaction on a tax return.

Congress enacted Section 7701(o) to codify the common law doctrine of the economic substance doctrine. Section 7701(o) does not necessarily change the definition of the common law doctrine economic doctrine. Section 7701(o) merely provides a uniform definition of economic substance and establishes a strict liability penalty. Thus, as indicated above, a reasonable cause defense such as reliance on a tax professional will not likely provide a defense to the economic substance penalty. Although a reasonable cause defense may not provide a defense to the economic substance doctrine under Section 7701(o), as with common law, entering into a transaction for a valid business purpose may provide a defense to the economic substance doctrine. Anyone involved in tax controversy will know that the IRS (or the Department of Justice) commonly aggressively alleges that transactions are fictitious or lack economic reality simply to reap a tax benefit. When the facts warrant, it is extremely important to lay out the business reasons for entering into a transaction and the facts as to why the transaction in question did not lack economic reality. Section 7701(o) keeps the common law standard that has been applied by courts to determine if a transaction has a business purpose and has economic substance. It is therefore incredibly important for anyone involved in an economic substance doctrine dispute to have a solid understanding of the common law cases interpreting economic substance and business purpose.

Section 7701(o)(5)(B) Contains an Exemption to the Economic Substance Doctrine

The economic substance doctrine does not apply to every transaction. Section 7701(o)(5)(B) contains a limited exception for “personal transactions of individuals.” As such, Section 7701(o) is not relevant to individuals where the transactions are not “entered into in connection with a trade or business or an activity engaged in for the production of income.” See IRC Section 7701(o)(5)(B). Whether a transaction is in “connection with a trade or business” requires examining the facts and circumstances surrounding the transaction. Thus, in any case involving the economic substance doctrine, a careful analysis should be done to determine if a transaction is excluded from the doctrine under Section 7701(o)(5)(B).

Any Time a Section 7701(o) Strict Liability Penalty is Assessed by the IRS, An Analysis Should be Done to Determine if the Penalty Violates the Fifth Amendment of the Constitution

The economic substance doctrine (at least the penalties authorized by the doctrine) raises a number of constitutional issues. The first of which involves the Due Process Clause of the Fifth Amendment to the Constitution. The Due Process Clause of the Fifth Amendment promises that the federal government shall not deprive a person of “life, liberty, or property without due process of law.” “Life, liberty, or property” might plausibly be read as a unit and given the “open-ended, functional interpretation” that the federal government cannot “seriously hurt someone without due process of law.” The goal of due process is fairness. Fairness refers to government action according to known standards that are impartially applied through revealed procedures. Known standards allow a person to better understand what the government expects of her, so that she can plan her life in some forehanded way. Known standards also limit the allocation choices of government officials. They require that choices be made according to principle rather than the preference of the government official.

The penalties that the IRS has authority to assess against taxpayers are not only substantial, these penalties are classified as strict liability penalties. As strict liability penalties, the individual assessed penalties under Section 7701(o) is liable for the penalty regardless of their intent or mental state. The Fifth Amendment to the Constitution not only requires a fair process before the federal government can deprive a person of their property (money in this case), the Fifth Amendment to the Constitution also provides that federal civil laws are unconstitutional if they are so unclear that ordinary people cannot understand them. A law must be written clearly enough for a person of common intelligence to understand what conduct is prohibited. Any litigant involved in a controversy involving the economic substance doctrine should consider if the process involved in the assessment of the Section 7701(o) penalty was fair and if that process potentially violated the Fifth Amendment to the Constitution. In addition, litigants involved in an economic substance doctrine controversy should consider if
Section 7701(o) statutory language is sufficiently clear to provide he or she fair notice of the prohibited conduct and if Section 7701(o) encouraged the IRS to act in an arbitrary and discriminatory manner when assessing the penalty.

Any Time a Section 7701(o) Strict Liability Penalty is Assessed by the IRS, An Analysis Should be Done to Determine if the Penalty Violates the Eighth Amendment of the Constitution

Beside Fifth Amendment considerations, litigants involved in an economic substance dispute with the IRS should ask if the Section 7701(o) penalty assessment violated the Eighth Amendment to the United States Constitution which prohibits excessive fines. Under the Excessive Fines Clause of Eighth Amendment of the United States Constitution, a fine is invalid if it is grossly disproportionate to the gravity of the taxpayer’s offense.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding of how the economic substance doctrine and its associated penalties operate. It should be evident from this article that this is an extremely complex subject. It is important to note that this area is constantly subject to new development and changes. If the IRS has alleged that you attempted to circumvent the economic substance doctrine, it is important that you consult with a competent tax attorney as soon as possible.

Anthony Diosdi represents individual and corporate clients, both domestic and international, before the Internal Revenue Service, United States Tax Court, Federal District Court, United States Court of Claims, and Federal, and United States Courts of Appeals.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.