The IRS has intensified its use of the economic substance doctrine, applying it more broadly across tax examinations than at any point in recent years.
The economic substance doctrine is a judicial anti-abuse rule, traceable to the landmark case Gregory v. Helvering, that allows the government to disregard transactions lacking genuine economic purpose beyond tax savings.
Congress codified the doctrine in 2010 as Section 7701(o) of the Internal Revenue Code, establishing a two-prong conjunctive test that transactions must satisfy to be recognised as having economic substance.
Under that test, a transaction must change the taxpayer’s economic position in a meaningful way apart from federal income tax effects, and the taxpayer must have a substantial non-tax purpose for entering into it.
For several years following the 2010 codification, the IRS adopted a relatively restrained posture when applying the doctrine during examinations of corporate and individual taxpayers alike.
That changed in 2022, when the agency decided to shift course and begin aggressively raising the economic substance doctrine and its associated penalties across a broader range of examinations than in prior years.
The penalties attached to economic substance violations are significant, with strict-liability charges of 40% available to the government when it successfully challenges a transaction on these grounds.
Recent litigation has demonstrated that courts are broadly willing to support the IRS’s more assertive approach, lending weight to the agency’s renewed enforcement strategy.
In Patel v. Commissioner, a unanimous reviewed Tax Court opinion held that amounts taxpayers paid to purported micro-captive insurance companies were without economic substance and sustained the strict-liability 40% penalty against those taxpayers.
Just five months later, in Liberty Global, Inc. v. United States, the US Court of Appeals for the Tenth Circuit held in a split decision that the codified economic substance doctrine under Section 7701(o) applied to a taxpayer’s multistep transaction structure.
The Tenth Circuit found that the taxpayer’s transaction structure generated no meaningful economic change and had no substantial non-tax purpose, reinforcing the government’s position in such disputes.
Together, these rulings signal that taxpayers engaged in complex, multi-step transactions face heightened scrutiny and a more difficult path to avoiding substantial penalties when economic substance is at issue.