Corporate IRS Strategies and the Economic Substance Doctrine

Chuck Hodges:

Now that economic substance is codified, the doctrine isn't just theoretical anymore. The IRS is raising it more and more, even when your transaction complies with the statute. And what I'm seeing is even in cases where Congress specifically encouraged or at least blessed the tax benefit you received, the IRS is testing the boundaries of the economic substance doctrine. And they're using it as a guardrail to verify that the tax benefits of structures within the lane of what the IRS will approve. I hear this too often from taxpayers, though, but we're right. But the question I ask back is, can you prove the IRS is wrong? Tax controversy is not just about being right, but whether you as a taxpayer have developed a roadmap to defend IRS in court scrutiny. At Jones Day, our tax litigation group has handled these cases for decades. We've tried more than 10 economic substance cases on both sides, because we have experienced former IRS trial attorneys who handled these cases for the IRS, as well as lawyers representing taxpayers.

We know what that roadmap needs to look like. So, what is the codified version of economic substance doctrine? It's a two-part test, but it's often overlooked as far as the actual words. First, the transaction must meaningfully change your economic position, apart from tax benefits. That's a little different than the wording from prior judicial doctrine application. Second, did the taxpayer have a actual substantial purpose for entering into the transaction, other than the tax benefits? Courts look at both prongs together. So, what counts as meaningful change when you're dealing with the economic substance doctrine? It's really a risk-reward analysis, but here's the bottom line. Your defense starts at the deal table, not in court and not when the audit begins. Document your business rationale contemporaneously, how the transaction changes your risk profile or cash flows, the alternatives that you considered, and why you chose the path for non-tax reasons.

Recently, Jones Day secured one of the few complete taxpayer victories of economic substance, involving transactions between related parties. And the IRS didn't appeal because we showed meaningful economic risk supported by contemporaneous, yet not perfect documentation, credible business purpose, and third party dealings that match the taxpayer's real market behavior. That's the roadmap you need. Three takeaways. First, assume economic substance can be raised even when you're following the statute, when you believe you are right. Second, build your defense early with valid documentation, real economic change, and a substantial non-tax purpose. But third, if you are challenged, you need a team who can defend your transaction from an economic substance attack.