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LB&I Commissioner Provides Guidance to Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties

July 29, 2011, Caplin & Drysdale
Waiting for Guidance

As most tax practitioners are aware, the Health Care and Education Reconciliation Act of 2010 added new section 7701(o) of the Internal Revenue Code (the "Code"). This provision codified the judicial doctrine of economic substance.1 Along with the new codification provision, a new penalty was added under Code section 6662(i) for non-disclosed, non-economic substance transactions. The provision imposes a 40% penalty and does not allow the usual reasonable-cause defense to penalties. Since enactment, practitioners have raised concerns about how and when the Internal Revenue Service ("IRS") will apply the new provisions.

The LB&I Directive and Its Four-Step Approval Process

On July 15th, the Large Business & International Division ("LB&I") issued guidance for examiners and managers on the codified economic substance doctrine and related penalties. LB&I-4-0711-015 (July 15, 2011). The guidance provides a series of questions the examiner must develop and analyze in order to seek approval for the application of the economic substance doctrine to a transaction. 

Previously, LB&I Directive LMSB-20-0910-024 (Sept. 14, 2010) stated that any proposal to apply the economic substance doctrine at the examination level must be reviewed and approved by the appropriate Director of Field Operations ("DFO"). The newly released guidance provides a four-step process that instructs examiners and their managers on how to determine when it is "appropriate" to seek the approval of the DFO in order to raise the economic substance doctrine. It fails, however, to use the "relevant" language found in the statute. The guidance also states that the penalties provided in Code sections 6662(b)(6) and (i) and 6676 are limited to the application of the economic substance doctrine and may not be imposed due to the application of any other "similar rule of law" or judicial doctrine (e.g., step transaction doctrine, substance over form or sham transaction).

The first and second step require the examiner to determine whether the circumstances in the case are those under which application of the economic substance doctrine to a transaction is appropriate. The facts and circumstances the examiner must analyze can be placed into three categories—the design, mechanics, and substance of the transaction. The "design" factors generally relate to things like who promoted or developed the transaction, whether it is highly structured or contains unnecessary steps, or whether tax-indifferent parties recognize substantial income. The "mechanics" factors include whether the transaction is at arm's length with unrelated third parties, accelerates a loss or duplicates a deduction, or generates a deduction that is not matched by an equivalent economic loss or expense. The "substance" factors relate to whether the transaction is consistent with Congressional intent in providing the incentives, creates a meaningful economic change on a present value basis or has a potential for profit, has a credible business purpose apart from tax benefits, or has significant risk of loss. 

If the examiner believes that the facts and circumstances of a transaction show that application of the economic substance doctrine is appropriate, the examiner must then answer another set of questions before seeking the DFO's approval for application of the doctrine. The questions ask whether application of the economic substance doctrine is the best course of action (e.g., is it the best argument available, or does recharacterizing the transaction or applying another judicial doctrine more appropriately address the noncompliance), and whether the doctrine might otherwise apply but is not appropriate for another reason (e.g., does the transaction involve credits designed by Congress to encourage the transaction, do courts reject application or fail to mention the doctrine when analyzing similar transactions, or is the transaction a statutory or regulatory election or subject to a detailed statutory or regulatory scheme).

Angel List?

Tax practitioners have been clamoring for an "angel list" – transactions that are exempt from application of the economic substance doctrine. The guidance does not clearly set forth such an angel list. It does, however, make clear that the economic substance doctrine is likely not appropriate when the transaction relates to the choice between capitalizing a business with debt or equity; a U.S. person's choice between using a domestic or foreign corporation in making a foreign investment; the choice to enter into a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; or the choice to utilize a related-party entity in a transaction, provided that the arm's length standard of Code section 482 and other applicable concepts are satisfied. If the IRS believes the doctrine should nevertheless be applied to a transaction, the DFO will provide the taxpayer an opportunity to explain his/her position regarding it.

The Take-Away

Caplin & Drysdale believes that the new guidance is very helpful. The extensive list of factors should be reviewed by tax advisors and carefully considered in analyzing the possible application of the economic substance doctrine to particular transactions. During a tax examination, the factors should be reviewed with the revenue agent to demonstrate why the new statute does not apply. The guidance also demonstrates that the IRS has put in place a process under which the IRS examiner, manager, and DFO must operate before application of the penalty. 

If you have additional questions about this alert, contact your Caplin & Drysdale representative or contact:

Mark D. Allison at 212.319.8710 or
Christopher S. Rizek at 202.862.8852 or
Charles M. Ruchelman at 202.862.7834 or


  1. Section 7701(o) states that "[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated 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 such transaction." The statute further states that the determination of whether the economic substance doctrine is relevant to a transaction will be made in the same manner as if section 7701(o) had never been enacted. 

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