40 Percent Strict Liability Penalty

What Tax and Transaction Attorneys Need to Know

Introduction. The economic substance doctrine has been a long-standing judicial doctrine disallowing tax benefits arising from transactions that meet the technical requirements of the Internal Revenue Code but do not result in a meaningful change to the taxpayer’s economic position other than the purported reduction in federal income taxes. While the doctrine has been applied by the courts in a variety of tax shelter transactions, it has also been applied to transactions that were not “tax shelters” in a traditional sense, but rather highly structured transactions to reduce or eliminate taxes in the context of a larger business transaction. Attorneys who assist clients in structuring operations or transactions must now be particularly sensitive to this doctrine as the doctrine has been substantively modified. There is now an automatic “no fault” penalty of 40 percent of the tax understatement (20 percent if adequately disclosed) if an adjustment is based on lack of economic substance.

The Health Care and Education Reconciliation Act of 2010 codified the economic substance doctrine with the addition of Section 7701(o) of the Internal Revenue Code of 1986, as amended (the Code). IRS officials maintain that this codification is not really a change and if counsel was not concerned in the past, counsel should not be concerned in the future.[1] Despite this assurance, however, something did change and it changed in both a “small” way, a “medium” way and a “big” way!


The “small” change makes the substantive test a “conjunctive test” with two prongs; the “medium” change imposes a present value concept in evaluating potential profit; and the “big” change imposes a massive “no fault” or “strict liability” penalty.

Conjunctive Test. Historically the judicial “economic effect” doctrine generally applied a two-prong test: (i) did the transaction change in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and/or (ii) did the taxpayer have a substantial purpose (apart from federal income tax effects) for entering into the transaction? The circuit courts were split as to whether meeting one prong would satisfy the doctrine or if both prongs had to be met. The Third Circuit had even rejected a rigid two-step analysis but rather considered them as related factors that inform the analysis of whether the transaction has sufficient substance to be respected for tax purposes. The Second Circuit viewed the two prongs as factors to consider which may (but need not) find against the taxpayer.[2] Under Section 7701(o), if the doctrine is relevant to a transaction, both prongs must be met. For Tennessee taxpayers, the conjunctive codification is a small change as the Sixth Circuit had adopted the conjunctive approach,[3] but for other taxpayers, particularly in circuits that determined economic substance to be met if either test was met,[4] it is substantive.

Concept of Present Value. While courts have universally looked at profit potential in the context of economic substance, there has been no per se judicial requirement imposing present value concepts nor has there been uniformity concerning the role of various costs and foreign taxes. Section 7701(o) imposes those aspects. How the present value concept will be applied and the present value discount rate to use likely will be the subject of frequent controversy.

Strict Liability. The universally viewed “big change” is the new massive “strict liability” penalty of Sections 6662(b)(6) and (i). As discussed below, if a transaction or series of transactions results in a deficiency and “economic substance” or a “similar rule of law” is the basis for the deficiency, there will be a penalty of 40 percent of the tax due (20 percent if the transaction is adequately disclosed).

Given the projected revenue estimates for the codification of economic substance and the penalty of $4.5 billion over 10 years, it can hardly be said nothing has changed. Nevertheless, counsel will be called upon to advise taxpayers as to whether economic substance or “similar rule of law” is applicable to the taxpayer’s transaction with little guidance and the knowledge that the IRS intends to further develop the case law. If the doctrine is applicable, counsel will then need to determine if the economic substance two prong test is met.

Application of the Doctrine to Commercial Transactions

Although the courts, at least in the past, have predominately limited the application of the economic substance doctrine to relatively aggressive cases, the IRS has commonly argued that more or less garden variety transactions should be restructured in a less taxpayer-friendly manner based on economic substance, business purpose, step-transaction or sham transaction. It is not uncommon for counsel and other tax advisors to plan transactions and follow steps that are designed to minimize the imposition of tax. Such planning and step structuring could be construed by the IRS as giving rise to the assertion of the penalty in a wide variety of transactions as the IRS may argue that one or more steps lack economic substance.

Threshold Question: When Is the Doctrine Relevant?[5]

The first issue in analyzing a transaction with respect to economic substance or defending a taxpayer in which the IRS has raised economic substance is whether the doctrine is relevant to the facts of the transaction. Section 7701(o) starts: “In the case of any transaction to which the economic substance doctrine is relevant …” Unfortunately, there is no statutory guidance as to when the economic substance doctrine is relevant other than to say: “The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.”[6] PricewaterhouseCoopers LLP has produced a lengthy “Summary of Economic Substance Case Law” covering 61 cases from the 1930s to 2010.[7] A few of their observations include: “… it is difficult, if not impossible, to draw firm conclusions as to the application of the economic substance doctrine to fact patterns beyond those at issue in the decided cases,”[8] and “Nor do the decided cases specifically address any so-called ‘long-standing administrative or judicial practice’ not to apply the economic substance doctrine to specific transactions.”[9]

Unfortunately, the IRS will not provide guidance as to when the economic substance doctrine is relevant and anticipates the case law regarding the circumstances in which the economic substance doctrine is relevant will continue to develop.[10] It has been very common for the IRS to include in its rationale for adjustments and routinely include in court briefs that a transaction was a step-transaction, a sham, did not have a profit motive, had no business purpose, lacked economic substance, and/or was otherwise improper even if it appeared to meet the technical requirements of the tax law.

In the author’s view, the litigated tax cases in which economic substance has been found to be relevant have predominately involved circumstances that many would consider as some form of “tax shelter”. However, in the author’s personal experience and from discussions with other tax counsel, examining agents and district counsel often invoke the “economic substance doctrine” or other amorphous doctrines that may or may not turn out to be “similar rule of law” when articulating the rational for proposed adjustments. Until there is clarity as to when the doctrine is relevant, counsel structuring transactions to minimize tax — particularly when involving related parties and/or tax indifferent taxpayers — should consider the potential of the application of the economic substance doctrine. Taxpayers hit with a 40-percent penalty plus interest are unlikely to think kindly of their counsel, particularly if the risk was not thoroughly discussed (and documented) at the outset. In defending a taxpayer when economic substance is raised, counsel should carefully determine whether economic substance is relevant to the transaction and forcefully present the case that it is not.

In connection with transactions that may be considered “tax shelters,” in the view of Lee Sheppard of Tax Analysts, the penalty is most likely to be successfully applied against individual taxpayers, particularly with respect to fusses over profit potential. “The profit analysis is messy, speculative, and fact-based. The taxpayer has control over the facts and can win corporate shelter cases. But the profit inquiry is a guaranteed loser for individual tax shelters.”[11]

No Legislative History. Section 7701(o) was enacted as a “pay for” as part of H.R. 4872, the Health Care and Education Reconciliation Act of 2010. This legislation was enacted in combination with the Patient Protection and Affordable Care Act. There are no House Report, no Senate Report and no Conference Report. The Joint Committee on Taxation did prepare a “Technical Explanation,”[12] which only lists four examples of transactions to which the doctrine would not apply. These were (1) the choice between debt or equity to capitalize a corporation; (2) the choice between a foreign or U.S. corporation to make a foreign investment; (3) entering tax-free reorganizations; and (4) the use of a related party entity (assuming section 482 is met).[13] Previously, there had been several legislative proposals offered concerning economic substance doctrine with legislative history, but those bills did not pass. Whether those committee reports will have validity in interpreting Section 7701(o) is presently unknown.

No Regulations. At this time there are no regulations with respect to Section 7701(o) and the new penalty. In October 2011, the IRS indicated regulations are in the works, but such regulations will not address when the doctrine is relevant, but may address “similar rule of law.” [14]

Other IRS Authority. The IRS has issued Notice 2010-62 and two directives, one from LMSB and the second from the realigned and renamed LB&I. The SB/SE has been silent, but presumably the LB&I directive will be utilized by SB/SE. While the IRS has said taxpayers can rely on administrative precedent, in the view of Lisa Zarlenga, Treasury deputy tax legislative counsel for regulatory affairs, administrative precedent does not include private letter rulings but does include revenue rulings and revenue procedures.[15] In Zarlenga’s view, the directives apparently would not constitute administrative precedent.

The notice provides limited guidance relating to the application of IRC §7701(o). It stated the IRS would neither issue an “angel list” of transactions that would not be subject to scrutiny under IRC §7701(o) nor issue any private letter rulings or determination letters on whether economic substance is “relevant”. This continued position of no guidance as to relevance was recently affirmed by Zarlenga.[16]

The notice provides that existing case law will apply to determine if the doctrine is relevant and, if so, whether the transaction has economic substance. However, the taxpayer may not rely on prior case law that applies a disjunctive (as opposed to conjunctive) test: i.e., both a meaningful change in economic position and business purpose are required. The IRS anticipates the case law concerning when economic substance is relevant will “continue to develop.”[17] This means the IRS will attempt to develop cases to expand and flesh out the doctrine that obviously “changes” the scope of economic substance as a practical matter.

The notice states that prior to the issuance of regulations requiring foreign taxes to be treated as expenses in appropriate cases, courts (and presumably agents) are not restricted from considering the proper treatment of foreign taxes in economic substance cases. Prior versions of economic substance statutory language provided that foreign taxes would be considered an expense for determining profit motive. Code Section §7701(o) as passed does not have such language. Given the new deference that regulations are given to the IRS following Mayo,[18] the manner in which the IRS frames the foreign tax provisions in the regulations is likely to control. It appears the IRS will be aggressive.

Directive I. On Sept. 14, 2010, the LB&I issued a directive, LMSB-4-0910-024 (Directive I). Directives are supposed to be non-substantive, not authority for taxpayers, and are not reviewed by the Treasury but are merely educational devices for the agents. Directive I did little more than tell agents that IRC §7701(o) exists, the new penalty exists and is applicable to transactions entered into on or after March 31, 2010, but did state that any proposal to impose an IRC §6662(b)(6) penalty must be reviewed and approved by the appropriate Director of Field Operations. It also refers the agents to the notice.

Directive II. On July 15, 2011, LB&I of the IRS issued a directive (Directive II) to its agents. Directive II lists the various factors that LB&I believes indicate the economic substance doctrine is not likely to apply and mirror image factors that would indicate the economic substance doctrine is likely to apply. Importantly, Directive II provides the procedure for an agent to refer a particular matter to a director of field operations for approval to impose the penalty.

The Directive II factors are not weighted and are generally mirror images of each other. For example one factor “is not highly structured” (factor saying it is likely not appropriate to raise economic substance) while the factor “is highly structured” indicates economic substance is likely appropriate to raise. The factors indicating that the “economic substance doctrine” is likely NOT to apply are: (i) is not promoted/ developed/ administered by the tax department or outside advisors; (ii) is not highly structured; (iii) contains no unnecessary steps; (iv) is at arm’s length with unrelated third parties; (v) creates a meaningful economic change on a present-value basis (pre-tax); (vi) the potential for gain is not artificially limited; (vii) does not accelerate or duplicate a deduction; (viii) does not generate a deduction that is not matched by an equivalent economic loss or expense (including artificial creation or increase in basis of an asset); (ix) does not involve offsetting positions that largely reduce or eliminate the economic risk of the transaction to the taxpayer; (x) does not involve a tax-indifferent counterparty that recognizes substantial income; (xi) does not result in the separation of income recognition from a related deduction either between different taxpayers or between the same taxpayer in different tax years; (xii) has credible business purpose apart from federal tax benefits; (xix) has significant risk of loss; (xx) involves a tax benefit that is not artificially generated by the transaction; (xxi) not pre-packaged; (xxii) is not outside the taxpayer’s ordinary business operations. There is one factor making it not likely that the doctrine applies that does not have a mirror image — “in the event it generates targeted tax incentives, it is, in form and substance, consistent with Congressional intent in providing the incentives.” Directive II identifies the four types of transactions identified in the explanation for which it is likely not appropriate to raise the economic substance doctrine.

Directive II at least provides talking points for practitioners and revenue agents to discuss if the revenue agent is considering the application of the penalty. Probably the most useful aspect of Directive II is the requirement and process to obtain the requisite approvals to impose the penalty is sufficiently burdensome to reduce revenue agent impulse to raise economic substance and the penalty as a matter of routine.

Substantive Economic Substance Doctrine Tests

Assuming the doctrine applies, there must be an inquiry regarding the objective effects of the transaction on the taxpayer’s economic position as well as an inquiry regarding the taxpayer’s subjective motive for engaging in the transaction. Failing either prong of the two-prong test means there is no economic substance.

The first prong: “Did the transaction objectively change in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position?” Some of the factors listed in Directive II are probably useful in this analysis. For example, is this a transaction that is arm’s length with unrelated third parties; is there a meaningful economic change of the taxpayer’s position on a present value basis (pre-tax); is the potential for gain not artificially limited; are deductions matched by equivalent economic loss or expense; are offsetting positions not involved that reduce or eliminate the economic risk of the taxpayer; and/or does the taxpayer have significant risk of loss.

In the IRS’s view, the role of tax indifferent counterparties recognizing substantial income, the separation of income recognition from that of a related deduction either between different taxpayers or with respect to the same taxpayer in different years, or the involvement of tax advisors and tax departments appear to be red flags.[19]

It should be noted that at least one of the prior versions of legislation to codify economic substance had a requirement that the means of achieving the business purpose must be a reasonable means. This was attacked by the tax professional community as punishing tax planning and was dropped as a specific requirement. However, vestiges may still come through the back door. For example, being highly structured, containing steps viewed by the IRS as “unnecessary,” and pre-packaged strategies are Directive II factors indicating the economic substance doctrine may be applicable and may be argued to be found in transactions that the IRS believes are not direct or reasonable means to achieve a stated business purpose.

The second prong: “Did the taxpayer have a substantial purpose (apart from federal income tax effects) for entering into the transaction?” This is akin to the old “business purpose” test. Profit motive, financial accounting benefits, and other valid businesses purposes can satisfy this prong. However, the explanation states that a state or local income tax effect related to a federal income tax effect is treated in the same manner as a federal income tax effect, and a financial accounting treatment based on a reduction of federal income taxes is not an effect.[20] If profit motive is the reason given, the present value of the reasonably expected pre-tax profit must be substantial in relation to the present value of the claimed net tax benefits. In computing the present value, transaction costs, including fees of advisors, are considered. Regulations in appropriate circumstances may treat foreign taxes as a “pre-tax expense.”[21] There is not a required or established minimum return to satisfy the profit potential test. The language does not appear to say the economic benefits must be greater than the tax benefits. The requirement is economic benefits must be substantial. Some of the factors in Directive II are focused on the intent of the taxpayer such as prepackaged strategies; the role of the tax department or tax advisors; and transactions outside the normal business of the taxpayer.

The analysis for this second prong will often involve self-serving statements of the taxpayer and support of various experts as to the business purpose and profit potential, etc. of the taxpayer.

The explanation, however, provides that Code Section 7701(o) is not intended to alter the tax treatment of basic business transactions that have been respected by long standing judicial decisions and administrative practice merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. In addition, if the tax benefits are incentives to induce taxpayers to undertake specific actions, undertaking those actions in a manner consistent with Congressional intent should not give rise to an economic substance argument or the imposition of the penalty. For an analysis of case law in the context of the codified economic substance, see Living with the Codified Economic Substance Doctrine, by Professor Martin J. McMahon Jr.[22]


If a disallowance is based on lack of economic substance or “failing to meet the requirements of any similar rule of law”,[23] the taxpayer is subject to a “no fault” penalty. The penalty is 20 percent of the tax on the understatement if the relevant facts are disclosed in the return or in a statement attached to the return or 40 percent if such disclosure is not made.[24] The deficiency is statutorily treated, per se, as not having a reasonable basis.[25] This is a strict liability penalty: recommendations of CPAs, counsel, investment bankers or written opinions of counsel will not be grounds for abatement of this penalty. Taxpayer good faith is irrelevant. This is a harsher penalty than those applicable to “reportable transactions.” Reportable transactions have a reasonable cause penalty relief where adequate disclosure is made on a timely return. For a non-disclosed “reportable transaction” the penalty is 30 percent as compared to a 40 percent penalty on a non-disclosed “economic substance” transaction. Non-disclosed corporate reportable transactions, however, are subject to a $50,000 penalty under IRC §6707A, which may be abated (but not for a “listed transaction”) by the IRS if it would promote compliance with the tax laws and effective tax administration.

The notice provides that disclosure will be considered adequate to reduce the 40-percent penalty to 20 percent only if the disclosure is made on a Form 8275 or 8275-R or as otherwise prescribed in forms, publications or other guidance subsequently published by the IRS. Disclosure consistent with Revenue Procedure 94-69 with respect to Coordinated Examination Program will also be taken into account for purposes of IRC §6662(i). If a transaction is defined in Treas. Reg. §1.6011-4(b) (listed transactions, confidential transactions, contractual protection transactions, IRC §165 loss transactions, and transactions of interest), both the economic substance disclosure and the IRC §6011 disclosure requirements must be met. Disclosure for one purpose does not satisfy the disclosure requirements for the other. Counsel and the tax return preparers should be sensitive to the disclosure requirements.

The application of the penalty to judicial doctrines other than economic substance that override the technical compliance with the code and regulations needs to be understood by counsel advising the taxpayer in a transaction. Previous versions of the economic substance codification (which were not passed) contained language that said “… shall not be construed as altering or supplanting any other rule of law, and the requirements of this subsection shall be construed as being in addition to any such other rule of law.”[26] The explanation states, “The provision [referring to Section 7701(o)] is not intended to alter or supplant any other rule of law, including any common-law doctrine or provision of the Code or regulations or other guidance thereunder; and it is intended the provision be construed as being additive to any such other rule of law.”[27]

The author anticipates that regulations, when issued, will expressly support this additive aspect and given the deference the courts must give properly issued IRS regulations under Mayo, that will likely be the result.


Taxpayers hit with a no fault penalty of 40 percent are not going to be happy or understanding toward their counsel. The frequent inability to say with reasonable certainty whether the economic substance doctrine will apply to a transaction is most troubling. The analysis of business purpose and change in the taxpayer’s economic position are not necessarily easy, but largely can be undertaken and aided with prior precedent. However, care should be taken when dealing with prior precedent as the present value concept/element is new and may change some of the prior results. Whether the requirement that a director of field operations must approve the assertion of the economic substance doctrine will have the effect of imposing appropriate discipline as to when the doctrine is raised by exam is presently unknown. Taxpayers and counsel must proceed at their own risk with respect to aggressive tax planning as economic substance doctrine develops and what constitutes “similar rule of law” for the penalty is developed.


  1. See e.g., comments of William Alexander, IRS Associate Chief Counsel (Corporate), 2010 TNT 133-2.
  2. ACM Partnership v. Commissioner, 157 F.3d 231 (3rd Cir. 1998); Altria Group Inc. v. U.S., 105 A.F.T.R.2d 2010-1419 (S.D.N.Y. 2010).
  3. Pastermak v. Commissioner, 990 F.2d 893, 898 (6th Cir. 1993).
  4. See e.g., IES Industries, Inc. v. U.S., 253 F.3d 350, 354 (8th Cir. 2001); Rice’s Toyota World v. Commissioner, 752 F.2d 89, 94 (4th Cir. 1985).
  5. With respect to individuals, the economic substance doctrine is only applicable to transactions entered into in connection with a trade or business or an activity engaged in for the production of income. IRC §7701(o)(5)(B).
  6. IRC §7701(o)(5)(C).
  7. Id.
  8. Id. at 1.
  9. Id. at 1.
  10. Notice 2010-62. The IRS will not issue a private letter ruling or determination letter regarding relevancy or compliance with section 7701(o).
  11. “Economic Substance Codification: Did We Do the Right Thing?” Lee A. Sheppard, 2010 STT 200-1.
  12. “Technical Explanation of the Revenue Provisions of the ‘Reconciliation Act’ of 2010, as Amended, in Combination with the ‘Patient Protection and Affordable Care Act,’” 142-156 (March 21, 2010) (The “Explanation”).
  13. Id. at 152.
  14. 2011 TNT 205-5.
  15. 2011 TNT 2005-5 (October 24, 2011).
  16. Id.
  17. Notice 2010-62, “Application of the Economic Substance Doctrine with Respect to Transactions Entered Into after the Effective Date of the Act, B. Determination of Economic Substance Transactions.”
  18. Mayo Foundation for Medical Education and Research v. United States, 131 S. Ct. 704 (2011).
  19. It should be noted that in some earlier versions of the codification of economic substance, there were special rules for applying what was essentially a per se lack of economic substance in transactions involving tax indifferent parties that involved financing and artificial income and basis shifting. Special statutory rules for determining the profitability of leasing transactions were also omitted from the legislation that was passed. See, e.g., H.R. 2345, 110th Cong., 1st Sess. (2007) and H.R. 2, 108th Cong., 1st Sess. (2003).
  20. See note 11, supra, at 154.
  21. IRC §7701(o)(2)(B).
  22. 2010 TNT 158-2. Professor McMahon is more sympathetic to the IRS position on not providing guidance than most. He has a good sampling of case law analysis demonstrating the development of the doctrine and the complexity of the analysis and often the lack of certainty.
  23. IRC §§6662(b)(6); 6662(i)
  24. Id.
  25. IRC §6676(c).
  26. See note 22.
  27. See note 11, supra, at 155.

J. Leigh Griffith J. LEIGH GRIFFITH, a partner with Waller, Lansden, Dortch & Davis LLP, is leader of the firm’s tax practice and the Global Trade, Tax, and Investment Services group. He received his bachelor of arts, magna cum laude, from the University of Virginia; his law degree from Vanderbilt University; and his LL.M. in taxation from New York University. He is a fellow of the American College of Tax Counsel. and was the principal draftsman of the Tennessee Limited Liability Company Act, creating the first LLC in Tennessee.