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Practical Tax Considerations for Taxpayers Applying the Economic Substance Doctrine to the Act of Incorporation

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Author(s): Rufus Rhoades and Alexey Manasuev
Date: March 2012

The Background

In 2010, Congress codified the economic substance doctrine, but left numerous unanswered questions for taxpayers on how to apply the doctrine. Along with codifying the economic substance doctrine, Congress also enacted strict liability penalties [IRC § 6662(b)(6) (20 percent strict liability penalty) and IRC § 6662(i) (40 percent strict liability penalty)]. This Emerging Issues Analysis looks at whether the codified doctrine is relevant to the basic transaction of formation of a corporation and, if so, how the doctrine should be applied.

Since the codification, the Service has issued a notice and one somewhat useful directive [Notice 2010-62, 2010-2 C.B. 411; LB&I-04-0711-015 (July 15, 2011) (the Directive)]. The Notice left us with a large number of unanswered questions. The directive (directives, as you recall, are addressed to field examiners), while generally lacking in meaningful guidance, did provide a helpful insight into the Service’s current perspective on the economic substance doctrine, as codified.

With no further guidance forthcoming, and significant penalty exposure for taxpayers who misapply the doctrine, taxpayers need to develop a practical framework as to how to approach the compliance with IRC § 7701(o). This Emerging Issues Analysis shares one of many potential approaches, taking into consideration the Service’s most recent guidance.

The Ground Rules

The statute provides that

“[i]n 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.” IRC § 7701(o)(1). …

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