New Law and Its Effects on Reportable Tax Transactions

Buried within the Health Care Reform Bill, which was signed into law on March 30, 2010, is the long anticipated codification of “Economic Substance.” Economic substance is the principle of whether or not transactions entered into by taxpayers create a meaningful change to the taxpayer’s economic position after completion, or if the purpose was merely to create a reduction in Federal income taxes. Since the doctrine of economic substance has been inconsistently applied in Court, the new law aims to challenge aggressive tax planning practices by creating uniformity.

Often called “tax shelters,” such transactions will now be subject to one test of economic substance, rather than various interpretations. Some specific transactions which will be covered under the codification include:

• Capitalization of debt vs. equity of a business enterprise;
• Foreign investments via foreign or domestic corporations;
• Corporate reorganization transactions;
• Arm’s length related party transactions.

Prior to March 30, 2010, Courts often tested economic substance by a combination of taxpayer proof of economic substance, business purpose and circumstantial facts. As of March 30 and forward, taxpayers must now prove that apart from Federal income tax avoidance, their tax positions:

• change their economic position in a meaningful way, AND
• have a substantial business purpose.

The Courts will continue to have the authority to interpret and potentially re-characterize transactions in implementing the new doctrine. Penalties will now be imposed for any reportable avoidance transactions. In general, taxpayers are now subject to a 20 percent accuracy-related penalty on any understatement of an adequately disclosed transaction, and 40 percent on understatements that are undisclosed at the time a tax return is filed.

Form 8886 should be used by taxpayers to list reportable transactions that may be of interest to the IRS when filing a return. Reasonable cause exceptions will no longer be available, yet burden of proof will still remain with the taxpayer who will be liable to prove the above mentioned items in relation to their tax position based on facts and circumstances in existence at the time that the return was filed. Subsequent events will bear no relevance to cases of this matter, nor will opinion of outside tax advisors. SEC regulations will require additional reporting to those taxpayers subject to the accuracy related penalties.

In addition to raising revenue and discouraging aggressive tax planning, the IRS is clearly providing taxpayers the incentive to consider their actions in engaging in potential tax shelter transactions that may not only lead them to Court, but will likely impose stringent penalties on Federal income tax liabilities. The IRS is likely to have more of an upper hand in such cases in their hopes to create consistency among the Courts in treatment of these transactions as they begin to uncover tax avoidance transactions.