When Does the IRS Call a Tax Strategy an Illegal Tax Scam?
New rules have given the IRS even more power in striking down transactions that save taxes. The issue is something called “economic substance.” Basically, the doctrine of economic substance means that the tax strategy must have an economic reason, not just a tax reason.
In 2006, the IRS won an additional $62 million in taxes from a single corporate transaction that flunked the economic substance test. So, how can you make sure the strategy you’re using will pass IRS muster?
Court cases that favor the IRS seem to largely be the case of “tax packages” that have been designed as “one size fits all” type of strategies. For example, a very large CPA firm put together a complicated structure that kicked off tax losses to offset income. They then proceeded to sell that same structure, again and again. The structure cleared didn’t pass the smell test in one case and that meant all of the cases were subsequently disallowed, even if the facts were different.
Other packages are allowed, almost endorsed, by the IRS.. For example, it seems that they are particularly fond of strategies involving life insurance. The bottom line is that it boils down to economic substance. Is there a chance for the taxpayer to gain from the transaction? This could be through asset protection, estate planning or additional income. But there has to be something more than just saving on taxes when you put a strategy in place.
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Isn’t there a famous Supreme Court ruling where they said you have the right to arrange your affairs to produce the lowest possible tax bill, you are not obligated to do it the way the IRS wants?
How does that reconcile with an “economic substance” regulation imposed by the IRS? (As long as you are not breaking the law of course.)
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Charlie
That would be Justice Learned Hand. There are a few judges out there who truly made a mark and he’s one of them.
As for the rest, well there’s the law … and then there’s the IRS.
But in all seriousness, the IRS has an incredible latitude for interpretation. They don’t say that the economic substance argument you are trying to make is illegal … instead they say you’ve misinterpreted the regulations, and won’t get the tax treatment you want unless you fit into their criteria. If you don’t like it, off to Tax Court. Once Tax Court rules (whichever way), you’ve got a precedent that can be relied upon in the future. The more cases that rely upon it, the more strength it gathers, until it essentially becomes a back-door law that didn’t require Congress.
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Megan Hughes
www.businessfirstformations.com
Last week, my business had its best month ever.