What are examples of transactions lacking economic substance? Searching on the internet did not give me actual examples.
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What are examples of transactions lacking economic substance? Searching on the internet did not give me actual examples.
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This might not be the exact thing that the code section in question was designed to address, but I believe it demonstrates the principle:
Bill and Fred form a partnership and invest some money. At the end of the year they've earned $100 in qualified dividends and $100 in interest income. Because Bill is in a higher tax bracket than Fred, they decide to allocate all of the qualified dividends (taxable as capital gain) to Bill, and all of the interest income (taxable as ordinary income) to Fred. Each receives $100.
This arrangement would lack economic substance because they each receive the same amount of money and the allocation serves no purpose other than to reduce/avoid taxation.
MTW
The examples are the actual court decisions that invoked the doctrine. Prior to codification in March 2010, the doctrine did not exist in the Internal Revenue Code. In Notice 2010-62 the IRS stated how they intend to apply it.
The most important aspect of the codification was not Sec. 7701. It is the change to the penalties if you are found to have failed the test. Reasonable cause no longer exists. It is 20% for the understatement or
40% for nondisclosure. In other words, getting a CPA firm to bless the transaction(s) and relying upon their expertise to enter into the transaction(s) will no longer shelter you from any penalty. See Revised Sec. 6662, 6662A and 6676 in the IRC.This subject gets a lot of attention in MBA and MST graduate classes. Since codification, everyone and their relatives have published commentary on this. I am providing a link to just one. I find that it takes a very complex subject and it sums it up very nicely. It is part of the Tax Update series by Orrick, Herrington & Sutcliffe LLP, one of oldest law firms in San Francisco.
The real issue is doing something that has no real purpose other than to get a tax deduction.
For example say a parent and child enter into a partnership. The child is allocated all the partnership income, while the parent is allocated all partnership deductions. There is no legitimate reason for the allocations other than to give the child all the taxable income (at his lower rate) and the parent all the deductions. There is no economic reason (substance) to the transaction other than for tax purposes.
Another might be a person who buys a truck on credit (nothing down, interest payments only) for ten times its actual value. He depreciates the truck and deducts the interest payments. When the truck is fully depreciated he turns it back to the seller and owes nothing more as a result. That is a transaction that has no economic purpose than to lower taxes.
___ Stu
On 12/28/11 12:01 PM, Alan wrote:
In looking at my notes on this subject, I discovered another piece of IRS guidance
The following facts and circumstances tend to show that application of the economic substance doctrine to a transaction is likely not appropriate. If some of the factors described in this section of the LB&I Directive apply to the transaction, and an examiner continues to believe that the application of the doctrine is appropriate, the examiner should continue to analyze the transaction using the guidance set forth in Steps 2-4.
Transaction is not promoted/developed/administered by tax department or outside advisors Transaction is not highly structured Transaction contains no unnecessary steps Transaction that generates targeted tax incentives is, in form and substance, consistent with Congressional intent in providing the incentives Transaction is at arm?s length with unrelated third parties Transaction creates a meaningful economic change on a present value basis (pre-tax) Taxpayer?s potential for gain or loss is not artificially limited Transaction does not accelerate a loss or duplicate a deduction Transaction 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) Taxpayer does not hold offsetting positions that largely reduce or eliminate the economic risk of the transaction Transaction does not involve a tax-indifferent counterparty that recognizes substantial income Transaction 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 Transaction has credible business purpose apart from federal tax benefits Transaction has meaningful potential for profit apart from tax benefits Transaction has significant risk of loss Tax benefit is not artificially generated by the transaction Transaction is not pre-packaged Transaction is not outside the taxpayer?s ordinary business operations. In addition, it is likely not appropriate to raise the economic substance doctrine if the transaction being considered is related to the following circumstances.
The choice between capitalizing a business enterprise with debt or equity A U.S. person?s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment The choice to enter into a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C The choice to utilize a related-party entity in a transaction, provided that the arm's length standard of section 482 and other applicable concepts are satisfied.
STEP 2: DOCTRINE MAY BE APPROPRIATE
The following facts and circumstances tend to show that application of the economic substance doctrine may be appropriate.
Transaction is promoted/developed/administered by tax department or outside advisors Transaction is highly structured Transaction includes unnecessary steps Transaction is not at arm?s length with unrelated third parties Transaction creates no meaningful economic change on a present value basis (pre-tax) Taxpayer?s potential for gain or loss is artificially limited Transaction accelerates a loss or duplicates a deduction Transaction generates a deduction that is not matched by an equivalent economic loss or expense (including artificial creation or increase in basis of an asset) Taxpayer holds offsetting positions that largely reduce or eliminate the economic risk of the transaction Transaction involves a tax-indifferent counterparty that recognizes substantial income Transaction results in separation of income recognition from a related deduction either between different taxpayers or between the same taxpayer in different tax years Transaction has no credible business purpose apart from federal tax benefits Transaction has no meaningful potential for profit apart from tax benefits Transaction has no significant risk of loss Tax benefit is artificially generated by the transaction Transaction is pre-packaged Transaction is outside the taxpayer?s ordinary business operations.
Makes sense.
This does not make sense to me. The company receiving the interest payments would report lots of income, which balances out the huge deduction of the buyer.
This makes sense.
I found one example at
This and two other cases are described at
If you depreciate something over seven years with no salvage value, you are deducting a bit more than 14% per year if you go straight- line. But if you are only paying 4% interest per year, you may be coming out way ahead.
People used to try this kind of thing with investments in movies and livestock - I don't think you can do it anymore.
___ Stu
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