The Health Care and Education Affordability Reconciliation Act of 2010 (the "Act") added a new provision to the Internal Revenue Code (the "Code"), commonly referred to as the "codification" of the "economic substance doctrine." In addition to restating the common law economic substance rule, the Act establishes new operating rules for application of the economic substance doctrine and a new, strict liability penalty scheme for transactions that lack economic substance. The new Code provision applies to transactions entered into after March 30, 2010, meaning that the economic substance doctrine applies to tax planning transactions undertaken at year-end to anticipate increases in individual tax rates resulting from the expiration of the Bush-era tax cuts. In the past, when significant tax rate increases were scheduled to occur at December 31, some taxpayers took steps to accelerate income into the pre-increase taxable period to obtain the benefit of the lower federal tax rates. A very common transaction involves selling an asset before year-end where the taxpayer expected to dispose of the asset sometime in the succeeding taxable year. Where the property is sold in an arms-length transaction to a third-party, the fact that the taxpayer transferred the economic incidents of ownership, and irrevocably changed its economic position, should mean that the sale will be sustained for tax purposes, regardless of the taxpayer's intent. Many of these taxpayers were unwilling to accept any material risk as to the amount of income that would be recognized and were likewise unwilling to give up potential appreciation in the asset between year-end and the time the asset would otherwise be sold. Those parties often attempted to accelerate the income by selling the asset to a related or subordinated taxpayer who would complete the sale in the next year. Similarly, taxpayers might attempt to accelerate the income by selling the right to receive ordinary income, e.g., a sale commission, to a related or subordinated taxpayer with the goal of accelerating the ordinary income into the lower-tax period. Where the transactions do not involve third parties acting at arms-length, however, the codification of the economic substance doctrine, particularly the strict liability penalty provisions, may render such tax planning among related parties more challenging than in the past.
Pursuant to the newly-codified economic substance doctrine, a transaction is treated as having economic substance only if the transaction changes in a "meaningful way (apart from federal income tax effects) the taxpayer's economic position" and the taxpayer has a substantial purpose (other than federal income tax effects) for entering into the transaction. Thus, 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 motives for engaging in the transaction. The profit potential of the transaction is generally considered in connection with the taxpayer's subjective intent for entering into the transaction. The new Code provision further clarifies that: (a) the profit potential of a transaction taken into account in determining whether the transaction meets the economic substance test must be measured by comparing the net present value of the reasonably expected pre-tax profit from the transaction with the present value of the expected income tax benefits that would be allowed if the transaction were respected; (b) any state or local income tax effects that are related to a federal income tax effect are treated in the same way as the federal income tax effect, i.e., the state or local income tax effect is not taken into account as a meaningful change in the taxpayer's economic position; and (c) achieving a financial accounting benefit is not taken into account as a purpose for entering into a transaction if the origin of the financial accounting benefit is a reduction of federal income taxes.
A transaction intended to accelerate taxable income into 2010 without meaningfully changing the taxpayer's economic benefits and burdens of the ownership of the property or receipt of the income would, almost by definition, fail the economic substance doctrine as articulated in the statute. For example, a transaction in which a capital asset were sold to a partnership in which the taxpayer or a closely related person, e.g., a spouse or a trust for minor children, owned substantially all of the economic interests in exchange for a note, combined with an election out of installment reporting, would be at risk of challenge under this rule if the acquirer did not have meaningful downside exposure for the repayment of the note or the seller retained a significant participation in the upside of the asset. Thus, the expression of the economic substance doctrine in new Code section 7701(o) raises meaningful hurdles to accomplishing a related party transaction intended to accelerate income into 2010 without a material change in the financial position of the taxpayer.
If a transaction is determined to lack economic substance, the taxpayer will be subject to one of two new penalties for noneconomic substance transactions. There is a 20% accuracy-related penalty to the portion of any underpayment attributable to the disallowance of claimed tax benefits by reason of a transaction lacking economic substance within the meaning of Code section 7701(o) or failing to meet the requirements of any similar rule of law. Alternatively, there is a 40% penalty (in lieu of the 20% accuracy-related penalty) where the transaction was "not adequately disclosed in the return or in a statement attached to the return." Both of these penalties are "strict liability" penalties. A prior disclosure must have been made by the taxpayer on a tax return, an amended return or a supplement to a return in order to avoid the 40% penalty. No exceptions to the penalty (including the "reasonable cause" exception to penalties) are available. Thus, under the provision, outside opinions or in-house analysis would not protect a taxpayer from imposition of a penalty.
The prospect of a 40% penalty applied to the undeunderstatement of tax makes implementation of an income acceleration strategy by related parties most problematic. Assuming that a taxpayer could shift $10 million from 2011 to 2010, thereby subjecting the income to tax at a 35% rate rather than a 39.6% tax rate, the expected tax savings would be approximately $360,000. If the IRS successfully asserted that the transaction lacked economic substance, and the taxpayer failed to adequately disclose the transaction, the penalty in 2010 would be approximately $1.6 million, or almost 450% of the expected tax savings. The presence of the 40% penalty for undisclosed noneconomic transactions presents a significant barrier to trying to accelerate taxable income into 2010 without changing the taxpayer's position in a meaningful way. Moreover, the potential penalty must be considered as a factor even in those transactions more clearly undertaken at arms-length prices. With the powerful 40% penalty weapon in its arsenal, the risk that the IRS might assert the penalty in due course to income accelerations it finds inappropriate cannot be ignored. Income acceleration strategies not involving arms-length transactions with unrelated persons are likely to be scrutinized by the IRS with a view to imposition of the new penalty scheme, particularly transactions in which the taxpayer failed to make the appropriate disclosures.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.