Broker Check

IRS Alters Rules, Empowering Auditors with Broad Authority to Challenge Transactions

| July 12, 2023

The IRS issued a memorandum on April 22, 2022, which updates the guidance for examiners and managers regarding the economic substance doctrine and related penalties. This makes it easier for the IRS to claim that a transaction lacks economic substance or a business purpose by removing the previously required four-step process and the need for executive approval.

The economic substance doctrine is a concept that was codified by Congress in 2010. It says that tax benefits from a transaction are not allowed if the transaction lacks economic substance or a business purpose. Penalties are imposed on underpayments related to tax benefits that were disallowed due to a lack of economic substance.

The previous IRS approach involved a detailed four-step process that examiners had to follow before asserting a penalty. This process included evaluating various factors, seeking approvals, and considering alternative approaches. The memorandum simplifies the process by requiring examiners to obtain approval only from their immediate supervisor.

The memorandum also removes the list of transactions where the economic substance doctrine is not applicable and eliminates the requirement to notify taxpayers about the potential application of the doctrine. However, providing notice to taxpayers is still considered a best practice.

It also emphasizes that penalties must be approved in writing by the immediate supervisor and involve Counsel, and it provides a list of facts and circumstances that may indicate the application of the economic substance doctrine is appropriate.

In addition, the memorandum allows for the consideration of other judicial doctrines and recharacterization of transactions alongside the economic substance doctrine. This contradicts the previous preference for alternative approaches.

Examiners now have more flexibility to consider different legal arguments and facts when determining whether to impose a penalty under the economic substance doctrine. However, documentation of the economic substance and business purpose of a transaction is crucial.

Although the four-step process and the Director of Field Operation's approval are no longer required, taxpayers should be prepared to provide additional information and documentation to newer examiners and Counsel team members who may have less experience with the economic substance doctrine.

Overall, the memorandum simplifies the process for asserting the economic substance doctrine and provides examiners with more discretion in applying the doctrine to transactions.