The new Health Care and Education Reconciliation Act of 2010 passed this year may have some very unhealthy consequences for unwitting small businesses and individual taxpayers in the form of strict liability tax penalties. With close to 150 million federal income tax filers in the country, taxpayers are given no comfort in the revelation that Congress enacted yet another strict liability penalty for transactions that lack “Economic Substance.” The weight of the Economic Substance penalty is sure to be borne by small businesses and individuals, not the large corporations that can afford the costs of engaging in controversy with the IRS.
With the enactment of the strict liability penalty, the IRS apparently seems unable to learn from its past mistakes. Section 6707A was enacted to impose strict liability for the failure to disclose and report tax shelters to the IRS. Although the penalties reaching $300,000 per year were intended for large corporations, Section 6707A victimized many small businesses for attempting to do good deeds such as establishing employee benefit plans. Laura Saunders, Small-Business Owners Fret Over Large IRS Fines, The Wall Street Journal, September 19, 2009 at B1.
As word spread of the damage being caused to small businesses by Section 6707A’s strict liability, senators and congressmen from around the country pleaded with the IRS to cease its imposition. What resulted was a moratorium on the collection of the penalty until Congress created a solution. Letter from Max Baucus, Chairman, Senate Committee on Finance, Charles Grassley, Ranking Member, Senate Committee on Finance, John Lewis, Chairman, House Committee on Ways & Means, and Charles W. Boustany Jr., Ranking Member, House Committee on Ways & Means, to Douglas H. Shulman, Commissioner, Internal Revenue Service (June 12, 2009) (available at the U.S. Senate Committee on Finance website). Even the National Taxpayer Advocate Nina Olson accused the fine of being unconstitutional in her yearly report. Taxpayer Advocate Service, 2008 Annual Report to Congress, vol. 1, p. 421. Congress has not fixed 6707A’s unintended damages but, nonetheless, the IRS marches forward with strict liability penalties for transactions that it unilaterally deems to lack economic substance.
By way of reference, a strict liability penalty is one for which there exists no reasonable cause defense under Section 6664. Even if the taxpayer had a reasonable basis for the position by relying on a tax professional in good faith and discloses the transaction to the IRS, the penalty still applies. See 26 U.S.C. §6707A(a); Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (to codify “economic substance” at 26 U.S.C. §7701(o)(1)). Thus, the only defense is to convince the IRS that the transaction in fact has economic substance. Good luck.
In theory, the IRS’s stated policy is against strict liability. Policy Statement 20-1 provides that the “Service will demonstrate the fairness of the tax system to all taxpayers by … providing every taxpayer against whom the Service proposes to assess penalties with a reasonable opportunity to provide evidence that the penalty should not apply; giving full and fair consideration to evidence in favor of not imposing the penalty, even after the Service’s initial consideration supports imposition of a penalty; and determining penalties when a full and fair consideration of the facts and the law support doing so.” Perhaps Congress should reexamine the IRS stated policies when deciding whether to enact strict liability penalties that strip the taxpayer’s right to full and fair consideration. In addition, the penalties are not insignificant.
The Economic Substance penalty is 20 percent of the taxpayer’s understatement if the transaction is disclosed and 40 percent if the transaction is not disclosed under Section 6662. In addition, the Section 6662A penalty is also stacked on top of it, which is another 20 percent. Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (to be codified at 26 U.S.C. §6662(b)(6)).
If a potential 60 percent penalty is not daunting enough, the economic substance doctrine is one of the most fluid and facts-and-circumstances based “test” in the Code and is a judicially created vehicle whose standard varies from circuit to circuit. In general, the Economic Substance Doctrine stands for the idea that anticipated tax benefits from a transaction may be denied, even if the transaction completely complies with the technical aspects of the Internal Revenue Code, if the transaction otherwise does not result in a meaningful change to the taxpayer’s economic position other than a reduction in federal income tax. See Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89 (4th Cir. 1985); see also ACM P’ship v. Comm’r, 157 F.3d 231 (3d. Cir. 1998). The codification does not provide further clarity.
Section §7701(o) states that “[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.” The only defined term relating to Section 7701(o) is “economic substance doctrine,” which is defined as the “common law doctrine [under which certain tax treatment may be disallowed if the transaction does not have economic substance].” Simply adopting a common law doctrine that varies from circuit to circuit implants ambiguity in the statute.
Congress also failed to define terms such as “transaction to which the economic substance doctrine is relevant”; “changes”; “meaningful way”; “taxpayer’s economic position”; and “substantial purpose.” The codification provides no further assistance in determining any red flags that may trigger a transaction’s disallowance. In fact, Congress seems to have codified the judicial doctrine and inserted some new, undefined terminology that will keep the litigation lively.
The issue with the application of the Economic Substance doctrine is that it is usually applied to transactions that occurred many years ago, and then the IRS makes a decision to aggressively attack the transaction. One such transaction of late would be stock loan transactions consisting of non-recourse loans individuals and businesses took on a stock portfolio. Many taxpayers’ advisors agreed with the loan treatment under the Internal Revenue Code. Even though law existed to support the loan treatment and the taxpayer did actually transfer stock to the lending entity, the courts agreed with the IRS that the transactions lacked economic substance. Nagy v. United States, Slip Copy, 2009 WL 5194996 (Dec. 22, 2009). These taxpayers would be subject to a 60 percent penalty because the loan proceeds would not have been disclosed on the return, and the return preparer may be subject to preparer penalties.
In the future, what could keep the IRS from taking the position that the discounts related to the transfer of Family Limited Partnership interests funded with stock, bonds and other liquid assets lack economic substance? I am sure that every tax practitioner could think of a client who engaged in a transaction in the past that may lack economic substance.
By codifying this ambiguous, strict liability economic substance penalty, Congress is undoubtedly placing an insurmountable burden on small businesses and individuals. The IRS will not consider any documentation, CPA’s advice, tax opinions or other facts and circumstances that could support a reasonable cause defense before imposing this penalty. There is no defense to this penalty on the administrative level unless you can convince the IRS that the transaction does have economic substance. Should the IRS remain unconvinced, the only option left is to litigate the economic substance issue, which is a fact intensive and expensive process, especially when facing the litigation resources of the United States. Jasper L. Cummings, Jr., Making Litigation Complex, Tax Notes, June 28, 2010.
Congress seems intent on implementing harsher and harsher penalties to raise revenue at the expense of small businesses and individual taxpayers.
Check out this article on the web, along with other publications from South Carolina Tax Reports Fall 2010.
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