As Part of an IRS Audit or Examination, Taxpayers Must Be Aware of IRS' Assertion of Economic Substance and Related Penalties
Nardone Law Group’s experienced tax attorneys routinely assist individuals and businesses in, Columbus, Ohio and nationwide, that become subject to an Internal Revenue Service audit or examination. An IRS audit or examination occurs when the IRS selects a tax return and reviews the taxpayer’s records from which the reported information on the tax return is derived. As part of that examination, the IRS will review the taxpayer’s transactions for the relevant years to ensure those transactions have economic substance. If the transactions are void of economic substance, the IRS may assert penalties against the taxpayer.
The economic substance doctrine is one of the longstanding judicial doctrines that must be considered as part of any tax planning and will be considered by the IRS as part of any IRS audit or examination. In general, and without getting in to the technicalities, this simply means that a transaction may be disregarded if the transaction does not change the taxpayer’s economic position independent of its federal income tax consequences. For the longest time, the courts have acknowledged and authorized a taxpayer’s lawful effort to avoid the payment of tax. In fact, one of the most famous quotes from Judge Learned Hand states:
Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant. Commissioner v. Newman, 159 F.2d 848, 850-851 (2d Cir. 1947).
But, taxpayers, in some instances, cross the line from tax avoidance to tax evasion when the transactions that they are entering into lack or are void of any economic substance. That is, there was no business purpose for the transaction. In those instances, the IRS will challenge the taxpayer’s position and may pursue both civil and criminal penalties. It is important to note that the economic substance doctrine was ultimately codified under Internal Revenue Code § 7701(o).
What Does All of This Mean?
In layman’s terms, if an individual or business is planning to enter into a transaction that is motivated by tax planning, the transaction must have independent significance from both a business purpose perspective and true economic impact on the taxpayer, separate from the tax consequences. That is, there must be a legitimate intent and reasonable expectation of profit. We cannot simply create tax planning transactions with no legitimate business purpose. Over the last decade or two, many so-called smart tax attorneys, and tax accountants at large law firms and accounting firms, have found themselves in harm’s way because they aided and abetted taxpayers in pursuing transactions void of economic substance. Tax professionals and taxpayers themselves must be careful to ensure that they do not participate in these tax evasion type activities versus those legitimate tax avoidance planning opportunities that exist in most legitimate business transactions that a taxpayer may enter into.
NLG Comment: Avoid the too-good-to-be-true type of planning that certain tax professionals may attempt to sell you. Question their guidance, their reliance on certain laws and their analysis of the tax code. Simply because something may sound complicated and may sound sophisticated, does not mean that what they are proposing will work or is even within the law. In fact, in many instances, tax professionals or tax promoters intentionally complicate facts in an attempt to disguise the true motivation of the transaction: tax evasion.
Contact Nardone Law Group
Nardone Law Group represents individuals and businesses in a multitude of federal tax matters, including taxpayers who are subjected to an IRS audit or examination. If you are facing an IRS tax audit or examination, or if you wish to learn more about the proper planning and how to avoid any potential enforcement action from the IRS, contact one of our experienced tax attorneys today. Nardone Law Group’s tax lawyers and professions have vast experience representing clients undergoing IRS audits and examinations. We will thoroughly review your case to determine what options and alternatives are available.