Substance Versus Form, Part I: The Economic Substance Doctrine

In episode 46 of How Tax Works, Matt Foreman begins his discussion of substance versus form issues, beginning with the Economic Substance Doctrine, from its beginnings in case law to its codification in I.R.C. ? 7701(o).

How Tax Works, hosted by Falcon Rappaport & Berkman LLP Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions.

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Transcript

Matt Foreman [00:00:00]:
Hello and welcome to the 46th episode of How Tax Works. I'm Matt Foreman. In this episode, I'll discuss the economic substance doctrine and the step 10 transaction doctrine in the context of. I'll just call them tax focused or tax influenced investments. I don't know what the right phrase is, but that's. We're going to talk about. How Tax Works is meant for informational and entertainment purposes only.

Matt Foreman [00:00:35]:
This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law and guidance to demystify how taxes shape the financial and business decisions that we all make. Before we get started, a few administrative things. New episodes every two weeks. Next episode is going to be. So we're doing economic intro and economic substance. They're going to close in two weeks.

Matt Foreman [00:01:00]:
Can be step transaction doctrine and more sort of discussions of what it is, an application and things like that. Stuff like this I find really interesting because it's the ultimate gray area, right? It really is something that I don't think there's ever. I mean sometimes there's really firm answers and the answer is no, but there's no, there's no firm answer anyway. If you have any questions, comments or constructive criticism, you can email me at my FRB email address. Going to do some, some more webinars in the spring. I'm probably only going to do two or three. I think probably in May I might do them a little tighter but we'll see how it goes. Definitely after, after tax season.

Matt Foreman [00:01:39]:
I know a lot of, a lot of councils do this. All right, so let's, let's get going. So economic, economic substance and step transactions. This is, this is substance versus form, part one, right. And why this episode is really the important part, I think at least for me. And you know, I talk about tax focus, tax influence investments. There are some that are really bold. You know, you can buy certain tax credits, right? New Jersey, for example, you can buy R and D credits there.

Matt Foreman [00:02:08]:
I guess now were a lot of energy credits that had. Markets got, got killed. No longer exists. But then there's this sort of gray area, right? Tax shelters and things like that that cover a variety of issues that create tax benefits that maybe they should, maybe they shouldn't, right? Section 469 passes loss rules, section 465 at risk rules. You know, the portfolio income under 469 issues of trust grants or non grants or come up a lot, a lot of Partnership stuff. A lot of using partnerships to try to sort of sidestep concepts, you know, mixing bowls, substantial economic effect with transitory allocations or even just, you know, I'll talk about one specific instance later. But you know, the fundamental question of whether something in fact is, is a partnership, you know, it's kind of a silly question to like, oh well, you know, it's an LLC and it stacks as a partnership, but it may not really be a partnership. And I'll kind of talk about why with an extremely, extremely public and I guess somewhat not as recent example, but you know, sort of thing that happened.

Matt Foreman [00:03:15]:
Anyway, what happens with these is these come from advisors. The advisors often have licenses and letters after their name. Cpa, ea, Esquire, cfp, elementop, you know, lny, you know, you know, rstl, ANY for anyone who gets that reference. But you know, just because you have license and I, I say this a lot, simply having a license doesn't mean you're right. Not having license mean you're not right. But you know, you see it and what ends up happening is I'm, I'm the bad guy, which, which I'm okay with me and Billy Eilish. So, you know, I have to come back and say I get what they're saying, but yeah, that's gonna be a no. That's gonna be a no for me, dog.

Matt Foreman [00:03:59]:
Right? Like the answer is no. And I explain why and I work through mechanics and, and explain it to them and you know, it's an issue. And what happens a lot of times is. And I see it, gosh, I see it too often is they have in their email signatures, they have that quote from Gregory about, you know, patriotic duty and taxes. And I always have to point out, always have to point out that Mrs. Gregory lost. And I talk about this probably far too often and somewhat unnecessarily perhaps, but you know, it's important to note that Mrs. Gregory lost.

Matt Foreman [00:04:32]:
So that quote is, is cute, but moot, you know, and I think that that's something that needs to be discussed. That. And it needs to be thought about and, and we need to go. So anyway, so it's in their email signature. They're like, oh, you know, there's no patriotic duty. And I'm like, yeah, but like there has to be economic substance behind the dot behind it, right? So this is sort of the, the ultimate. You know, my, my intro is really like, okay, this is a substance versus form, right? The form must comport with the substance unless there's firmly established otherwise, right? You gotta be able to cite the regulations, code, regs, you know, cases, revenue ruling, revenue procedure are similar. Do not, do not, you know, go.

Matt Foreman [00:05:11]:
If you only live once, like, like this is where, this is where a lot of them get in trouble is. My view is they get in trouble because what happens is, is they take it and they take it two steps further, right? They go just that little extra bit and it's always like, I don't know if that's the way to go. I don't know if that you want to do, you know, the taxpayer is bound by the form they've chosen and the substance must prevail over empty, empty forms. So the key is that every step, every part of the transaction has to have a reason, a business purpose, right? Tax lawyers talk about business purposes. Regular people, human beings, they talk about reasons, right? Same thing, right? Why are you doing this? Other than tax benefits? Right. The economic substance doctrine is generally speaking, a transaction that is minimal or no economic effect, but it has tax benefits. So what happens if it's recharacterized? You ignore the transaction altogether or a significant part of it gets recast. The step transaction doctrine, slightly different.

Matt Foreman [00:06:08]:
Pretty different, but same idea, right? You add in a step in a larger transaction solely to achieve some tax benefit, that additional step is undone, reversed or combined with another step. So you effectively ignore the step or a couple steps, right? You can ignore multiple steps in a larger transaction and they can be used to ignore a participant if that participant only exists for tax benefits. I call it the three party trade rule, right? There are certain general managers in professional sports who seem to kind of wiggle their way into something, right? The best GM at he's now, now the Mets. He's not his title, but I'm going to call him GM David Stearns. And when he was the Milwaukee brewers gm, he used to always wiggle into things and he would like somehow get some player or prospect or something by moving a couple players around a little more. And he just always seemed to get the better end of the deal, right? And you're like, well, why was he involved in the first place? And the answer is you can't quite get it right? And so he would add some benefit in ignore David Stearns, right? Not to, not to knock on him as, you know, New Yorker, fellow New Yorker and fellow Mets fan, right? There's also what's called the recharacterization doctrine. I'm not going to really talk about. It kind of flows to the other two.

Matt Foreman [00:07:19]:
The idea is, you know, pure substance over ruling form and the recharacterization doctrine is really part of the other stuff especially steps interaction doctrine and examples include the business purpose, continuity of shareholder interest constituted business enterprise. A lot of stuff under 368 is really where it comes in. So now let's, let's get some music in, have a little quick musical break and we'll come back. We're going to talk about the economic substance document foreign. We're back. Let's talk about the economic substance doctrine. Right. It was initially common law then after March 30, 2010.

Matt Foreman [00:08:10]:
Right. So not even that long ago. Right. 7701 oh as an Oscar was passed and 7710 pretty explicitly says hey, like we don't actually think we need to codify this but there's sort of some, some inconsistent phrasing. Inconsistent whatever. So what we're going to do is we're codifying it to create a rule but we're going to pull in all of the history. Right. So Congress got, you know, kind of grumpy, went after it.

Matt Foreman [00:08:39]:
Right. And under 7710 I'm shortening it a little bit. You only have economic substance if and I'm about to read so important words. I think a transaction changes in a meaningful way apart from federal income tax effects the taxpayer's economic position restate the transaction changes in a meaningful way the taxpayer's economic position. If you ignore the federal income tax effect effects. Okay, that's part one. Then part two. You need both is the taxpayer has a substantial purpose apart from federal income tax effects for entering into such transaction.

Matt Foreman [00:09:19]:
So I'm going to read them together because I think they're important. You have economic substance only if ignoring federal income tax effects A the transaction changes in a meaningful way the taxpayer's economic position and the taxpayer has a substantial purpose for entering into the transaction the federal income tax. There's some parts in this. I'm going to break it down. Federal income tax effects not state, not non income taxes. So state gift excise. Right. So not state, not estate, not gift, not excise.

Matt Foreman [00:09:53]:
You could have a state corollary. A lot of states do follow 7701 so they have their own. So the federal government won't care if it has a state tax benefit. But if you're doing something only for state tax benefits, hahaha. Of course people always talk about well why would I do R and D if only for state tax benefits or there are certain credits 45 cap F for example they really, you know, it's only exist and, and structuring is going to happen for it. That's different. Right. If there's something, a specific purpose for it, economic substance kind of gets muddled because of the benefit of the tax.

Matt Foreman [00:10:22]:
Right? So watch out, right. It in, in function it disallows a transaction and that's what it does. But the, you know, if you don't have economic substance, it disallows the transaction. However, the definition of a transaction includes a series of transactions. So you can aggregate, disaggregate or otherwise recharacterize a transaction. Coltech talks about that. 454 Fed 3rd 1340 Federal Circuit 2006 so you can take apart, you can eliminate part of a transaction, a whole transaction or you can take multiple transactions and take out one of them. Right.

Matt Foreman [00:10:55]:
So it kind of operates in a way. I'll talk about the step transaction option two weeks. But it operates in a similar way, right? It is very broad, intentionally so Congress intended for it to be broad and it does not fail in that regard. The real difference between a tax motivated step and a non tax motivated step is the overall transaction. Right? It looks at the transactions, not the step. What is the goal? What are you trying to accomplish in the transaction? Is it, are there tax benefits or is it a legitimate transaction? Right. What are you trying to do? Each step, each part. You want to have substantial economic, you want to have economic substance.

Matt Foreman [00:11:30]:
Similar substantial economic effect. I mixed up the phrasing but they are very different things. Right. So steps versus overall. Right. The IRS has tried to invoke the economic substance doctrine for steps and structuring in a transaction where there is otherwise a business purpose that is was a legitimate transaction. But there's problems, right? Flextronics really good example of 100 TCM394. The IRS was unsuccessful.

Matt Foreman [00:11:56]:
The IRS suggested in that one in the context of 33 8h10 that the context of a 338h10 election that the use of short term note is a small step in a part larger transaction can only be used in limited circumstances. There's an LBNI directive LBNI 040-711015. It is only used when one or more tax motivated steps that bear only a minor or incidental relationship to a single common business or financial transaction. So like if the overall transaction has a business purpose, right. But there's a little part that you're like well let's just add in, maybe we'll get a step up in basis or something like that, you know obviously through 38 10, but that has a material effect other than federal tax. Right. And through 38:10, because it's a tax on the election, it allows for certain things to happen. Right.

Matt Foreman [00:12:49]:
PLR 201126003 has a list of non tax motivated transactions. I'm not going to read them. These, these, these episodes are already long enough and they have way too much of my reading. So I don't think it's necessary for me to read. The LBNI directive gives four step procedures for the IRS revenue agent auditor to use to determine whether to apply the economic substance doctrine. I am going to go through those because I think they're important. First one, whether circumstances of application of economic substance doctrine is not appropriate. So first you look to see is it not appropriate? Right.

Matt Foreman [00:13:29]:
It gives examples. I'm not going to list them. Key ones to me, lack of a promoter, minimal structuring. Right. Transaction is at arm's length with an unrelated third party. That's a really good sign. Right. No tax in different parties.

Matt Foreman [00:13:42]:
Right. So you don't have like a non profit sort of stepping in. I'll talk about that one in a second. Substantial risk of loss, credible business purpose. That's what we're looking for. Okay. Okay. And I think those are really important.

Matt Foreman [00:13:52]:
Right. Promoter. The IRS hates promoters. Hates, hate, hates. Right. The next one is whether the application of economic subjects, economic substance doctrine is likely to be appropriate. I'm not going to tell you what that is because it's in there, but it's kind of mushy. A lot of stuff's mushy.

Matt Foreman [00:14:12]:
If the IRS says number two is yes, you have seven questions. I'm not going to go through each of the seven questions. But the goal is that if you anything looks weak or isn't aligned with congressional or regulatory intent, the auditor must speak with the manager or hire and get their approval to continue or start questioning. Under the economic substance doctrine. If you're doing an audit and they start questioning the economic substance, they are supposed to have already gotten manager approval, which you can request to see. This is really important because sometimes they don't. They skip a step, they just start asking questions. Can't do it.

Matt Foreman [00:14:43]:
Not allowed under the LBNI directive. Now you might say LBNI doesn't really exist anymore. It still kind of does. Directive still active. I still think they need to use it. And finally. Well, I'm going back one thing. Well, this report is talking about congressional or regulatory intent.

Matt Foreman [00:14:55]:
If there's a tax credit or a tax election like 338, 10. That's going to say, well, that's aligned with congressional or regulatory intent. So, no, there is no economic substance doctrine. If that is the case, that can be sort of a substitute of sorts for business purpose. Finally, fourth, you get to number four. You provide written and analysis to be read by the Director of field operations and IRS counsel. There will be no rogue auditors. They will not go off the res.

Matt Foreman [00:15:21]:
They will not have problems and go totally off and do different things. That's probably if, if, if it is recast under the economic substance doctrine, okay, there's a 20% strict liability penalty under 6662B6. So there's no reasonable cause or good faith abatement. And the 20% increases to 40% under 6662i. If relevant facts affecting the tax treatment are not adequately disclosed on the taxpayer's return. This is why adequate disclosure is so important. Okay. Because it can really save you if all the facts are there.

Matt Foreman [00:15:55]:
Right. Obviously you're going to get into fighting whether there's adequate disclosure. And I'm of the opinion I've never had, I've never had a transaction recharacterized under the economic substances doctrine, although I've dealt with that on the back end. I'm of the opinion the IRS could use this as a negotiating tool. Very much so. Could. Would be problematic for a variety of reasons if they did, but it's something they can do. Say, look like we see that you did not disclose and then you're stuck with the situation.

Matt Foreman [00:16:24]:
Do we litigate or appeal whether there's adequate disclosure? That's when you have to look into what is adequate disclosure. Right. So you have to look into what did you do, how did you do it? Is it sufficient? Are there examples of it's being sufficient under other case law and other things like that? And that's really important. You definitely want a situation where you have adequate disclosure, inadequate or not. See, it's interesting. It's not that you have to avoid inadequate. You have to be able to show, not the irs, you have to show that there was adequate disclosure. The IRS has to show there's not inadequate disclosure is actually less because that's just even farther.

Matt Foreman [00:17:00]:
Right. They just have to show you didn't do enough. And that's really important. Now I'm going to talk about two situations in economic substance that I think are really important, you know, and how to think about it. Right. The first one is a fairly famous case. There. There are cases on this in basically every single circuit the one I'm going to talk about is the most recent one, at least to my knowledge.

Matt Foreman [00:17:22]:
I don't think there's been any since. Since, which is Historic Boardwalk Hall. Historic Boardwalk hall was a historic hall used for concerts, pageants, I think like Miss America was there for a while, may still be there, I don't know, on the Jersey Shore. And historic Boardwalk hall had fallen into disrepair and needed to be rehabilitated. So the state of New Jersey said, all right, well how are we going to do this? And they said, look, there are historic renovation credits are available. So what they did was they went out and they found a partner. They formed a joint venture. And what the joint venture was, was the company put in money into us, into a partnership, llc, tax partnership.

Matt Foreman [00:18:07]:
Might have been a general partnership, I don't remember exactly. It doesn't really matter for this example. And what they did with the partnership is the credits went 99:1, one way and then the profits, which there would be none, went 50, 50. The money that was put in by the state, okay, was significant. And the bulk of the money they needed and the money that was put in by the private company was less than the amount of the credit, the credits. But here's the thing, and if you're going through this and thinking about what I said is the state didn't really care about the credits. Why doesn't the state care about credits? Because states don't care about tax credits, especially not non refundable ones. Right? They're what's called a tax, tax indifferent partner.

Matt Foreman [00:18:48]:
So the question became at the district court level after an audit was, is this a partnership? And you say, what do you mean this is a partnership? It's an llc. It's taxes. A partnership. No, no, this is not a partnership. There was no business purpose. This whole thing was just to split tax benefits. This entire partnership itself, the entire partnership itself is a sham. Okay? It is not a partnership.

Matt Foreman [00:19:11]:
There is no purpose for it. There is no economic substance to the partnership. Therefore it's gone. So what happened? What happened is very simple. Tax credits got disallowed because there was no partnership. The money was recharacterized, maybe got based on the percentage of money put in, which was much less from the private party. And everything blew up. There was a tax opinion that got back that went back to the insurer for the tax opinion.

Matt Foreman [00:19:39]:
Actually, they went to the reinsurer and went back. There are cases. That's third Circuit. I know the fact that there's cases in first, second, fourth, fifth, sixth and seventh I think there's eighth, I don't think there's ninth, I think there's not tenth, there's eleventh and there's Fed circuit if I'm ever serving. Right. And so it's important to note people say, oh, well, you know, there was this, look, the thing is, and this is really important is who lost the insurance company or reinsurance company probably and who won the state because they got Boardwalk hall redone and it didn't cost them any extra money. Problematic, definitely an issue such as lie. The second one is sort of the fundamental question that I always ask people when they're entering into transaction.

Matt Foreman [00:20:19]:
Okay, I will get these slide decks and they are of, I'll say, inconsistent quality. And this is sort of fascinating to me in this regard because this is something that I would do really well is put together a really nice slick deck and people seem to just be doing. And I'd say those, this is what a middle schooler would put together in a slide deck. But I actually think middle schoolers are probably better than they are. So you get these, these people and they have these mediocre decks with inconsistent citations and they're overstabbing it. And I'm just like, well, would you do this transaction without the tax? They're like, well, no, but you know, tax can be part of it. But there has to be some other benefit like, oh, it's a long term appreciation rights. And you read through the decks and long term appreciation rights, terrible.

Matt Foreman [00:21:03]:
And you look at the return on the investment and it's a 1.2% investment year over year, which, if you'll pardon my french, very not good. You do better putting that money in munis. So that's problematic. Occasionally you get ones that say things like, oh, well, you know, there's an underlying business like, oh, you know, if the real estate isn't rented, you know, because of the other factors, you will still get your annual dividends. And it's like, so what you're saying is even if the business fails, you'll still get all your money. And so that just, you know, first off, don't put, don't put that in the thing, like, how stupid are you? But secondly, like, don't, don't do that, right? So that's the question you have to ask yourself when you're evaluating it. And I get these with some level, you know, from clients. I get them, I get them sometimes from other advisors, you know, financial advisors.

Matt Foreman [00:21:57]:
I get them from, from, you know, accountants sometimes, like, is this real? This what's going on. And my answer is like, it depends, right? Some are. Some are just, like, hard, no, don't do it. Not gonna work. Some are like, look, this will work, but you gotta get 100 hours. You know, 469 is a big one. Some of them, like, look, I don't think this is a partnership. I think you have core issues here going on.

Matt Foreman [00:22:16]:
I think that you're like, oh, this is grand tour, you know, a grant grantor. This is pure recourse financing. But, like, there's real questions as to whether they'll actually collect, etc. Etc. Etc. So you have fundamental issues, and I don't want to do it. I've seen ones where partnerships have deficit restoration or deficit makeup obligations, which I have not discussed that. That'll be a future webinar and probably at some point a podcast episode.

Matt Foreman [00:22:41]:
And, man, why would you enter into that? If they have a cash shortfall, you have to pay it back. That's awful. That's a terrible idea from an investment stage standpoint. So, like, the deal may work, but it may be a stupid thing to do. So, you know, that's the question, right? Would you do this without tax? No. A lot of times no. And. And tax is important, and I appreciate that.

Matt Foreman [00:22:59]:
I probably poo poo it in some ways more than I probably should, but, you know, you shouldn't necessarily only do things for tax, so. On that note, that was the 46 episode of how Tax Works. Hope you learned something. I'll be back. Two short weeks or two long weeks, depending on how cold it stays days. With the 47th episode. Be discussing more of this. Right, we're going to do that, and then let's get some music in and we'll come back for the next episode.

Matt Foreman [00:23:40]:
Sam.