Larry Jacobson

The Economic Substance Doctrine

What you should know about it and how it can affect your practice.

January 15, 2009
by Larry Jacobson CPA/JD

In the last few years, you have probably read about tax litigation involving the Internal Revenue Service involving so called "tax shelters." Unlike tax shelter cases in the 1980s, when most matters involved real estate or commodity/option straddle-like transactions, the current tax shelter cases do not fit into one neat category. Some cases involve complicated lease arrangements. Others involve the use of partnerships in a manner not previously contemplated by Congress or the IRS. Another line of cases involve the use of third-party intermediaries for the sole purpose of a taxpayer obtaining a tax benefit otherwise not available under tax law. What all of these cases have in common is an aggressive reading of the tax law by tax advisors in areas in which case law was not fully developed.

What Is Economic Substance Doctrine?

In pursuing these cases, the IRS frequently asserted that the transactions in question did not meet the "economic substance doctrine."

What is the "economic substance doctrine?" The economic substance doctrine can not be found in the Internal Revenue Code or Treasury Regulations. The economic substance doctrine has been developed by the courts since the United States Supreme Court's decision in Gregory v. Helvering, 293 U.S. 465 (1935). A technical discussion of the different permutations of the economic substance doctrine is beyond the scope of this article as different courts interpret the doctrine differently. However, there is a common theme in terms of the application of the economic substance doctrine. The most common sense description of the economic substance doctrine was set forth by Judge Posner in the case of Yosha v. Commissioner, 861 F2d 494 (7th Cir. 1988):

"A transaction has economic substance when it is the kind of transaction that some people enter into without a tax motive, even though the people fighting to defend the tax advantages of the transaction might not or would not have undertaken it but for the prospect of such advantages — may indeed have had no other interest in the transaction ... The transactions (in question) must have been entered into 'for profit', a term that has been interpreted to require the 'nontax profit motive predominates'."

Judge Posner correctly observes that tax motivations, standing alone, do not turn a typical business transaction into one that is disregarded for tax purposes. For example, a business might not purchase equipment but for accelerated depreciation available under the tax law. The business might decide to lease the equipment rather than buy it on the theory that the business does not presently need accelerated depreciation deductions. Moreover, the amount paid in a legal settlement may depend, in part, as to whether the payment is tax deductible. Businesses frequently finance their operations through debt rather than equity since the payment of interest is deductible and the payments of dividends are not. In each of these cases, tax motivations impact the decision making process, but the economic substance doctrine does not serve to deny the expected tax treatment since these are traditional business transactions motivated by business concerns in which the tax benefits have a favorable economic impact on entering into the transaction but are not the sole reason for the transaction in the first place.

How Economic Doctrine Affects Your Practice

  • The transaction has no realistic expectation of generating an economic profit, without regard to tax considerations. For example, if a taxpayer enters into a transaction where its nontax economic return is five percent and its nontax economic outlay is six percent, the transactions is not likely to pass muster under the economic substance test even if on an after-tax basis the transaction is profitable due to special tax treatment of the amounts paid in the transaction. The second situation where the economic substance doctrine is applied is where a very complicated structure is created among two or more parties to create a series of transactions that do not comport with normal business transactions. Examples include:
    • the use of partnerships of a short duration among parties that have no expectation of long-term relationships or partnerships formed solely to obtain tax advantages found in the Internal Revenue Code,
    • complicated lease transactions involving multiple leases of the same property among the same parties and
    • use of third-party intermediaries (outside of the area of like kind exchanges) to facilitate a transaction that, but for their participation, would generate a different tax treatment if the transaction were directly between the two real parties in interest.

    This list is by no means exclusive; the IRS uses the economic substance doctrine to attack any transaction where the motivation for the taxpayer to undertake the transaction is solely or almost solely tax motivated.

  • With rare exceptions, the IRS attempts to impose significant penalties on taxpayers who undertake transactions that it believes are devoid of economic substance. These penalties can amount to as much as 40 percent of the disallowed tax deductions attributable to the transaction.

    Of course, the IRS does not win 100 percent of the economic substance cases it litigates. Sometimes the IRS goes too far in asserting the doctrine when a taxpayer does have a good faith business motive for entering into a transaction. Nevertheless, the IRS is apt to challenge taxpayers who attempt to push the envelope by engaging in tax-motivated transactions that do not fit a traditional business model.


The bottom line is that if one of your clients come to you with a transaction that appears out of the ordinary and is marketed to create tax advantages that also appear to be beyond those normally anticipated, your job as a tax advisor is to analyze the transaction very carefully to see whether it has economic substance beyond tax savings. Furthermore, if the transaction appears to be too complicated to analyze from a tax perspective, consider obtaining assistance from another tax advisor who specializes in reviewing or litigating tax motivated transactions. Given the IRS’ aggressive litigating posture, a client who enters into a transaction without economic substance may face a far higher bill than for back taxes and interest.

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Larry Jacobson, an attorney and CPA, is a senior partner in the Chicago office of the law firm of Schiff Hardin LLP. He holds a BA from Washington University, an MBA from the University of Chicago, an MSOD from the University of Pennsylvania and a JD from the Georgetown University Law Center.