IRS Gives Examiners More Guidance on Codified Economic Substance Doctrine

The IRS Large and International Business (LB&I) Division provided additional guidance for examiners on the codified economic substance doctrine in a directive posted on its website on July 15. The IRS also advised examiners that penalties for underpayments attributable to transactions lacking economic substance should not be imposed due to the application of any other “similar rule of law” as allowed under statute.


Congress codified the economic substance doctrine in the Health Care and Education Reconciliation Act of 2010 (HCERA) (P.L. 111-152). In 2010, the IRS issued interim guidance (Notice 2010-62, I.R.B. 2010-40, 411; TAXDAY, 2010/09/14, I.1) The IRS also issued a directive (LMSB-4-0910-024) advising examiners that any proposal to impose the codified economic substance doctrine at the examination level must be reviewed and approved by the appropriate Director of Field Operations (DFO) (TAXDAY, 2010/09/15, I.2). Now, the IRS has followed-up with instructions how to develop cases and when it is appropriate to seek DFO approval to raise the codified doctrine.

“The directive is a positive step,” Matthew D. Lerner, partner, Steptoe & Johnson, LLP, Washington, D.C., told CCH. “While it is not binding on the Service and is subject to change, it gives greater insight into how LB&I views the codified economic substance doctrine.”


The IRS outlined various factors for examiners to consider in determining if application of the doctrine is appropriate. Many of the factors overlap. Factors tending to show that the doctrine is not appropriate include, but are not limited to, the transaction was at arm’s length with unrelated third parties, the transaction had a credible business purpose apart from federal tax benefits and the transaction had a meaningful potential for profit apart from tax benefits. Factors indicating that the doctrine may be appropriate include, but are not limited to, the transaction created no meaningful economic change on a present value basis (pre-tax) and whether the tax benefit was artificially generated by the transaction.

“It is encouraging to see the directive provide a list of facts and circumstances tending to show whether application of the economic substance doctrine to a transaction may be appropriate or not appropriate,” Lerner added. “The factors listed as tending to suggest that application of the economic doctrine is not appropriate include many of those suggested by bar associations and practitioners in comment letters and include the four types of “basic business transactions” specifically identified in the JCT Technical Explanation as not intended to be altered by codification.”

After reviewing the appropriateness of the doctrine, the IRS instructed examiners to answer a series of inquiries before seeking approval to apply the doctrine. The IRS also described how to request DFO approval.


HCERA imposes a 20-percent penalty for an underpayment attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance or failing to meet the requirements of any similar rule of law. The penalty increases to 40 percent where the underpayment is attributable to a undisclosed economic substance transaction.

Examiners should not impose HCERA’s penalties due to the application of any other similar rule of law, the IRS instructed. A similar rule of law for this purpose would be, for example, the step transaction doctrine, substance over form or sham transaction, the IRS explained.

By George L. Yaksick, Jr., CCH News Staff

LB&I Directive: Guidance for Examiners and Managers on Codified Economic Substance Doctrine and Related Penalties, LB&I-4-0711-015


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