Daily Tax Update - January 25, 2005

Today, in a speech, IRS Chief Counsel Donald Korb discussed the economic substance doctrine in the current tax shelter environment. Korb said, "Generally, there are three common situations when the IRS needs to determine whether the economic substance doctrine should be asserted for a particular case. First, revenue agents need to determine whether the doctrine applies to a transaction which is under examination. Second, IRS attorneys need to determine whether the argument should be pursued in Tax Court proceedings. Third, for cases in federal district courts or the U.S. Court of Federal Claims, IRS attorneys need to determine whether to include the doctrine in the defense letters that we provide to the Department of Justice. In all three situations, it seems to me that we should take a serious look at asserting the economic substance argument in those cases where the tax result produced by the transaction does not appear to be in accord with Congressional intent and common sense. In such cases, I believe that it is appropriate for our revenue agents and attorneys to drill down further to determine if the transaction should be respected."

  • Korb continued, "Now in each of these three situations, it is very important for us exercise discretion in determining whether to utilize an economic substance argument in any particular case.  The doctrine of economic substance is not to be used as a general antiabuse rule raised in every case where the taxpayer receives tax benefits that the IRS views as unintended or just because we do not like the transactions. Let me repeat that by saying it another way: the economic substance doctrine should be used only rarely and judiciously. However, let me also be clear that consideration should be given to using the doctrine in cases where, even though there are sufficient technical arguments to be made -- which, of course, should be asserted as our primary arguments -- the facts also show that the transaction generated the tax benefits at issue, with no meaningful and appreciable enhancement in the net economic position of the taxpayer (other than to reduce its tax). If, the economic substance doctrine applies to a particular transaction, then the IRS should go ahead and assert the doctrine, regardless of whether there are technical arguments that also may apply. However, in those cases where there are technical arguments available to the IRS, while it may still be appropriate to raise the economic substance doctrine argument, it should only be asserted as a secondary or tertiary argument, following any appropriate technical arguments. This means that, there will be some cases in which the IRS asserts the economic substance doctrine in addition to asserting technical arguments, but there will also be other cases in which the IRS asserts the doctrine even if technical arguments are not available." Korb added, "However, I want to make it crystal clear that the IRS is not bound to respect transactions lacking in objective economic substance. We see cases where there is no real change in the net economic position of the taxpayer. In order to determine whether a particular transaction has objective economic effect, the IRS must consider all of the relevant facts and circumstances, including any side agreements or oral understandings among the parties, the relationships of the parties, and the effects of local law. For example, it is common, as part of a tax motivated transaction, for taxpayers to create or terminate a substantial contractual obligation. But any change in the nature of the obligation will not be meaningful if the change is prohibited or offset by a separate written or oral agreement among the parties or the operation of state law."
  • Korb concluded, "Unfortunately, over the past 10 years we have witnessed a resurgence of tax shelter activity that has caused great damage to the integrity of our tax system. We have many cases under examination and many others in various stages of litigation. In working these cases, we must keep in mind that the economic substance doctrine is not a general antiabuse rule that can be raised to attack every transaction that the IRS does not like. On the other hand, taxpayers and practitioners should not forget that the doctrine is an indispensable tool which the IRS must be able to employ to challenge transactions where the tax results appear inconsistent with Congressional intent and common sense. What this means is that in appropriate cases, the IRS will use all of the tools at its disposal to combat abusive tax shelters, including the economic substance doctrine."

Yesterday afternoon, Senate Majority Leader Bill Frist (R-TN) unveiled the Senate Republicans’ "top ten" bills for the 109th Congress. Social Security reform was the first bill highlighted by Frist, while tax reform was second on the list. Permanently extending the tax cuts in the Marriage, Opportunity, Relief and Empowerment Act, which includes expanding the 10 percent income tax rate bracket, "marriage penalty" relief, the $1,000-per-child tax credit, the expanded dependent care credit, the 25 percent credit for employer-provided child care, and the expanded $10,000 adoption tax credit was on Frist’s list. Additionally, extending the marginal rate reductions and reduced tax rate on dividends and capital gains, and permanently repealing the estate tax in The Jobs and Growth Tax Relief Act of 2004 were included on Frist’s agenda. Rounding out the list were fighting the war on terror, class action reform, health care, education and energy reform. Frist did not give a timetable for acting on the tax bills.


  • S. 6 sponsored by Sen. Rick Santorum (R-PA) would provide permanent family tax relief, reauthorize and improve the program of block grants to States for temporary assistance for needy families and to improve access to quality child care, and provide incentives for charitable contributions by individuals and businesses, improve the public disclosure of activities of exempt organizations, and enhance the ability of low-income Americans to gain financial security by building assets.
  • S. 7 sponsored by Sen. Jon Kyl (R-AZ) would increase American jobs and economic growth by making permanent the individual income tax rate reductions, the reduction in the capital gains and dividend tax rates, and the repeal of the estate, gift, and generation-skipping transfer taxes.
  • S. 27 sponsored by Sen. Kay Bailey Hutchison (R-TX) would make permanent the deduction of State and local general sales taxes.
  • S. 35 sponsored by Sen. Kent Conrad (D-ND) would extend the credit for production of electricity from wind. 
  • S. 76 sponsored by Sen. Maria Cantwell (D-WA) would permanently increase the maximum annual contribution allowed to be made to Coverdell education savings accounts, and provide for a deduction for contributions to education savings accounts.
  • S. 78 sponsored by Sen. Kay Bailey Hutchison (R-TX) would make permanent marriage penalty relief. 
  • S. 83 sponsored by Sen. Daniel Inouye (D-HI) would provide tax relief for the conversion of cooperative housing corporations into condominiums.
  • S. 84 sponsored by Sen. Daniel Inouye (D-HI) would exempt certain sightseeing flights from taxes on air transportation.
  • S. 94 sponsored by Sen. Richard Lugar (R-IN) would provide for a charitable deduction for contributions of food inventory.
  • S. 104 sponsored by Sen. Jim Talent (R-MO) would provide tax-exempt financing of highway projects and rail-truck transfer facilities. 
  • S. 132 sponsored by Sen. Gordon Smith (R-OR) would allow a deduction for premiums on mortgage insurance.

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