The codified economic-substance doctrine and captive insurance companies.

• Author: Buechler, William F., Jr.

On March 30, 2010, Sec. 7701(o), which codified the economic-substance doctrine, became law as part of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152. This provision provides that for any transaction to which the economic-substance doctrine is relevant, the transaction is treated as having economic substance only if:

* It changes in a meaningful way (without considering federal or state income tax effects) the taxpayer's economic position, and

* The taxpayer has a substantial purpose (not including federal and state income tax effects) for undertaking the transaction.

The new provisions also added a special rule for testing the profit potential of a transaction. Sec. 7701(o)(2) provides that where a taxpayer asserts that the transaction's profit potential satisfies the economic-substance requirement, the tax-payer must establish that the present value of the reasonably expected pretax profit from the transaction is substantial in relation to the present value of the net tax benefits (pretax profit less fees and transaction expenses).

Guidance on the economic-substance doctrine's codification was provided in Notice 2010-62 and applies to transactions entered into on or after March 31, 2010. The notice clarifies that the IRS will still rely on prior case law in determining whether the two-prong conjunctive test of Sec. 7701(o)(1) has been met, but will challenge taxpayers that rely on prior case law that determined the economic-substance test had been met merely because it satisfied one prong of the tests

The notice also states that the IRS will apply prior case law in determining whether the present value of the reasonably expected pretax profit is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected for federal income tax purposes. The notice does not provide specific guidance on how to compute the present value, such as what interest rates to use in computing the present value or a specific percentage to use in determining whether the profit was substantial compared to the net tax benefits. The notice also states that the IRS will not issue private letter rulings on whether the economic-substance doctrine is relevant to any transaction or whether a specific transaction meets the economic-substance test of Sec. 7701(o).

Captive Insurance Companies

Because Sec. 7701(o) was only recently enacted and certain sections of the new law are...