New developments: Economic Substance guidance and non-compete covenant decision.

• Author: Josephs, Stuart R.
• Position: FedTax

The June 2010 California CPA discussed the following statutory provisions effective for transactions entered into after March 30, 2010:

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Economic Substance Doctrine Codified: The application of this doctrine is clarified and enhanced through a new uniform definition of' economic substance. Any transaction Fir which this doctrine is relevant is treated as having economic substance only if--besides federal income tax effects--the following tests are met:

1. The transaction changes the taxpayer's economic position in a meaningful way; and

2. The taxpayer has a substantial purpose lor entering into this transaction.

This doctrine is defined as the common law doctrine under which the federal income tax benefits with respect to a transaction--are not allowable if the transaction does not have economic substance or lacks a business purpose.

Related Penalties: A 20 percent penalty applies for an underpayment attributable to any disallowance of claimed tax benefits for a transaction lacking economic substance.

The penalty is increased to 40 percent if the taxpayer does not adequately disclose the relevant facts affecting the tax treatment in the return or in a statement attached to the return.

Caution: There is no exception to these penalties for reasonable cause and good faith.

Recent IRS Directive

The Large Business and International Division Commissioner issued guidance (LB & 1-4-0711-015) July 15 for examiners and managers on this doctrine and its related penalties, which has the following steps:

Step 1: An examiner should evaluate whether the circumstances in the case are those under which application of the economic substance cloctiine to a transaction is likely not appropriate. There are 22 types of facts and circumstances listed in this Directive, which tend to show that application of this doctrine to a transaction is likely not appropriate. These facts and circumstances can be accessed at www. calcpa.orgg/111FedtaxAppendix1.

Step 2: The examiner should evaluate whether the circumstances in the case are those under which application of the doctrine to the transaction may be appropriate. The Directive lists 17 types of facts and circumstances, which tend to show that application of the doctrine may be appropriate. These facts and circumstances can be accessed at www. calcpa.org/1110FedTaxAppendix2.

Step 3: If the examiner determines that the application of the doctrine may be appropriate, the guidance provides seven...