Internal IRS guidance released on the application of the economic substance doctrine.

• Author: Chambers, Valrie

Internal IRS Guidance Released on the Application of the Economic Substance Doctrine

On July 15, 2011, the IRS issued an important directive to its examiners on how the economic substance doctrine, which was codified by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, and the new penalty associated with it should be applied to cases in the field (LB&I-4-0711-015). Since the IRS's Large Business and International Division (LB&I) is auditing more high-wealth clients, this directive will be important to more practitioners.

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The economic substance doctrine has long been a judicial doctrine, and for transactions entered into after March 30,2010, it is now codified in Sec. 7701 (0). There is also a new strict liability penalty in Sec. 6662(b) (6) equal to 20% (or 40% for undisclosed transactions) on any underpayment attributable to the disallowance of claimed tax benefits resulting from the application of the economic substance doctrine. Taxpayers cannot use the reasonable cause exception (Sec. 6664) to avoid this penalty.

To apply the new economic substance doctrine and the associated penalty, IRS examiners must obtain the review and approval of their director of field operations (DFO). Before requesting DFO review, examiners should perform four steps:

1. Evaluate the 22 factors in the directive showing that the application of the economic substance doctrine to a transaction is likely not appropriate.

2. If the examiner still feels that the doctrine is warranted, evaluate whether the facts and circumstances in the case support the application of the doctrine.

3. Make additional inquiries consistent with the guidelines, including whether another judicial doctrine such as step transaction or substance over form more appropriately addresses the noncompliance. These other doctrines would then take precedence in application over the economic substance doctrine.

4. Review the logistical guidance for requesting DFO approval when the examiner and managers have concluded that the application of the doctrine is merited.

The importance of these guidelines is to ensure that the IRS is applying the economic substance doctrine and strict liability penalty consistently across taxpayers. It is important for tax practitioners to understand how the IRS is prioritizing this doctrine relative to other traditional judicial doctrines.

From Mark VanDeveer, CPA, Virginia Beach, VA

States Increase Use of U.S. Treasury Offset Program for Collection of State Income Taxes

Budget-weary states are increasingly relying on the federal tax intercept program to collect state income tax liabilities. The U.S. Treasury Offset Program (TOP) has long been available to apply taxpayer income tax overpayments to collect nontax debts. Sec. 6402(e) authorizes Treasury to offset a tax refund against the taxpayer's past due, legally enforceable state income tax obligations. Treasury's Financial Management Service (FMS) administers the TOP.

Tax preparers need to consider that state tax seizure of federal overpayments will affect the amount of an overpayment available for scheduled federal estimated tax payments. Projected federal tax refunds may not be available for use in payment of the current-year state income tax obligations. New spouses may need to file for injured spouse relief to prevent their share of the refund on a joint return from being applied to their spouse's separate property state income tax obligation.

An analysis of the requirements placed on states for administration of the program will be helpful when representing taxpayers with state income tax debts. States need to apply for inclusion in the tax intercept program and must adhere to the program's guidelines. Only state income taxes can be satisfied by the program, and not other types of state taxes.

The California Franchise Tax Board recently issued this note in its online newsletter for tax practitioners:

On June 20, 2011, we will fully participate in the Federal Treasury Offset Program (FTOP), a debt collection program, where we intercept federal refunds for payment of past-due California income tax debts. In a limited study, we collected more than $22 million since September 2008. When fully implemented, we project the number of offsets to dramatically increase. Before we intercept a federal refund for state income tax debts, we issue a notice to taxpayers by certified mail. The notice allows 60 days for the taxpayer to resolve their debt or expect to have their federal refund intercepted. Taxpayers already in...