I’m coming across more and more “tax strategies” that are actually just “tax fraud”. Usually, these strategies implement a complicated or convoluted entity structure in order to lessen or avoid taxes altogether. These are not legal according to the Economic Substance Doctrine.

If you ask the layperson on the street, they’re not going to know what the Economic Substance Doctrine is. It’s a part of the IRC (Section 7701(o)), which states: "...the tax benefits of a transaction are not allowed if the transaction does not have economic substance or lacks a business purpose.”

This means setting up multiple entities and shifting income around strictly to avoid paying income taxes is a no-no. Basically, what happens is the courts will throw out the extra entities as if they never existed and assign the income/expenses to the entity where the business is occurring.

A current case (October 2023) where this was applied was Liberty Global Inc. v. United States, where Liberty Global had to claim a $2.4B taxable gain (and denied a $110M tax refund). Basically, they attempted to create a loss to offset their gain through a series of different transactions. The transactions themselves that created the loss are what the courts disagreed and said lacked “economic substance.”

To me, the most interesting quote from the opinion was the red flag phrase “…when a transaction produces enormous tax savings without a concomitant economic loss.”

Did you catch that? The red flag was a huge tax savings with no actual economic loss occurring.

Also, keep in mind - the IRS said in 2022 that this argument will be used more in cases they pursue, and since this is a huge win for the IRS, Expect to see this case referenced in future proceedings.

By Mark Toney
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