Withstanding IRS Economic Substance Challenges: The Business Purpose Doctrine

The business purpose doctrine is not defined in the Internal Revenue Code. However, the scope of the IRS' reach in utilizing this doctrine to invalidate transactions is unarguably broad. Having an IRS-sanctioned business purpose is vital for reorganizations, partnership allocations, transfer pricing arrangements, and simply checking boxes on required forms. Every act must have a business purpose beyond avoiding or mitigating federal income tax. In April 2022, the IRS' Large Business & International and Small Business Divisions updated their procedures on asserting penalties for lack of economic substance. These taxpayer-unfavorable changes include the removal of the requirement for executive approval, making it easier for the IRS to assert claims for noncompliance.

The business purpose test examines taxpayers' motives for entering into a transaction, while the economic substance doctrine determines whether the transaction itself affects the taxpayer's economic position substantially. IRC Section 7701(o) explains the application of the economic substance doctrine.

(o) Clarification of economic substance doctrine

     (1) Application of doctrine: In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if—

        (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and

        (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

Most business reorganizations are structured to be tax-free. The first requirement under Treasury Regulation 1.368-1(b) for business acquisitions and reorganizations is that the reorganization have an independent business purpose.

IRS frequently challenges partnership allocations for lacking substantial economic effect under IRC Section 704(b) regulations. Safe harbors in place include deficit restoration obligations (DROs) and qualified income offsets (QIOs) that ensure partnerships' transactions meet the requirements of the economic substance doctrine.

Taxpayers working with partnerships, corporations, and other business entities need to comprehend the significant reach of IRS challenges to business transactions. Listen as Aaron Hegji, Wealth Strategist/Chief Fiduciary Officer at Wealthgate Trust, explains the business purpose doctrine and the best strategies for compliance.