The Economic Substance Doctrine: Withstanding IRS Challenges

This webinar will review the economic substance doctrine (“ESD”) as it has been applied by courts and the IRS. The panelists will discuss the history of the doctrine, key judicial developments, the doctrine’s 2010 codification at I.R.C. § 7701(o), and the strict liability penalty of I.R.C. § 6662(b)(6), among other topics. The webinar is intended to assist practitioners and taxpayers in navigating ESD issues.

The ESD is a cornerstone of federal tax law that empowers courts and the IRS to disregard transactions that comply with the literal language of the Code but lack economic reality. Shaped by a century of caselaw, courts have generally interpreted the ESD to require that taxpayers show a substantial non-tax purpose and a change in economic position before tax benefits will be respected, though some courts have required that one (but not both) of these prongs be met.

In 2010, the ESD was codified at I.R.C. § 7701(o). Like its judicial counterpart, the codified ESD contains two prongs, commonly referred to as the “objective prong” and the “subjective prong.” Under I.R.C. § 7701(o):

(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.  

Because both prongs must be met, the codified ESD in some instances may impose a stricter standard than the judicial approach.

The webinar will also discuss the “relevancy requirement” imposed by I.R.C. § 7701(o), which has been the focus of two high-profile opinions. In Patel v. Commissioner, 165 T.C. No. 10 (2025), the US Tax Court in a reviewed opinion recognized a threshold relevancy requirement in the context of sustaining the penalty under I.R.C. § 6662(b)(6). In contrast, a Federal District Court in Liberty Global v. United States, No. 1:20-cv-03501-RBJ (D. Colo. Oct. 31, 2023) (on appeal to 10th Circuit), held that there is no threshold inquiry.

The webinar’s focus will also include the penalty under I.R.C. § 6662 for transactions that fail the ESD. In April 2022, the IRS Large Business & International Division updated its procedures on asserting penalties for lack of economic substance. These changes include the removal of the requirement for executive approval, which appears to have lowered the internal threshold for asserting the ESD penalty.

What does all this mean for tax planning? There are numerous areas in the Code where the doctrine is potentially applicable. Listen as our panelists discuss a few important ones.