Patel v. Commissioner, 165 T.C. No. 10 (Nov. 12, 2025), gave the US Tax Court its “first opportunity to examine when the codified economic substance doctrine applies.” Patel at *16. The Tax Court made two key holdings:
- Section 7701(o) requires a relevancy determination that “is not coextensive with the two-part test set forth in section 7701(o)(1)(A) and (B).” Patel at *17.
- Adequate disclosure to reduce the 40% economic substance penalty imposed by sections 6662(b)(6) and (i) must be made at the time the return is filed and not at a later time. Patel at *30.
Relevancy determination
Section 7701(o) provides:
Sec. 7701(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.
While the Internal Revenue Service (IRS) endorses a seemingly limitless application of the codified economic substance doctrine, taxpayers contend that it does not apply to every transaction. Rather, the plain language of section 7701(o)(1) requires a threshold relevancy determination. If the economic substance doctrine is not relevant, the inquiry ends.
There are very few cases that have considered whether section 7701(o) requires a threshold relevancy determination. And those that have found that section 7701(o) does not impose a separate relevancy requirement. See Liberty Global, Inc. v. United States, No. 20-cv-63501, 2023 WL 8062792 (D. Colo. Oct. 31, 2023); Chemoil Corp. v. United States, No. 19-cv-6314, 2023 WL 6257928 (S.D.N.Y. Sept. 26, 2023). While Liberty Global was appealed to the US Court of Appeals for the Tenth Circuit – and many speculate the Tenth Circuit may clarify that there is a relevancy requirement – the Tax Court beat the appellate court to the punch.
The Tax Court’s holding had solid statutory support. The plain language of section 7701(o)(1) states: “In the case of any transaction to which the economic substance doctrine is relevant…” After quoting these words, the Tax Court stated, “we easily conclude that the statute requires a relevancy determination. To put it plainly—the statute says so, right there, on its face.” Patel at *17.
Adequate disclosure of transactions
The second key holding in Patel is that the taxpayers in the case are liable for a 40% penalty for engaging in a transaction that lacks economic substance that was not adequately disclosed. Section 6662(b)(6) imposes a 20% penalty on transactions that lack economic substance. This penalty is increased to 40% under section 6662(i) if the transaction is not adequately disclosed.[1]
In the current wave of economic substance challenges, it is unclear what constitutes adequate disclosure under section 6662(i) such that the 20% (instead of the 40%) penalty applies. Based on current audit activity, it’s not clear whether an adequate disclosure must be attached to the tax return or can be made at a later time – perhaps at the beginning of an audit.
Patel clarified this issue. The Tax Court found that adequate disclosure for purposes of section 6662(i) means that a statement is attached to a tax return or relevant facts or sufficient information is provided on the tax return “to enable [the IRS] to identify the potential controversy involved.” Patel at *30. Because the taxpayers in Patel did not attach such a statement or provide such information on their returns, the taxpayers did not make adequate disclosure. As a result, the Tax Court held that section 6662(i) applies to increase the penalty from 20% to 40%.
Practice points
While the taxpayers lost in Patel, the Tax Court’s relevancy determination may nevertheless help other taxpayers that are facing economic substance challenges. Taxpayers facing such challenges should consider developing arguments that the economic substance doctrine is not relevant to the transactions at issue. These arguments provide taxpayers with an additional defense.
The Tax Court’s 40% penalty determination is a good reminder of the importance of detailed disclosures at the time tax returns are filed. Easier said than done as it is not always easy to predict which transactions the IRS may challenge as lacking economic substance. Nevertheless, if there is a risk that certain tax planning – even long-respected tax planning transactions – may be challenged on economic substance grounds, taxpayers should consider making a protective disclosure with their returns.
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[1] Both the 20% and 40% penalties are strict-liability penalties that are not subject to any defenses, including reasonable cause.
