Codified Economic Substance Doctrine Archives

Tax Court confirms codified economic substance doctrine requires threshold relevancy determination, upholds 40% strict-liability penalty

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, [...]

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IRS Changes Position on Approval for Assertion of Codified Economic Substance Doctrine

In March 2010, Congress codified the economic substance doctrine in Internal Revenue Code (Code) Section 7701(o). The codification clarified that a conjunctive analysis applies in determining if the doctrine applies. The codified economic substance doctrine applies when a transaction does not have economic substance or lacks a business purpose. When the doctrine applies, a taxpayer is subject to a 20% strict liability penalty (40% in the case of undisclosed transactions) on any underpayment attributable to the disallowed tax benefit claimed.

Congress acknowledged that the codified economic substance doctrine should be applied sparingly, and the Joint Committee on Taxation, in a report issued prior to the enactment of the doctrine, provided detailed guidance on when the doctrine should apply. The Internal Revenue Service (IRS) issued guidance shortly after the codification acknowledging these points. The IRS also put in place detailed procedures for examiners to follow in determining whether to assert the codified economic substance doctrine.

One of the procedures put in place was the approval by the Director, Field Operation before the codified economic substance doctrine could be formally asserted. An approval request was to be made after consultation with the revenue agent’s manager and local counsel. Additionally, taxpayers were to be provided “the opportunity to explain their position.”

On April 22, 2022, the IRS’s Large Business & International (LB&I) Division issued a memorandum—LB&I-04-0422-0014—to all LB&I and Small Business/Self Employed examination employees (Updated Guidance). The Updated Guidance removes the requirement to obtain executive approval before asserting the codified economic substance doctrine. The Updated Guidance states that this change aligns penalties for lack of economic substance with other assessable penalties which do not require executive approval. However, the changes do not remove the supervisory approval requirement under Code Section 6751.

In connection with the Updated Guidance, revisions are being made to the relevant provisions of the Internal Revenue Manual (IRM). The IRM revisions eliminate some of the considerations previously set forth in the four-step process that revenue agents were required to undertake in determining whether the doctrine should be applied.

Practice Points: Although the Updated Guidance has no impact on the substance of the codified economic substance doctrine itself, the change is disappointing news. As a result of the relaxed rules for the doctrine’s assertion, taxpayers can reasonably assume that the doctrine may more frequently be asserted on audit. Thus, it is now even more important to properly document transactions to demonstrate they have sufficient economic substance and a business purpose.