Note: This is a complicated subject. We will only
touch on some topics. We recommend that you talk these issues over
with an attorney and a CPA.
I can perform present value computations to refute and
defend against the 40% penalty for transactions that lack economic
substance. Call me at 1-720-493-4804. Thousands of accountants have used
software that I have developed that use
present value calculations.
the penalty for taking deductions or losses that lack economic substance?
40% of the tax benefit related to transactions that lack
economic substance. [Internal Revenue Code §6662(b) and §6662(i)].
How do we know that a transaction has economic
In plain terms, a transaction has
economic substance, if the transaction appears to be profitable,
regardless of any tax benefits. However, this explanation is vague. What
does the tax law say about economic substance?
The general (vague) description of economic
The transaction changes in a meaningful way (apart from
income tax effects) your economic position, AND
you have a substantial purpose (apart from income tax
effects) for entering into the transaction.
[Paraphrased from Internal Revenue Code §7701(o)(1)].
Please note the vague - subjective terms "meaningful" and
"substantial purpose." Those are terms that can mean one thing to you and
something entirely different to the IRS. What you want is a "safe harbor"
description of "economic substance."
The "safe harbor" description of economic substance:
The tax law does provide for a
somewhat more objective test for economic substance. If the present value
of the potential reasonably expected pre-tax profit is substantial
compared to the present value of the expected tax benefits, the government
will accept the transaction as having economic substance. [Paraphrased
from Internal Revenue Code §7701(o)(2)].
Even though this is more
objective, there certainly could be a difference of opinion of what is
Also, a discount rate is required
to discount future profits to the present to arrive at a present value. A
high discount rate makes the earliest profits and tax benefits more
important. A very low discount rate still favors early transactions, but
not a strongly as if a high discount rate was used.
When should a present value computation be made to
support economic substance?
I recommend making the present
value computations before the transactions are begun. My thoughts on
this timing is based on the phrases, "profit potential" and "reasonably
expected" [Internal Revenue Code §7701(o)(2)].
However, if the present value
computations are not made before the transactions began, the next best
time to make the computations would be before the preparation of the first
income tax return that reports the consequences of the transactions.
The worst time to make the present
value computations would be after the IRS has commenced an examination of
the tax return. Better late than never. Go ahead and make the
present value computations, but this is a bit like arranging the deck
chairs on the Titanic.
My track record with
economic analysis using present value:
I have developed all of the
software sold by Denver Tax Software.
Some of the programs that I have
developed that use extensive and often complicated present value analysis
Lease Vs. Buy Analyzer.
Roth Vs. Regular IRA Analyzer.
Education Funding Planner.
Call me if you would like me to
make economic substance computations for you. 1-800-326-6686 (Dave
Remember - call me before
you commence a transaction that the IRS might attack for lacking economic
No penalty, if you disclose that transactions lack
That's the good news. The bad news
is that you have just given the IRS a roadmap to deny your deductions!
The information contained here are simplifications of complex subjects. Talk to your CPA
attorney if you want more information.
If you have questions about this, do not hesitate to contact us