Economic Substance Penalty


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David M. Kaufmann, CPA

Voice: 720.493.4804


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1466 Adobe Falls Way
Fruita, CO 81521

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PO Box 700
Fruita, CO 81521-0700

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.

What is 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 substance?

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 substance:

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 "reasonably expected."

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 are:

The Lease Vs. Buy Analyzer.

The Roth Vs. Regular IRA Analyzer.

The Education Funding Planner.

Call me if you would like me to make economic substance computations for you. 1-800-326-6686 (Dave Kaufmann).

Remember - call me before you commence a transaction that the IRS might attack for lacking economic substance.

No penalty, if you disclose that transactions lack economic substance.

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 or attorney if you want more information.

If you have questions about this, do not hesitate to contact us at 720-493-4804.