The entire tax code rests on two doctrines which are not in the tax code per say, but which for all intents and purposes provide the foundation the entire tax code was based on – Economic substance & valid business purpose. Every time I think about this I am reminded of the parable about building your house on solid rock instead of shifting sand. The entire tax code was built on shifting sand. It took a Supreme Court decision, Glenshaw Glass, to place a solid foundation underneath. These two precepts lurk in the background of every tax controversy. So you need to be aware of them.
Economic Substance and Valid Business Purpose.
Economic substance is a doctrine in the tax law of the which a transaction must have both a substantial purpose aside from reduction of tax liability and an economic effect aside from the tax effect in order to be considered valid. It isn’t valid to pursue a course of action if saving taxes is the only reason you do it. Every transaction must have an economic substance aside from avoiding taxes in order to be valid. Just satisfying the technical requirements of the code, isn’t enough. You also have to pass the test of economic substance. If it doesn’t, it’s considered abusive. Economic substance made its way into the tax code for the first and only time in in 2010 in ACA.
Valid business purpose raises the issue of motive on federal income tax liability. Tax avoidance “by means which the law permits” traditionally has been viewed as a legal right. Justice Learned Hand of the New York Court of Appeals, made the famous statement, “It is perfectly legal to so arrange your affairs to pay the least income tax.” However, for forty-five years, the Commissioner of Internal Revenue (Commissioner) has been probing taxpayers’ business motives, generally with the blessing of courts. This has led to the development of the business purpose doctrine, which permits the Commissioner to reverse tax benefits for certain transactions motivated by tax avoidance or non-business purposes. Although the doctrine arose in the context of reorganizations, it was extended rapidly to other areas.- Recently, it has been discussed as a “pervasive judicial doctrine” in tax law. When and how the doctrine should be applied, however, is still the subject of controversy … because it has never been codified by adding it to the tax code.
These concepts developed organically in the courts because they were necessary to hold the tax code together. As people with uncommon abilities began working in the tax code on behalf of their clients to avoid income tax, some very bright people discovered ways to work in the seams of the tax code to follow the letter of the law but cut taxes to nothing.
That’s still possible. But today you have to be aware of these two foundational precepts. People have overlooked them & gone to prison for their efforts.
Case in Point:
Captive Life Insurance Companies.
I have always thought this particular tax strategy failed to meet either the economic substance test, or the valid business purpose test. It appears I was right. The IRS just launched (3/10/17) a search for all captive life insurance companies. As far as I know, the only reason they do that is to find taxpayers & preparers who are fraudulently abusing the tax code.
Link to the same doc my newsletter email linked to today. The Camino PDF