NTUF continues the fight in the courts over the Economic Substance Doctrine. In Harty v. Commissioner, our amicus curiae (“friend of the court”) brief tells the United States Tax Court how “rulemaking by litigation” is harmful to taxpayers.
The Economic Substance Doctrine means that the IRS can sometimes disregard a transaction done for tax reasons and not for a business purpose. But, because many transactions are done, at least in part, for tax reasons, the Doctrine can be a dangerous weapon for the IRS to use whenever it might want. Congress recognized this, explicitly requiring a threshold relevance determination: “[i]n the case of any transaction to which the economic substance doctrine is relevant” then the government may apply the two-part test of § 7701(o)(1). The Tax Court last year (in another case where NTUF provided our expertise) recognized this first step is to see if the doctrine is even relevant.
But, the problem is that case-by-case litigation cannot adequately provide the guidance when it matters the most to taxpayers—before the government starts asking questions. Instead, we argue that the IRS should define in advance where it will apply the Doctrine, providing direct guidance through rulemaking. Yet the Treasury and IRS have specifically avoided doing so, stating: “The Treasury Department and the IRS do not intend to issue general administrative guidance regarding the types of transactions to which the economic substance doctrine either applies or does not apply.” This leaves taxpayers in the dark and beholden to the whim of IRS enforcement over whether they will be subject to defending the economic substance of their transactions.
The danger of this approach is not only practical but also a constitutional harm. Congress makes legislative choices to promote certain activity by tax advantages (e.g. credits, deductions, or other offsets). But, as the Ninth Circuit observed 30 years ago: “If the government treats tax-advantaged transactions as shams unless they make economic sense on a pre-tax basis, then it takes away with the executive hand what it gives with the legislative.” In other words, the IRS should not be in the business of second-guessing the tax advantages set by Congress.
As it is, the IRS has set a trap for the unwary, with taxpayers learning only after the fact that the Service disfavors their business transactions. This also creates unnecessary litigation burdens—creating backlogs in the courts and costing taxpayers thousands of dollars to fight, case-by-case. Finally, this system creates the very real possibility of the IRS asking courts to substitute the Administration’s preferences for those of Congress.
We argue that forward-looking guidance from the IRS will help taxpayers, advisors, and the IRS agents themselves to know when the economic substance doctrine applies, avoiding costly litigation for every new financial arrangement. Congress often creates tax incentives to encourage specific economic behaviors, such as small business investments, historical preservation, and home ownership. It is entirely appropriate for taxpayers to try to maximize these tax savings, and doing so should not be viewed as lacking “economic substance” or somehow misapplying the tax laws.
The case is Harty v. Commissioner, T.C. Docket Nos. 23354-21 & 19159-23.