NTUF continues the fight in the courts over the economic substance doctrine. We have fought for a constitutionally-permissible test before the Tax Court and the United States Court of Appeals for the Tenth Circuit. We also closely followed the case of Sunil S. Patel and Laurie McAnally Patel. After losing before the Tax Court, the Patels have now appealed to the United States Court of Appeals for the Fifth Circuit. Once again, NTUF’s Taxpayer Defense Center filed an amicus curiae (“friend of the court”) brief, urging the adoption of a rule to end taxpayer uncertainty.
The economic substance doctrine means that the IRS can sometimes disregard a transaction done for tax reasons and not for a business purpose. But many business and financial transactions are done, at least in part, for tax reasons. Indeed, the Internal Revenue Code is full of incentives and programs that Congress wants people to use: S Corporations, historic preservation credits, the mortgage interest deduction, and Roth 401(k) accounts.
Congress recognized that the economic substance doctrine cannot be used as a cudgel against ordinary tax planning and therefore explicitly required a threshold relevance determination before its use. Congress limited the use of the doctrine in IRC §7701(o)(1), instructing: “[i]n the case of any transaction to which the economic substance doctrine is relevant” only then may the government apply the two-part test of the doctrine. This threshold relevance determination is necessary to avoid unjustly penalizing taxpayers for legitimate activity.
The problem is that “relevant” is not defined in the tax code here, so taxpayers don’t know when their tax planning becomes subject to the economic substance doctrine. 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.
In this case, the U.S. Tax Court denied tax deductions claimed by Sunil S. Patel and Laurie McAnally Patel for captive insurance payments. A captive insurance company, explicitly allowed for in the tax code, pools resources for small businesses to self-insure on things like property insurance. The Tax Court agreed with the IRS’s argument that the deductions should be disallowed because the transactions were primarily designed to obtain tax benefits. The Tax Court then asked for more briefing on the scope of the economic substance doctrine and whether it applied to the whole of the Patels’ business arrangements. The Patels have now appealed to the Fifth Circuit, based in New Orleans.
We argue that the IRS should define in advance where it will apply the doctrine, providing direct guidance through rulemaking. In its decision, the Tax Court did require a relevancy test before invoking § 7701(o) against the Patels. We argue that the Fifth Circuit should affirm that part of the Tax Court decision. But the Tax Court also created what amounts to a per se rule that any microcaptive insurance program (or indeed, possibly any insurance program) could be subject to § 7701(o) simply because insurance is a closely-regulated industry. That’s untenable and besmirches programs Congress specifically blessed. We therefore argue that part of the Tax Court analysis should be reversed, remanding to the IRS to promulgate a regulation through notice and comment to establish a new test on relevancy.
As for what test should be used, we suggest both the government and any reviewing court should presume economic substance is satisfied in business transactions unless and until there is clear evidence that the taxpayer attempted to avoid paying taxes at all. Only then should the government begin to apply the factors of § 7701(o).
The case is Patel et al. v. Commissioner of Internal Revenue, Fifth Circuit Nos. No. 26-60180, 26-60181, and 26-60194.