August 1, 2012

Brad Pettit, Senior Attorney, National Legal Research Group

As part of the Health Care and Education Reconciliation Act of 2010, Congress codified the long‑standing common‑law doctrine of "economic substance," which is applied in federal income tax cases to prevent taxpayers from trying to claim tax benefits from transactions that have no bona fide nontax purpose.  Pub. L. No. 111‑152, § 1409(a), 124 Stat. 1029, 1067‑68 (effective with respect to transactions entered into on or after March 31, 2010) (adding subsection (o) to 26 U.S.C. § 7701 and redesignating former subsection (o) as subsection (p)).  The Internal Revenue Code now expressly provides that

[i]n the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if—

(A)       the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and

(B)       the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

26 U.S.C. § 7701(o)(1) (Westlaw current through P.L. 112‑90 approved 1‑3‑12).  Section 7701(o) goes on to explain that the term "economic substance doctrine" means the common‑law doctrine under which income tax benefits with respect to a transaction are not allowable if the transaction or series of transactions do not have "economic substance or lack[] a business purpose."  Id. § 7701(o)(5)(A), (D).  It is critical to note that under § 7701(o), there is an "[e]xception for personal transactions of individuals" because Congress expressly provided that the economic substance doctrine is applicable "only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income."  Id. § 7701(o)(5)(B).

The Code also makes it clear that a taxpayer can be subjected to "accuracy‑related penalties" if he or she tries to claim tax benefits from a transaction or series of transactions that lack economic substance.  Id. § 6662(b)(6) (subsection (6) added to § 6662(b) by Pub. L. No. 111‑152, § 1409(b)(1), 124 Stat. at 1069).  Specifically, the Code now expressly provides that accuracy‑related penalties

apply to the portion of any underpayment which is attributable to . . . :

 . . . .

(6)        Any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.

Id.

On at least three occasions, the U.S. Tax Court has noted that the above‑described provisions of § 7701(o) essentially represent the adoption by Congress of the common‑law doctrine of economic substance as articulated by the U.S. Court of Appeals for the Third Circuit in the case of ACM Partnership v. Commissioner, 157 F.3d 231, 247‑48 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999).  Crispin v. Comm'r, T.C. Memo. 2012‑70, T.C.M. (RIA) ¶ 2012‑070, 2012 WL 858406, at *6 n.14; Blum v. Comm'r, T.C. Memo. 2012‑16, T.C.M. (RIA) ¶ 2012‑016, 2012 WL 129801, at *17 n.21; Rovakat, LLC v. Comm'r, T.C. Memo. 2011‑225, T.C.M. (RIA) ¶ 2011‑225, 2011 WL 4374589, at *27 n.11. 

April 3, 2012

Brad Pettit, Senior Attorney, National Legal Research Group

Corporate and tax law attorneys frequently are asked to assist clients who have formed or want to create an organization that will serve the public good.  Section 501 of the Internal Revenue Code recognizes the desirability of such organizations by according tax-exempt status to "[c]orporations, and any community chest, fund, or foundation" that is "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition . . . , or for the prevention of cruelty to children or animals."  I.R.C. § 501(c)(3) (emphasis added).  The Treasury Regulations further indicate that in order to be exempt from taxation under § 501(c)(3), an organization must be both "organized and operated exclusively for one or more of the purposes specified in such section."  Treas. Reg. § 1.501(c)(3)-1(a)(1).  According to the Regulations, "[i]f an organization fails to meet either the organizational test or the operational test, it is not exempt [from taxation]."  Id.

A.         Organizational Test

The Treasury Regulations provide that an organization is organized exclusively for one or more exempt purposes only if its articles of organization (1) limit the purposes of the organization to one or more exempt purposes, and (2) do not expressly empower the organization to engage, other than as an insubstantial part of its activities, in activities which in themselves are not in furtherance of one or more exempt purposes.  Treas. Reg. § 1.501(c)(3)-1(b)(1)(i).  The Regulations go on to caution that

An organization is not organized exclusively for one or more exempt purposes if its articles expressly empower it to carry on, otherwise than as an insubstantial part of its activities, activities which are not in furtherance of one or more exempt purposes, even though such organization is, by the terms of such articles, created for a purpose that is no broader than the purposes specified in section 501(c)(3).

Id.  § 1.501(c)(3)-1(b)(1)(iii).  As part of an organization's application to the IRS for tax-exempt status, it must submit a detailed statement of its proposed activities.  Id. § 1.501(c)(3)-1(b)(1)(v).

B.         Operational Test