Will IRS Limit Exam’s Assertion of the Economic Substance Penalty? TIGTA Report Suggests Not.

Since codification of the economic substance doctrine in March 2010, taxpayers have expressed fears that IRS will assert the doctrine unpredictably, resulting in an in terrorem effect among taxpayers because of the lack of clear authorities interpreting the doctrine and the new 40% strict-liability penalty for falling on the wrong side of it.  To promote predictability in the exam processes, taxpayers have requested that Treasury or the IRS issue formal guidance instituting prescribed procedures to assert the penalty.  The government had declined these requests, but officials have promised queasy taxpayers that IRS will only assert the penalty after certain approvals.  For example, in September, LMSB Commissioner Heather Maloy issued a directive mandating that any assertion of the penalty during exam must be approved by the appropriate director of field operations.  Then, as reported by Tax Analysts, Associate Chief Counsel (Procedure and Administration) Deborah Butler said in October that Chief Counsel would review any notice of deficiency that applied the economic substance penalty before it was sent to the taxpayer.

In spite of these informal assurances, a recent  report by the Treasury Inspector General for Tax Administration (“TIGTA”) provides some support for taxpayers’ fears of broad, unfettered assertions of the economic substance penalty in examination.  In the report, TIGTA reviewed exam’s decision to survey 311 tax returns for potential abusive tax avoidance transactions, or “ATATs,” often referred to as  tax shelters.  After an ATAT designation, a return is given priority workload, meaning that exam will more closely scrutinize the return by assigning more examiners to the return to look for more issues.  To promote confidence in the IRS and equitable treatment of similarly situated taxpayers, IRS guidelines require two levels of approval (first, by the group manager and second, by the planning and special programs function) before exam can survey a return for a potential ATAT.  However, TIGTA’s report concludes that exam failed to obtain the necessary approval in a whopping 97% of reviewed cases.

With results like those, it isn’t surprising that taxpayers are apprehensive to believe the well-intended assurances of IRS officials promising the measured assertion of the economic substance penalty.  The IRS’ failure to follow its own informal guidelines, which were put in place to limit ATAT designations, should cause Treasury and the IRS to take a second look at their decision not to issue formal guidance regarding the economic substance penalty.  While formal rules would protect taxpayers, there is real danger that informal guidance will be ignored and the penalty will be asserted imprudently.

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