Amanda L. Yoder


Almost every federal circuit, as well as Congress, has weighed in on the economic substance doctrine and attempted to clarify its boundaries. The economic substance doctrine deals with transactions that, although technically in accord with the Internal Revenue Code (the Code or I.R.C.), were originally structured solely for tax avoidance purposes. The Internal Revenue Service and courts dislike these transactions because they thwart the general intent of Congress in enacting certain tax-saving Code provisions. Until recent amendments to the I.R.C., the federal circuits were split between two different approaches to tax avoidance transactions, yet the application of the two approaches was slightly unique in each circuit. There were many, albeit unsuccessful, attempts to codify the economic substance doctrine in the past ten years. Although there were several proposed bills, the language in each proffered version was largely the same - effectively the same language that appears in the newly codified economic substance doctrine. These proposed bills, and now the newly codified doctrine, specify certain factors to be considered (such as profit potential) and the requirements needed to find economic substance. Although there was a majority forming as to which test to use, the circuit split was creating unrest among the lower courts. At times, even knowing which test a specific circuit used was not particularly helpful in guiding a taxpayer. In addition, if a taxpayer planned incorrectly, he or she may have faced severe tax penalties. Moreover, the different standards applied at the appellate level made it difficult for the tax and district courts to assess particular transactions because the test applied by the court changed depending on where the appeal was heard. Thus, the economic substance issue created uncertainty for both taxpayers and courts and most recently surfaced in the U.S. Court of Appeals for the Fifth Circuit case Klamath Strategic Investment Fund ex rel. St. Croix Ventures v. United States.1

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