IRS Limits When It Will Apply The "No-Economic-Substance Penalty"

On July 15, 2011, the Internal Revenue Service issued guidance¹ to its examining agents addressing when and how to assert the "no fault" penalty² for failure of a transaction to meet the recently codified economic substance doctrine. While the directive is addressed solely to IRS examining agents, the guidance should prove useful to both taxpayers and their representatives in determining (a) how the IRS seeks to apply the standard of economic substance, and (b) the procedures followed and opportunities to defend against possible assertion by the IRS that a transaction or series of transactions lacks economic substance. If applied, the penalty (the "no-economic-substance penalty") is levied at 20% (or 40% absent adequate disclosure) of the underpayment attributable to the failure to meet the economic substance hurdle.