November 2014 Newsletter

IRS changes course and issues notice 2014-58 on the economic substance doctrine

The economic substance doctrine was historically a judicial doctrine. It was codified by the Health Care and Education Reconciliation Act of 2010 in Section7701(o). Although practitioners describe it as a codification, Section 7701(o) is a clarification of how the doctrine is to be applied when a court determines it is relevant. Importantly, Section 6662(b)(6) was also added to the Code to implement Section 7701(o). Section 6662(b)(6) imposes a 20 percent penalty on any underpayment attributable to tax benefits that were disallowed because a transaction lacks economic substance. This is a strict liability penalty with no reasonable cause defense and no penalty relief even if a taxpayer receives an opinion on the transaction. 1

The doctrine states that a transaction has economic substance if it changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position and the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such transaction. 2 If a transaction lacks economic substance, the tax benefits of the transaction are disallowed and the strict liability penalty applies.

Bifurcation Of Steps

There is no official legislative history for Section 7701(o) other than a pamphlet prepared by the Joint Committee on Taxation and a discussion in a report of the Ways and Means Committee. The Joint Committee on Taxation pamphlet points out that a court has the ability to bifurcate the steps of the transaction and independently analyze each step for economic substance, rather than view the transaction as a whole for economic substance. In Coltec Industries, Inc. v. United States, the Court of Appeals for the Federal Circuit demonstrated a court's ability to bifurcate a transaction in this manner by focusing on only one essential step of a transaction rather than the overall transaction. 3

In Coltec, the taxpayer had transferred assets into a subsidiary in exchange for stock and the subsidiary's assumption of contingent asbestos-related liabilities. The taxpayer then sold the high-basis stock at a large discount that generated a $378.7 million capital loss, and the taxpayer argued that the contingent liabilities had not reduced the basis of the stock. In narrowly defining the transaction at issue as the asset-liability exchange with the subsidiary, the court found the "transaction" to have failed the economic substance doctrine because it lacked business purpose and economic reality.

Section 7701(o) fails to define "transaction." It is unclear whether the IRS can examine only a tax motivated step to determine the overall transaction's economic substance. The IRS issued Notice 2010-62 laying out interim guidance on Section 7701(o) and the related penalty provision. 4 The LMSB and LB&I divisions of the IRS issued two field directives on the application of Section 7701(o) and the related penalty provisions. 5 The LB&I directive states that if an examiner wants to bifurcate a transaction in applying Section 7701(o), the examiner must obtain guidance from the manager and local counsel. This gave practitioners a sense of relief that Section 7701(o) would likely not be applied by bifurcating a transaction.

Notice 2014-58

The IRS issued Notice 2014-58 6 on October 9, 2014, to provide guidance concerning "the definition of 'transaction' for purposes of applying the codified economic substance doctrine under Section 7701(o)" and "the meaning of 'similar rule of law' as described in the accuracy-related penalty under Section 6662(b)(6)".

Under Section 7701(o)(5)(D), the term "transaction" includes a "series of transactions." The Notice states that the Service's intention is to not "alter the court's ability to aggregate, disaggregate, or otherwise recharacterize a transaction when applying the [economic substance] doctrine." 7 The Notice states that "facts and circumstances determine whether a plan's steps are aggregated or disaggregated when defining a Transaction." Generally, the IRS considers a transaction to include all the factual elements relevant to the expected tax treatment of any investment, entity, plan or arrangement, including any or all of the steps that are carried out as part of the plan. In the case of a transaction that generates a tax benefit which involves a series of interconnected steps with a common objective, the Service will generally include all of the steps taken together (an "aggregate") in its analysis of economic substance. When a transaction includes a tax-motivated step that is not necessary to the overarching non-tax objectives, the Service may disaggregate the steps and view the "transaction" as only including the tax-motivated steps not necessary to accomplish the non-tax goals.

What's In A Name? Independent Contractor v. Employee

One of the earliest decisions a start-up will make is whether it will engage independent contractors or hire employees. Some new businesses prefer to utilize independent contractors to do specific tasks, like accounting functions, because contractors can provide hiring flexibility and cost savings. A business can lower its expenses on things like payroll taxes and employee benefits if it engages an independent contractor instead of an employee for certain projects.

However, it is not enough to merely call a worker a "contractor" instead of an employee. Further, it can be costly if an employer misclassifies an employee as an independent contractor. For instance, the business could be liable for withholding taxes for the worker for the time he or she was employed.

The IRS and the states utilize different tests to determine whether an individual is an employee or independent contractor. Some states examine the previous IRS 20 factor test to determine the appropriate classification of workers. The IRS looks at a number of factors that include the amount of control the business has over the individual's work (that is, the business's control over how the individual does the task and the business aspects of the work). Notably, the IRS examines the type of relationship between company and worker, including the description of that relationship in written contracts. It is essential for a company engaging an independent contractor to have a written agreement that establishes the terms of the relationship.

Note that there is no definitive test or factor for determining whether a worker is an employee or an independent contractor, and any such determination may vary depending on the type of business. Any new business will want to contact an attorney who focuses on tax or labor and employment issues to guide it in appropriately classifying its workers.

Independent contractors, when used properly, can be a great option for start-ups looking for help but without the cost associated with hiring an employee.

Admissions Made In Lawsuit Challenging Whether President Of S-Corporation Earned His Compensation Used Against President In His Claim That Self-Rental Rule Did Not Apply

In the case of Schumann v. Commissioner, TC Memo 2014-138,, a number of issues related to passive activities and rental real estate were before the court. However an interesting issue arose as a taxpayer discovered that positions taken in one legal proceeding can come back to haunt the taxpayer in another.

The case is one of a series of cases of a taxpayer who has substantial income arising from trades or businesses that are not real estate trades or businesses attempting to avail himself of the real estate professional designation. This case is unique first due to the amounts claimed-the losses in question soared to the seven figure range for 2009, the second year at issue.

However the facts and results aren't that unique-the taxpayer could not present records of his actual activity, and what was submitted that purported to be a timely record had inconsistencies that caused the court to reject the evidence.

But a couple of side issues were of note. First, a pair of commercial rentals (which generated net income) were at issue regarding whether they were covered by the self-rental provisions of Reg. §1.469-2(f)(6). Under that rule, if a taxpayer rents property for use in a trade or business in which the taxpayer materially participates, an amount of gross rental income equal to the net rental income is treated as from a nonpassive activity.

The effect of this is to still treat any net loss from the activity as passive, but once the activity shows net income that net income cannot "free up" passive losses from other activities.

The taxpayer in this case rented the properties to two S corporations in which he was both president and majority shareholder. As the court noted:

Petitioner's tax reporting suggests that he was an active participant in both businesses in 2008 and 2009. For 2008 petitioner reported $5,375,000 of wages from P-Q Controls and $10,000 of wages from P-Q Controls Maine. On his Schedule E he reported $21,643 and $729,959 of nonpassive income from P-Q Controls Maine and P-Q Controls, respectively. For 2009 petitioner reported $856,989 of wages from P-Q Controls and $10,000 of wages from P-Q Controls Maine. On his Schedule E he reported $371,525 of nonpassive income from P-Q Controls Maine and $659,223 of nonpassive loss from P-Q Controls.

The taxpayer argued that his reporting for the year was "tax provisioning" and that, in reality, he provided effectively no services to either company for the year. Ignoring the other tax issues this clearly raises, the court pointed out that the taxpayer did admit to reviewing the monthly financial statements and communicated regularly with management of the companies.

One fact that initially seemed a "good" one for the taxpayer was that his adult children, all minority shareholders of one of the companies, agreed with their father's view of what he was not doing for the companies. Unfortunately for the taxpayer they decided, based on that fact, to sue their father in court over the fact that he was doing minimal work (and, presumably, failing to earn the seven figure salary he had been paid in 2008) for the company.

The taxpayer denied that charge in that case, and the Tax Court noted that in depositions:

Petitioner admitted that he was responsible for ensuring that P-Q Controls had enough resources to invest capital in new projects. Petitioner also admitted that he was involved actively in sales calls during 2008 and 2009. Petitioner also stated that as of the date of the deposition, he was still with P-Q Controls "creating and inventing" and continued to be "a participant in the overall strategy and growth of the business."

While his children might have doubted that story, the fact that the taxpayer took that position in the other legal proceeding led the Court to conclude he had conceded enough activity to be deemed materially participating in the activity-and, thus, the net income from the rentals were not passive income.

The Tax Effects Of Paying Compensation Or Dividends In Closely Held C-Corporations

Since the American Taxpayer Relief Act of 2012 (ATRA), P.L. 112-240, changed only individual tax rates but left corporate tax rates the same, this article examines the tax effects of paying dividends instead of compensation. For a large, publicly held corporation, the deductibility of compensation is seldom questioned because the corporation is usually dealing at arm's length with its employees. The issue of unreasonable compensation arises more frequently in a closely held corporation as its owner-employees can often control whether amounts paid are compensation or dividends.

ATRA increased the top individual tax rate from 35% to 39.6% for amounts earned after Dec. 31, 2012. For 2013, this rate was imposed on taxable income in excess of the "applicable threshold" ($450,000 for married taxpayers filing jointly and surviving spouses, $425,000 for heads of households, $400,000 for singles, and $225,000 for married taxpayers filing separately). For years after 2013, these threshold amounts are adjusted for inflation, but the exhibits and figures in this article are based on 2013 tax rates. (For 2015, the inflation-adjusted amounts are $464,850 for married taxpayers filing jointly and surviving spouses, $439,000 for heads of households, $413,200 for singles, and $232,425 for married taxpayers filing separately.)

ATRA also made the 15% tax rate on qualified dividends permanent for the majority of taxpayers. For 2013 and later, the tax rate on this income is 0% for taxpayers in the 10% and 15% ordinary income tax brackets, 15% for taxpayers in the 25% to 35% income tax brackets, and 20% for taxpayers in the top income tax bracket of 39.6%. In addition, higher-income individuals are subject to an additional 3.8% tax on net investment income.

Compensation vs. Dividends

Since qualified dividends are taxed at a maximum rate of 20% (or 23.8% if they are subject to the net investment income tax), it could make sense to pay out some amount of a corporation's income in the form of dividends instead of paying compensation.

In the past, the tax strategy for most closely held C corporations has been to avoid double taxation of corporate earnings. This has been accomplished by paying salary and bonuses to shareholder-employees to "zero out" the corporation's income, which results in having this amount taxed only once at the employee level. But these salaries and bonuses are subject to Social Security and Medicare taxes and possibly to an additional 0.9% Medicare tax for wages above a certain amount ($250,000 for married filing jointly, $200,000 for single filers, and $125,000 for married filing separately).

One strategy to reduce taxes is to have shareholder-employee compensation levels that reduce corporate income to $50,000. The first $50,000 of corporate income is taxed at 15%, so total federal corporate income tax would be $7,500 ($50,000 × 15%). The remaining $42,500 is paid out to the shareholder-employee as a dividend. The exhibits below provide a comparison of paying compensation and paying dividends and the resulting cash flow to the shareholder-employee.

Exhibit 1: Zero out corporate income with wages

Wages to zero out
corporate income


























Exhibit 2: $50,000 corporate income/pay out remaining as dividends

Corporate income


cash for

tax on




















Note: The exhibits do not consider the additional 0.9% Medicare tax on wages in excess of $200,000, nor do they consider state taxes.

Reasonable Compensation Considerations

Of course, care must be taken that the compensation paid to shareholder-employees would be considered "reasonable." Reasonableness of compensation is normally based on the facts and circumstances. The courts base their decisions in this area on the application of two possible tests-a multiple-factors test (see Elliotts, Inc., 716 F.2d 1241 (9th Cir. 1983)) or a hypothetical-investor standard (see Dexsil Corp.,147 F.3d 96 (2d Cir. 1998)).

The multiple-factors test considers the following factors to determine whether compensation is reasonable:

  • Employee qualifications;
  • External comparison of employee salaries with those paid by similar companies for similar services;
  • Character and condition of the company;
  • Any conflict of interest in the relationship between the company and its employees that "would permit the company to disguise nondeductible corporate distributions as salary"; and
  • Internal consistency in how bonuses and other compensation are calculated and paid to controlling shareholders compared to nonowner management.

The hypothetical-investor standard asks "[w]hether an inactive, independent investor would be willing to compensate the employee as he was compensated" (Elliotts, 716 F.2d at 1245). An independent investor would require a certain amount of money to be retained in the corporation to be paid out as a return on the investment. In determining unreasonable compensation, courts have calculated how much a reasonable return on investment would be. The difference between this amount and the amount retained has been determined to be unreasonable compensation.


With the right fact pattern and considering any unreasonable compensation issues, it is possible to lower taxes and thus retain more cash for the owners of closely held corporations by paying some dividends to the owners instead of "zeroing out" the corporation's income by paying additional compensation to the owner-employees. An owner in the 25% tax bracket (married-filing-jointly taxable income between $73,800 and $148,850) would be indifferent as the difference in the remaining cash is only $650 between the two scenarios ($36,775 - $36,125). However, as the owner's tax bracket creeps up, the savings become larger; an owner in the 39.6% bracket would save $2,910 in taxes ($32,385 - $29,475).