I’ve been accused of that a couple of times, but in this case, I’m talking about economic substance. Recently a taxpayer lost their battle with the IRS, with the Tax Court citing that the transactions of their business entities lacked economic substance, and were only done to pay the couple’s personal living expenses.

Believe it or not, the IRS actually has written guidance on the subject, giving taxpayers a two- prong test to determine whether the transaction has economic substance. The first is that the transaction must, in a meaningful way (other than federal tax purposes), CHANGE the taxpayer’s economic position. The second test is that the taxpayer has a substantial PURPOSE (other than federal income tax purposes) for the transaction. Seems pretty simple, huh?

As in most things with the IRS, they (and the Tax Court) are going to look at the facts and circumstances surrounding the transaction. As an example, in the above-mentioned case, the taxpayer failed to show the economic substance for one of their entities paying for the individual’s food, medical and dental, and residential real property taxes. Although these items may have been deductible to the individual taxpayer, the transactions at a company level failed to prove economic substance (other than just not having to pay income tax).

As I am so fond of saying, pigs get fat and hogs get slaughtered. Often times small business owners go to extreme lengths to not pay income taxes when in reality they are doing nothing other than playing “audit roulette”. When looking at transactions of a business entity, try applying a simple test, if taxes had nothing to do with it, would I be doing this?

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