“Loophole Closers”

Codification of Economic Substance Doctrine

The president proposes to clarify and codify the economic substance doctrine. A transaction would satisfy the economic substance doctrine only if (1) it changes in a meaningful way (apart from federal tax effects) the taxpayer’s economic position and (2) the taxpayer has a substantial purpose (other than a federal tax purpose) for entering into the transaction. Additionally, the proposal would clarify that a transaction will not be treated as having economic substance solely by reason of a profit potential unless the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the net tax benefits arising from the transaction.

Penalty. The president also proposes a new 30 percent penalty on an understatement of tax attributable to a transaction lacking economic substance. The penalty would be reduced to 20 percent if the taxpayer made adequate disclosure of the relevant facts on the taxpayer’s return.

IMPACT: The president’s proposals are prospective. Clarification and codification of the economic substance doctrine along with the new understatement penalty would apply to transaction entered into after the date of enactment. The denial of the interest deduction would be effective for tax years ending after the date of enactment with respect to transactions entered into after such date.

COMMENT: Codifying the economic substance doctrine has appeared several times as a revenue raising provision in various legislative proposals. Most recently, the House approved codification of the economic substance doctrine as part of its health care reform bill, the Affordable Health Care for America Act (H.R. 3962).

Carried Interest

The president revived his proposal to tax carried interests as ordinary income. The proposal would apply to a profits interest in a partnership that is received in exchange for services. The services partner would also owe self-employment taxes on income earned on the carried interest. The proposal would be effective for tax years beginning after December 31, 2010.

IMPACT: The proposal is controversial but would be a big money-maker. It is estimated to raise almost $24 billion through 2020.

COMMENT: The proposal identifies “services partnership interest” (SPI) as the partner’s share of income that would be subject to tax as ordinary income. An SPI is a carried interest held by a person who provides services to the partnership.

Source: CCH, a Wolters Kluwer business