Economic Substance Doctrine and How to Beat the IRS

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Recently I’ve been asked by clients and students alike about the “Economic Substance Doctrine,” a tool the IRS has been using for years to suck more money out of us. Unfortunately, this doctrine has now been set into law by Mr. Obama.

The IRS’ policy, and the courts has supported the notion, that if a person does something whose primary purpose is to save taxes, the IRS has the power to undo that something. But the fact of the matter is, people do things all the time for the sole purpose of paying less in taxes.

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Interestedly enough, many tax laws are created with the idea that it will get people to do something: installing solar panels on a home, buying an electric vehicle, putting up a windmill on a farm. All of these undertaking are done primarily because of the tax benefits.

If you are caught doing somethings just for the tax savings, the court will ask you such questions as: Was there a reason other than saving money on taxes for the transaction? What was the non-tax reason for the business deal? Was the transaction motivated by profit?

Having the Economic Substance Doctrine put into law was like giving the bully a much bigger stick to hit us with to get our lunch money. However, we should have been on the lookout for said bully long before he had a bigger stick.

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What’s vital here is the “window dressing,” i.e., when shuffling assets out of the reach of creditors, you also should be doing estate planning tasks, such as wills and trusts, simultaneously. Again, this is the “window dressing,” not the economic doctrine issue itself.

When you’re asked if you transferred those assets to elude creditors (and save on taxes) you can now give the judge a satisfactory, window dressing, answer. If you don’t have a good answer, you’ll get slapped – hard – by the judge.

Everything you do that has anything to do with estate planning, tax planning, and asset protection needs to be done with a “window dressing,” another motive. If you can prove that the transaction was done for estate planning or asset protection motives, and not just to save money on taxes, then you will be removed from the consequences of the Economic Substance Doctrine.

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Falling prey to the Economic Substance Doctrine comes up most often in matter of estate planning and tax planning. Thinking ahead and creating a window dressing will save your butt down the road. The IRS’ main target is the guy who knows the investment will loose him a lot of money but save him a bundle in taxes.

If you can’t prove that the motivation behind your transaction, action, investment, or other business deal was something other than saving money in taxes, you’ll get hit by the big stick and it’ll hurt. Your initial tax savings will be disallowed in addition to a 40 percent fine, courtesy of the IRS.

Interested in learning more about the Economic Substance Doctrine or Wills and Trusts? Visit Phillips Estate Planning for free tips, videos, webinars, and other useful information.

categories: estate planning,personal finance,taxes

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