When economic substance becomes a litigation surprise
Economic substance has learned to wait.
The economic substance doctrine exists to stop transactions that comply with the Code but defeat its purpose.
Over time, that tool has shifted from a backstop to a latent threat. It now appears less as a predictable filter and more as a device that can surface late, even after careful planning and partial victories.
What happened?
Congress codified the economic substance doctrine in 2010.
§7701(o) requires two things when the doctrine is relevant. The transaction must meaningfully change the taxpayer’s economic position apart from tax effects. The taxpayer must also have a substantial non-tax purpose.
At the same time, Congress created a 20% penalty, increased to 40% in some cases, for transactions lacking economic substance. The penalty is strict liability. Reasonable cause does not apply.
In 2022, the IRS issued internal guidance removing the requirement for executive approval before exam teams could assert the doctrine and the penalty. The stated goal was to increase use where appropriate.
Despite that change, reported assertions of the penalty remain rare. Public IRS data does not track it separately. Only a small number of cases outside clearly abusive shelters address the penalty directly.
In several recent cases, the IRS assessed the penalty during examination but later conceded it in court due to procedural or factual issues.
What has changed is timing.
In multiple cases, the government raised economic substance for the first time during litigation rather than during audit.
In Patel v. Commissioner, a captive insurance case, the IRS included the penalty in the notice of deficiency but did not cite economic substance as the reason for disallowing deductions.
The government raised the doctrine for the first time in its answer. The Tax Court sustained the argument.
In Liberty Global, Inc. v. United States, the taxpayer obtained summary judgment on statutory grounds under §245A and on the invalidity of regulations. In the next phase, the government successfully invoked economic substance to undo the result. The case is now on appeal in the Tenth Circuit.
The institutional pattern
The pattern is not aggressive in volume. There is uncertainty in the process.
Economic substance now operates as a flexible litigation argument rather than a defined audit position. That flexibility favors the government. It also weakens taxpayers’ ability to assess hazards, price settlements, and plan defense strategy.
The strict liability penalty magnifies the imbalance. When the doctrine appears late, the taxpayer has already made irreversible decisions. Discovery is underway. Costs are sunk. The penalty exposure becomes real only after the procedural window for mitigation has closed.
This pattern reflects institutional strain more than intent.
The 2022 guidance followed years of examiner attrition and uneven training on judicial doctrines. Knowing when §7701(o) is relevant requires judgment and experience. Both have been in short supply.
Ongoing staffing disruption has pushed complex doctrine analysis down the priority list during audits. The result is not restraint. It is deferred.
The doctrine resurfaces later, handled by litigators rather than exam teams.
Lessons for practitioners
The doctrine’s relevance threshold matters more than its merits.
Late-stage assertions change risk without changing facts.
Strict liability penalties exacerbate procedural timing issues.
Transactions Congress explicitly encouraged still face scrutiny.
Documentation shapes credibility long before litigation begins.
Taxpayers plan transactions in accordance with statutes and guidance. Exam teams work under turnover and shifting mandates. Counsel steps in once positions harden. Each group responds rationally to its incentives. The friction arises where those incentives do not align in time.
Forward view
This pattern is likely to persist in the near term. Internal guidance remains in place. Examiner experience remains uneven. Litigation teams will continue to inherit incomplete audit records and search for doctrines that fit the remaining facts.
Economic substance will appear less as a gatekeeper and more as a backstop argument. Especially in large or unusual transactions, taxpayers should assume it will be evaluated at some stage, even if not during audit.
Related-party loans illustrate the point.
Courts still focus on basic signals of economic reality. Market terms. Actual payments. Cash movement. Formal approvals. Consistent internal treatment.
Patel and the eventual outcome in Liberty Global may also clarify limits. Both cases highlight the relevance inquiry and the tension between targeted incentives and broad doctrines. That clarity will come slowly.