The Case Against a Strict Liability Economic Substance Penalty

The latest wave in tax shelter reform is the recent codification of the so-called “economic substance doctrine” and the accompanying strict liability penalty for violations of the doctrine. The new strict liability penalty has been criticized by tax scholars and practitioners for being unfair and disproportionate. However, most commentators have not evaluated whether there is any need for a separate penalty for violations of the economic substance doctrine at all, strict liability or otherwise. The first part of this Article considers the new economic substance penalty in light of the current penalties applicable to tax shelters and argues that a separate penalty provision for violations of the economic substance doctrine should not have been enacted. This Article will demonstrate that the current accuracy-related penalty regime is sufficient to address transactions that violate the economic substance doctrine and that the new penalty adds significant and undue complexity to the current regime. This Article will then explore the strict liability aspect of the penalty and consider whether there is any justification for carving out transactions that violate the economic substance doctrine as especially deserving of strict liability as compared to other tax shelter transactions. Congress’s justifications for the new strict liability penalty largely focus on taxpayer deterrence and reducing disadvantages to the IRS in enforcing penalties. However, Congress has failed to articulate why violations of the economic substance doctrine have been singled out for strict liability when other tax shelter penalties contain taxpayer defenses. The only way to properly justify a new tax shelter penalty with strict liability would be to tie that penalty to the most egregious forms of taxpayer misconduct, but there appears to be no link between violations of economic substance and the worst kinds of tax shelters. Given that violations of the economic substance doctrine are not a proxy for the most abusive tax shelter transactions, this Article concludes that the imposition of a strict liability penalty cannot be reconciled with other tax shelter penalties that provide for various forms of a reasonable cause defense