Planning for IRS Audits in an Era of Uncertainty
Using the economic substance doctrine as a general anti-abuse rule

In its ongoing crusade against so-called “basis-shifting” transactions, the Internal Revenue Service has created widespread uncertainty regarding the tax treatment of routine transactions.¹ For example, last year, the IRS released Revenue Ruling 2024-14,² establishing its position that the tax effect of certain related-party basis adjustment transactions should be disallowed under the economic substance doctrine. The IRS’ position set forth in Revenue Ruling 2024-14 is emblematic of the government’s increasing use of the economic substance doctrine as a general anti-abuse rule to disallow results it dislikes. The Department of the Treasury and the IRS also had finalized Treasury Regulations Section 1.6011-18, designating certain basis adjustment transactions among related parties as “transactions of interest,” which would require participants and material advisors to provide information about the transactions to the IRS.³ However, Treasury and the IRS have since announced their intent to remove the recently promulgated regulations from the Federal Register.⁴ This article summarizes Revenue Ruling 2024-14 and the promulgation and subsequent removal of Treasury Regulations Section 1.6011-18, discusses recent litigation concerning the economic substance doctrine, reviews the application of the economic substance doctrine as a tool of statutory interpretation, and provides important considerations for taxpayers in an audit where the IRS has invoked the economic substance doctrine.

Revenue Ruling 2024-14 and the Promulgation and Subsequent Removal of Treasury Regulations Section 1.6011-18

Prior to the promulgation of Treasury Regulations Section 1.6011-18, Treasury issued Notice 2024-54, which set forth its intent to publish two sets of regulations that “would address certain basis-shifting transactions involving partnerships and related parties.”⁵ The IRS simultaneously released Revenue Ruling 2024-14, setting out the IRS’ litigating position on certain transactions involving partnership basis adjustments. The revenue ruling sets forth three examples of basis adjustment transactions the tax results of which the IRS would disallow under the economic substance doctrine as clarified in Section 7701(o). Section 7701(o)(1) provides that, in the case of any transaction to which the economic substance doctrine is relevant, that transaction shall be treated as having economic substance only if 1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position, and 2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into that transaction. Furthermore, Section 7701(o)(5)(A) clarifies that the “term ‘economic substance doctrine’ means the common law doctrine under which tax benefits under subtitle A [of the Internal Revenue Code] with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.”

In Revenue Ruling 2024-14, the IRS asserted that “[u]nless a ‘meaning plainly appears’ that Congress intended a provision to grant a tax benefit to transactions without economic substance or business purpose, such an intent ‘will not [be] attribute[d] to Congress.’”⁶ The IRS stated in the revenue ruling that the “economic substance doctrine was developed to address transactions such as these, which follow the literal words of the Code but lie outside of Congress’s plain intent.”⁷ The IRS will apply the doctrine to transactions described in the revenue ruling despite their “literal compliance” with the Code, because the transactions, in the view of the IRS, lie outside of Congress’ plain intent.⁸ In addition, the IRS noted that it will assert that transactions give rise to a twenty percent penalty under Section 6662(b)(6), which will increase to forty percent for nondisclosed noneconomic substance transactions under Section 6662(i),⁹ for the portion of any underpayment attributable to a transaction lacking economic substance under Section 7701(o). The reasonable cause exception under Section 6664 does not apply to penalties asserted under Section 6662(b)(6) and (i), effectively making them strict liability penalties.¹⁰

On January 14, 2025, Treasury and the IRS released final regulations designating certain basis adjustment transactions among related parties as “transactions of interest.”¹¹ Under the final regulations as promulgated, material advisors and participants would have been required to disclose these and “substantially similar” transactions to the IRS, with penalties for noncompliance. The partnership and the partners that participated in the related-party basis adjustment transaction would have been required to file a Form 8886, Reportable Transaction Disclosure Statement, for each taxable year of participation. Material advisors also would have been required to make disclosures by filing Form 8918, Material Advisor Disclosure Statement, by the last day of the month following the end of the calendar quarter in which they became material advisors.

However, in an unusual move, in Notice 2025-23, Treasury and the IRS recently announced their intent to remove Treasury Regulations Section 1.6011-18. Notice 2025-23 provides immediate relief from penalties for participants and material advisors that would have been required to file disclosure statements for transactions identified as “transactions of interest.” Notice 2025-23 also withdrew Notice 2024-54, “which describes certain proposed regulations that the Treasury Department and the IRS intended to issue addressing partnership related-party basis shifting transactions.”¹²

Although Treasury Regulations Section 1.6011-18 will be removed and Notice 2024-54 has been withdrawn, recent cases shed light on the IRS’ litigating position concerning the application of the economic substance doctrine.

Recent Litigation Involving the Economic Substance Doctrine

The recent disputes in Liberty Global, Inc. v. United States¹³ and Patel v. Commissioner¹⁴ are clear examples of the IRS’ use of the economic substance doctrine as a weapon against taxpayers’ business transactions, leading taxpayers to question whether the IRS, and the courts, can simply invoke the economic substance doctrine to disallow results with which they disagree. These cases exemplify the inherent uncertainty caused by the IRS’ interpretation of the economic substance doctrine as a general anti-abuse rule with no threshold relevance requirement. The 2024 decision of a US district court in Exxon Mobil Corp. v. United States¹⁵ demonstrates the difficulties the IRS may have in convincing courts that the economic substance doctrine is a general anti-abuse rule. We discuss this important trio of cases below.

Liberty Global, Inc. v. United States

In an attack on transactions that comply with the letter of the law, the US District Court for the District of Colorado disallowed the tax treatment claimed by Liberty Global under the economic substance doctrine.¹⁶ In that case, Liberty Global argued that the economic substance doctrine did not apply due to a threshold relevancy determination that was unmet.¹⁷ The district court found that “the economic substance doctrine applies when a transaction lacks economic substance.”¹⁸ An appeal is pending before the US Court of Appeals for the Tenth Circuit. A decision from the Tenth Circuit will be binding authority for taxpayers residing in Colorado, Kansas, New Mexico, Oklahoma, Utah, and Wyoming.

In its opening brief in the Tenth Circuit, Liberty Global argued that the IRS wrongly wielded the economic substance doctrine to rewrite the law rather than to interpret it.¹⁹ Liberty Global argued that the doctrine is relevant only when ordinary interpretive tools show that a tax term’s application turns on “economic reality” and “taxpayer motive.”²⁰ Liberty Global noted that some provisions, like those at issue in the case, do not make economic reality and taxpayer motive relevant but rather allow the taxpayer to make choices purely based on tax consequences.²¹ Liberty Global criticized the district court’s analysis in collapsing the statutorily mandated threshold relevance inquiry with the two-prong test of Section 7701(o)(1).²²

The government in Liberty Global argued that there is no threshold relevance test divorced from the facts and circumstances of each case.²³ Furthermore, the government argued that the economic substance doctrine is not an interpretive canon but rather a substantive anti-abuse rule that applies to all Code provisions unless Congress clearly indicates otherwise.²⁴ Thus, in the government’s view, economic reality and taxpayer motive are relevant for all tax provisions unless Congress explicitly says otherwise.²⁵

During oral arguments, the appellate panel was focused on whether there was a threshold relevance inquiry and when the doctrine should be considered relevant. The US Court of Appeals questioned whether the doctrine is relevant in all types of transactions except for personal transactions of individuals as set forth in Section 7701(o)(5)(B). Liberty Global argued that Section 7701(o)(5)(B) is but one exception to the application of the doctrine. Liberty Global also argued that the doctrine is not relevant where the taxpayer’s economic position is what the taxpayer claims and what the Code requires. Consistent with its opening brief, the government argued that the economic substance doctrine applies to all transactions that generate tax benefits unless Congress provides otherwise, and relevance can be determined only after examining the facts and circumstances of each case. The Tenth Circuit heard oral arguments for the Liberty Global case on November 19, 2024. The median interval from oral argument to decision in the Tenth Circuit is about three months; therefore, a decision has been anticipated in the first half of 2025.

Patel v. Commissioner

The US Tax Court is considering issues of broad importance related to the economic substance doctrine in Patel v. Commissioner. That case involves an arrangement the IRS characterizes as a micro-captive structure, a tax strategy the IRS has long considered abusive.²⁶ In Patel, the tax court sustained the commissioner’s deficiency determinations disallowing the taxpayers’ deductions of insurance premiums as business expenses.²⁷ The IRS did not assert that the deduction should be disallowed under the economic substance doctrine. However, the commissioner asserted the twenty percent accuracy-related penalty under Section 6662(a) and Section 6662(b)(6) for the portion of any underpayment attributable to a transaction lacking economic substance within the meaning of Section 7701(o).²⁸ In response to the assertion of penalties due to the failure to meet the requirements of the economic substance doctrine, the taxpayers argued that the use of the phrase “[i]n the case of any transaction to which the economic substance doctrine is relevant”²⁹ leaves the application of the doctrine ambiguous.³⁰ The tax court ordered the parties to submit briefs regarding whether Section 7701(o) contains a threshold relevancy determination and, if it does, when the economic substance doctrine is “relevant” within the meaning of Section 7701(o).³¹ Recognizing that the case involved questions of first impression in the tax court concerning Section 7701(o), the court took the highly unusual step of inviting amicus briefs.³² Ten organizations submitted amicus briefs. Section 7701(o) contains two explicit provisions: 1) the application of the economic substance doctrine is limited to those situations and transactions where it is “relevant,”³³ and 2) courts shall determine whether the economic substance doctrine is “relevant” as if the statute had never been enacted.³⁴ Treating relevancy as a threshold determination mandates that courts and the IRS determine whether the doctrine is relevant as a first step in analyzing a transaction. If the doctrine is not “relevant,” it simply does not apply, and there is no basis to proceed to the second step of evaluating a transaction under the “clarified” two-prong test.

The tax court heard oral arguments in the Patel case on February 12, 2025. At oral argument, Judge Courtney Dunbar Jones seemed inclined to conclude that Section 7701(o) requires a relevancy determination but did not appear disposed to conclude—at least in the context of the Patel case—that certain transactions or Code provisions exist to which Section 7701(o) is never relevant.

Exxon Mobil Corp. v. United States

In another attempt to wield the economic substance doctrine as a general anti-abuse rule, the IRS sought to disallow Exxon Mobil Corporation’s deductions for certain production payments that complied with the literal letter of the Code.³⁵ In declining to apply the economic substance doctrine to disregard the production payments, the US District Court for the Northern District of Texas noted that the economic substance doctrine is not a “‘smell test’ that authorizes the government or the courts to disregard the plain meaning of a statute that specifies the applicable tax treatment.”³⁶ Rather, the court noted that the doctrine “recognizes and respects” taxpayers’ ability to “choose to finance transactions in tax efficient ways.”³⁷ In the court’s view, like other judicial doctrines, the economic substance doctrine cannot be used to “override the congressionally mandated tax treatment.”³⁸ Because the “plain meaning” of the statute at issue was “clear and unmistakable,” the economic substance doctrine simply did not apply.³⁹ The decision of the district court is appealable to the US Court of Appeals for the Fifth Circuit.

Taken together, Liberty Global, Patel, and Exxon Mobil paint a picture of an aggressive IRS litigating position, with mixed results in court.

The Doctrine as a Tool of Statutory Construction

In our view, the economic substance doctrine, both under common law and as clarified in Section 7701(o), is a tool of statutory construction. It is not a substantive anti-abuse rule that the IRS, or the courts, can use to disallow results that follow the letter of the law but are inconsistent with their own “individual policy preferences.”⁴⁰ In the 1935 foundational case establishing the economic substance doctrine, Gregory v. Helvering, the Supreme Court considered “whether what was done, apart from the tax motive, was the thing which the statute intended.”⁴¹ The heart of the opinion is one of statutory interpretation. The Court sought to determine the meaning of the statute drafted by Congress.

In the US Court of Appeals for the Second Circuit’s predecessor opinion in Helvering v. Gregory,⁴² the court carefully analyzed the facts along with the statute at issue. The Second Circuit noted that: “[i]f what was done here, was what was intended by [the statute], it is of no consequence that it was an elaborate scheme to get rid of taxes, as it certainly was.”⁴³ Thus, when relevant, the economic substance doctrine is a tool to interpret a statute consistent with the intent of Congress.

Indeed, the US Constitution grants the power to enact law imposing a federal income tax to Congress alone. Congress exercised that power by enacting the Code. Courts are empowered to interpret provisions of the Code, but they are not authorized to change the laws as written by Congress.⁴⁴ Thus, the economic substance doctrine as developed by these foundational precedents must be applied as what it is—a tool of statutory interpretation—not as carte blanche to ignore outcomes dictated by the Code due to perceived abuse. As demonstrated above, the IRS’ increased invocation of the economic substance doctrine leads to pervasive uncertainty for taxpayers both during and after routine transactions. Consequently, taxpayers should be aware of certain considerations in the event the IRS invokes the economic substance doctrine in an audit.

Important Considerations When Audits Invoke the Doctrine

It is difficult to predict when the IRS will invoke the economic substance doctrine. Where the IRS views a tax result as too good to be true, it is more likely to raise questions of economic substance and business purpose. The likelihood seems to increase even more where tax advisors provide tax advice in the course of the transaction, even though obtaining tax planning advice in business transactions is, of course, customary and expected.

In the IRS audit context, observation suggests that the IRS raises the question of business purpose more often and earlier than in the past—including in the context of partnership audits. Where a partnership basis adjustment transaction falls within the scope of Revenue Ruling 2024-14, it is expected that the IRS agent will apply the revenue ruling’s conclusion and examine the transaction’s economic substance. The revenue ruling, after all, is the IRS’ litigating position and therefore provides a good overview of how it will challenge the transaction.

Economic substance audits typically are intense, since the question of economic substance is highly fact specific. The audits can be document intensive and often require the testimony (formal or informal) of businesspersons involved in the transaction. And even when objective criteria seem obvious, one must still consider whether evidence is available to prove subjective motives. It is therefore important to consider at the outset how a taxpayer will prove compliance with the economic substance doctrine—especially because the taxpayer typically bears the burden of showing that its tax return is correct.

As noted above, penalties imposed for lack of economic substance are not subject to a reasonable cause defense. Thus, it is critical to consider whether it would be advisable to disclose privileged tax advice. Disclosing a privileged communication likely will lead to the required production of other privileged communications on the same topic due to subject matter waiver issues. Moreover, tax opinions often provide the IRS with a road map on the issues to be examined, including issues that the IRS may not otherwise have questioned.

Resolving an economic substance issue is often time consuming and expensive. Where an IRS agent has determined that economic substance is lacking, the likelihood of resolving the issue before the IRS Independent Office of Appeals on terms that are satisfactory to the taxpayer is ordinarily low. Thus, where a taxpayer is unwilling to concede the matter, questions of economic substance frequently lead to protracted litigation. Resolving economic substance cases can take years; they are extremely document intensive and can involve significant disputes over discovery, which may include disputes over privileged materials. Taking steps early in the process—before an audit even commences—to consider the economic substance doctrine, including making sure there is adequate evidence to prove both prongs of the doctrine, could mitigate some of the common issues that may emerge in a later dispute.

Kathy Pakenham and Adriana Wirtz are partners at Vinson & Elkins. Their practices focus on tax controversy, litigation, and risk management.

Endnotes

1. Unless otherwise noted, all “Section” references are to sections of the Internal Revenue Code of 1986, as amended (the “Code”), and all references to “regulations” are to the Treasury Regulations promulgated thereunder.
2. 2024-28 Internal Revenue Bulletin 18.
3. See Treasury Regulations Section 1.6011-18.
4. See Notice 2025-23.
5. 2024-54 Internal Revenue Bulletin 24.
6. Revenue Ruling 2024-14 (quoting Knetsch v. United States, 364 U.S. 361, 367–69 (1960)).
7. Revenue Ruling 2024-14 (citing Gregory v. Helvering, 293 U.S. at 469–70 (1935)).
8. See Revenue Ruling 2024-14 (quoting Coltec Industries, Inc. v. United States, 454 F.3d 1340, 1354 (Federal Circuit 2006) and citing Gregory v. Helvering, 293 U.S. at 469–70).
9. According to Section 6662(i)(2), a nondisclosed noneconomic substance transaction means any portion of a transaction with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return.
10. Section 6664(c)(2).
11. Treasury Regulations Section 1.6011-18.
12. Notice 2025-23.
13. No. 23-01410 (Tenth Circuit, argued November 19, 2024).
14. Nos. 24344-17, 11352-18, 25268-18 (U.S. Tax Court, argued February 12, 2025).
15. No. 3:22-CV-00515-N (Northern District of Texas, October 30, 2024).
16. Liberty Global, Inc. v. United States, No. 1:20-CV-035501-RBJ, 2023 Bloomberg Law 426671, at *13 (District of Colorado, October 31, 2023).
17. Liberty Global, Inc., 2023 Bloomberg Law 426671, at *4–6.
18. Liberty Global, Inc., 2023 Bloomberg Law 426671, at *6.
19. Plaintiff-Appellant Liberty Global, Inc.’s Opening Brief at 3, Liberty Global, Inc. v. United States, No. 23-01410 (Tenth Circuit, April 30, 2024).
20. Plaintiff-Appellant Liberty Global, Inc.’s Opening Brief at 39, Liberty Global, Inc., No. 23-01410.
21. Plaintiff-Appellant Liberty Global, Inc.’s Opening Brief at 53–58, Liberty Global, Inc., No. 23-01410.
22. Plaintiff-Appellant Liberty Global, Inc.’s Opening Brief at 36–37, Liberty Global, Inc., No. 23-01410.
23. Brief for the Appellee at 43–47, Liberty Global, Inc. v. United States, No. 23-01410 (Tenth Circuit, June 27, 2024).
24. Brief for the Appellee at 29, Liberty Global, Inc., No. 23-01410.
25. Brief for the Appellee at 50, Liberty Global, Inc., No. 23-01410 (emphasis in original).
26. Treasury and the IRS promulgated final regulations on January 14, 2025, designating certain micro-captive insurance transactions, involving small captive insurance companies that elect to be taxed only on net investment income under Section 831(b), as listed transactions under Treasury Regulations Section 1.6011-10(c) or transactions of interest under Treasury Regulations Section 1.6011-4(b). Treasury Decision 10029, 2025-9 Internal Revenue Bulletin 936. Micro-captive insurance arrangements were listed on the IRS’ “Dirty Dozen” list from 2022 to 2024. See IRS News Release IR-2022-125 (June 10, 2022); IRS News Release IR-2023-71 (April 5, 2023); and IRS News Release IR-2024-105 (April 11, 2024). Notably, the micro-captive insurance arrangements were not listed on the “Dirty Dozen” list for 2025. See IRS News Release IR-2025-26 (February 27, 2025).
27. Patel v. Commissioner, Tax Court Memorandum 2024-34.
28. Patel v. Commissioner, Tax Court Memorandum 2020-133.
29. Section 7701(o)(1) (emphasis added).
30. See Order at 2, Patel v. Commissioner, Nos. 24344-17, 11352-18, 25268-18 (Tenth Circuit, July 19, 2024).
31. Order at 2, Patel, Nos. 24344-17, 11352-18, 25268-18.
32. Order at 3, Patel, Nos. 24344-17, 11352-18, 25268-18.
33. Section 7701(o)(1).
34. Section 7701(o)(5)(C).
35. Exxon Mobil Corp. v. United States, No. 3:22-CV-00515-N, slip opinion at 15, paragraph 43, at 29–30, paragraph 37 (Northern District of Texas, October 30, 2024).
36. Exxon Mobil Corp., No. 3:22-CV-00515-N, at 29–30, paragraph 37 (citing Benenson v. Commissioner, 887 F.3d 511, 523 (First Circuit 2018)).
37. Exxon Mobil Corp., No. 3:22-CV-00515-N, at 30, paragraph 38.
38. Exxon Mobil Corp., No. 3:22-CV-00515-N, at 30, paragraph 39.
39. Exxon Mobil Corp., No. 3:22-CV-00515-N, at 31, paragraph 41.
40. See Loper Bright Enterprises v. Raimondo, 603 U.S. 369, 374 (2024); accord Varian Medical Systems, Inc. v. Commissioner, 163 Tax Court No. 4 at 18 (U.S. Tax Court 2024) (citing cases).
41. Gregory v. Helvering, 293 U.S. at 469 (emphasis added).
42. Helvering v. Gregory, 69 F.2d 809 (Second Circuit 1934).
43. Helvering v. Gregory, 69 F.2d at 810–11 (Second Circuit 1934).
44. See Loper Bright, 603 U.S. at 369 (explaining that when “the meaning of a statute was at issue, the judicial role was to interpret the act of Congress, in order to ascertain the rights of the parties”) (internal quotation and citation omitted).