Strictly Wrong as a Tax Policy: The Strict Liability Penalty Standard in Noneconomic Substance Transactions

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This Note analyzes the propriety of using a strict liability standard to assess tax penalties for transactions lacking economic substance. Non-economic substance transactions lack legitimate business objectives and exist only to produce tax benefits. Under current law, the Internal Revenue Service can disallow the tax benefit claimed by the taxpayer and then assess a penalty for the taxpayer’s understatement of tax liability. In response, the taxpayer can assert a reasonable cause exception, which can serve as a defense to the penalty should the taxpayer demonstrate that he had reasonable basis for his tax position. In the last decade, numerous legislative proposals sought to eliminate the reasonable cause exception and replace it with a strict liability standard. This Note examines the conflict created by this potential change in the tax law. This Note begins by defining the economic substance doctrine, as used in the U.S. courts of appeals, to determine whether a transaction lacks economic substance. This Note then explains the accuracy-related penalty assessed for non-economic substance transactions, as well as the reasonable cause exception to the penalty. Two cases illustrate the interaction of the economic substance analysis, the tax penalty, and the reasonable cause exception. Next, this Note summarizes legislative proposals spanning from 1999 to 2009, which would codify the economic substance doctrine and adopt a strict liability penalty standard. The strict liability standard is then analyzed at length, as this Note discusses the arguments for and against it. Ultimately, this Note concludes that on balance, the strict liability standard should not be adopted, but regardless of whether the current penalty regime is retained or alternative solutions are developed, the reasonable cause exception should remain a feature of the standard by which to penalize non-economic substance transactions.