IRS Seeks to Reduce the Impact of Its Economic Substance Doctrine Field Directive by Stating it is Not Legal Precedent

Oct 14, 2011   

On October 6, 2011, the Internal Revenue Service (IRS) announced that its July 15, 2011 field directive (the “directive”) pertaining to the codified economic substance doctrine (the “doctrine”) should not be viewed as legal precedent because the IRS reserves the ability to modify the directive at any time.

According to Mark Periwen, special counsel to the Associate Chief Counsel, the directive is “just that,” and therefore does not have the force of law.  Notably, the function of field directives issued to employees of the IRS is similar to the function of the Internal Revenue Manual (IRM), which directs IRS personnel in their day-to-day activities. Smith v. U.S., 478 F.2d 398 (5th Cir. 1973).  This does not follow, however, that field directives and the IRM will not be taken into consideration by reviewing courts.

Instead, as discussed in Griswold v. United States, 59 F.3d 1571, 1575 n. 8 (11th Cir. 1995), "[w]hile the IRS Manual does not have the force of law, the manual provisions do constitute persuasive authority as to the IRS’s interpretation of the statute and the regulations." (emphasis added).  Similarly, each field directive provides insight as to the IRS’s interpretation of the laws it is entrusted to enforce.

As we previously reported here, transactions shall be treated as having economic substance only if the transaction changes the taxpayer’s economic position in a meaningful way and the taxpayer has a substantial purpose for entering into the transaction. The doctrine only applies to a transaction entered into in connection with a trade or business or activity engaged in for income.

Taxpayers are concerned how the IRS will apply the doctrine due to the no-fault penalty of up to 40 percent. Tax practitioners speculate the issuance of the directive suggests the IRS wants to ensure that the doctrine is appropriately applied.  In fact, the directive specifically provides that agents should limit the assertion of penalties to transactions that implicate the doctrine and not a “similar rule of law” as provided in the statute.

The IRS’s original field directive regarding the application of IRC §7701(o) was issued on September 14, 2011 with the objective “to ensure consistent administration of the strict liability penalty related to the application of the doctrine.”  The July 15, 2011 field directive was issued to “instruct examiners and their managers how to determine when it is appropriate to seek the approval of the Director of Field Operations in order to raise the economic substance doctrine.”

As further elaborated in the directive:

Once an examiner determines that raising the doctrine may be appropriate, this directive sets forth a series of inquiries the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.

The directive, which is publicly available to all Taxpayers, clearly provides the IRS’s interpretation of IRC §7701(o).  Although it may not be binding as legal precedent, it is nonetheless highly persuasive and will not be ignored by courts that are deciding issues pertaining to the application of the doctrine.

Fuerst Ittleman will continue to monitor the progress of cases where the doctrine may be an issue. Our professionals at are knowledgeable in the newly codified economic substance doctrine. If you believe you have been affected by the new law, please contact our professionals at