Economic Substance and Tax Planning

As we move into Q2 2026, two recent Tax Court decisions from Q1 are worth paying attention to for their reinforcement of a core principle in how tax positions are evaluated in practice.

The IRS and courts increasingly continue to analyze tax positions under the economic substance doctrine. In Otay Land Company, LLC v. Commissioner, the Tax Court disallowed over $700 million in deductions tied to a partnership basis step-up. While the transaction involved a technical termination under prior law, the issue was more fundamental.

The basis step-up did not reflect the economic realities of the partnership. The partnership had a section 754 election in place. The basis step up was documented and followed the correct form. However, at the heart of it, the position lacked economic substance. In fact, in its opinion the Tax Court states, “With respect to the subjective aspect of the transactions at issue…was “an artifice to facilitate indefinite tax deferral…and when considering the subjective elements of the transactions at issue, we struggle to find a compelling non-tax business purpose.”

Moreover, the court stated, “After examining the tax opinions rendered by EY it seems rather apparent that the transactions at issue were predetermined and engineered principally to create a substantial inside-outside basis disparity…which in turn sought to achieve indefinite tax deferral for [the partners]. The transactions at issue are exceedingly complex and contrived by outside tax advisors in furtherance of one goal: elimination of deferred taxable gain. Accordingly, after considering these subjective factors we cannot conclude that the transactions at issue contain a useful non-tax business purpose. Although tax laws affect nearly every business transaction, tax consequences should not and cannot be the driving factor for structuring a transaction.”

In Royalty Management Insurance Co. Ltd. v. Commissioner, the Court revisited a microcaptive insurance arrangement, this time in the context of penalties. The underlying structure had already been challenged and found to lack real insurance risk and economic substance. In its opinion, the Court states, “The transactions did not result in a meaningful change in economic position with respect to insurance.” However, in this case, the taxpayer was particularly keen on achieving contrived tax benefits.

The opinion also states, “we note evidence showing [the taxpayer’s] focus on income tax benefits when he decided to form his second microcaptive. Even though he was aware of the IRS examination his first microcaptive and other captives formed by his advisor, he insisted on forming another captive. Emails over the next several months discussed the ownership structure both microcaptives, in no small part for the purpose of determining the new captive's income tax benefits.”

The Court sustained 40% penalties. These cases highlight a point that is often understated in tax planning. It is possible to have a transaction that is technically structured, documented, and seemingly feasible, yet still fail scrutiny when viewed through the lens of the economic substance doctrine

At a practical level, the analysis remains consistent:

• Has anything actually changed from an economic standpoint?

• Is there a real business purpose driving the structure?

If those questions cannot be answered clearly, the position will not sustain. Taking an affirmative position in tax planning is not inherently problematic. However, it requires more than simply reaching a desired outcome. A defensible position is one that is grounded in real economics, supported by analysis, and capable of withstanding scrutiny if challenged.

These decisions underscore the role of legal analysis in tax planning and where the role of a Tax Attorney becomes critical.The analysis is not limited to whether something can be done. It extends to whether it should be done, and whether it is defensible.

If you are relying on a tax strategy or structure, the question is not just whether it works, but whether it is properly aligned with the underlying economics. Positions that are not aligned can often be adjusted, refined, or restructured before they are tested.

If you would like to evaluate or adjust a position, you can schedule a consultation.