In 2025, the doctrines of business purpose and economic substance are once again at the forefront of tax compliance and litigation. These longstanding judicial doctrines—codified at the federal level and increasingly embraced by states—are now being applied to dismantle complex structures designed to reduce tax liabilities. As courts and revenue agencies step up enforcement, taxpayers must be prepared to demonstrate that their transactions have genuine economic consequences and legitimate non-tax business purposes.

This article explores the current state of economic substance doctrine (ESD), key federal developments, and recent state court decisions where tax authorities successfully disallowed tax benefits on the basis of sham transactions or lack of economic substance. The article also outlines practical takeaways for tax professionals structuring or defending tax-sensitive transactions in 2025.

A Brief History of Economic Substance and Business Purpose Doctrines

The economic substance and business purpose doctrines originate from judicial decisions, most notably the Supreme Court’s ruling in Gregory v. Helvering, 293 U.S. 465 (1935). In Gregory, the Court denied tax benefits for a corporate reorganization that lacked any genuine business purpose beyond tax avoidance. This foundational case cemented the idea that a transaction, no matter how compliant in form, must have substance and a valid business rationale to receive favorable tax treatment.

Over time, additional doctrines developed to police tax-motivated behavior:

• Business purpose doctrine: A transaction must serve a substantial business purpose other than tax reduction.

• Substance-over-form doctrine: The substance of a transaction—not its legal form—governs tax consequences.

• Sham transaction doctrine: Transactions without real economic activity or purpose are disregarded.

• Step transaction doctrine: Multiple formally distinct steps may be treated as a single transaction if interdependent.

Federal Codification of Economic Substance Doctrine (IRC § 7701(o))

In 2010, Congress codified a version of the economic substance doctrine at IRC § 7701(o). Under this statute, a transaction will be treated as having economic substance only if:

1. Objective Test: The transaction meaningfully changes the taxpayer’s economic position, apart from federal income tax effects;

2. Subjective Test: The taxpayer has a substantial non-tax purpose for entering into the transaction.

Codification also introduced significant penalties:

• IRC § 6662(b)(6) imposes a 20% penalty (or 40% if undisclosed) for underpayments due to disallowed benefits under the ESD.

• The penalty is strict liability—there is no reasonable cause defense.

The statute includes exemptions for personal transactions, debt vs. equity structuring, certain international entity choices, and reorganizations under subchapter C—but only if conducted under recognized norms and not solely for tax reduction.

IRS Internal Revenue Manual Factors

The Internal Revenue Manual provides additional guidance, listing factors that may indicate a transaction lacks economic substance:

• Structuring that creates no real economic effect apart from tax

• Lack of arm’s-length terms or third-party involvement

• No credible profit potential or risk of loss

• Deductions without corresponding economic loss

• Absence of any role in the taxpayer’s ordinary business operations

These criteria are now standard in IRS examinations, and many state revenue departments are adopting similar frameworks.

The Liberty Global Case: Federal ESD Enforcement in Action

A recent federal district court decision provides a blueprint for modern ESD litigation. In Liberty Global, Inc. v. United States, the court rejected a multistep transaction designed to take advantage of international tax mismatches. The court emphasized the following:

• The entire series of steps must be analyzed collectively.

• Even where each step has technical validity, the transaction fails if it lacks real economic impact or substantial non-tax purposes.

• The generation of earnings and profits (E&P) through coordinated steps for the purpose of securing a dividend deduction under § 245A was insufficient.

• The court imposed full tax consequences on the gain, disregarding intermediate steps and denying the claimed deduction.

This case affirms that courts will reject transactions where tax benefits are the sole objective, especially if the steps are choreographed over a short period and lack economic reality.

State-Level Expansion of Economic Substance Doctrine

More states are now adopting or enforcing economic substance principles. While some follow federal definitions under conformity statutes, others have codified state-specific ESD provisions. Notable states include:

• California: Cal. Rev. & Tax. Code § 19774(c)(2)

• Colorado: Colo. Rev. Stat. § 39-22-303(8)

• Massachusetts: Mass. Gen. L. ch. 62C, § 3A

• North Carolina: N.C. Gen. Stat. § 105-130.5A(a)

• Ohio: Ohio Rev. Code § 5703.56

• Wisconsin: Wis. Stat. § 71.30(2m)

Even in states without formal codification, agencies apply common law doctrines to disallow tax avoidance structures.

Recent State Cases Applying the Economic Substance Doctrine

Massachusetts: Allied Domecq Spirits & Wines USA, Inc.

In this case, the taxpayer shifted employees and office space to a parent entity to create tax nexus and claim favorable inclusion in combined returns. The state tax board and appellate court found the transfer had no credible business purpose and was structured purely for tax savings. Internal documents confirmed that no contemporaneous rationale existed beyond tax planning.

Illinois: PepsiCo Inc.

PepsiCo created a domestic shell company to house expatriate payroll, thereby qualifying for the 80/20 exclusion. The court concluded that the entity had no economic substance, no employees or assets, and existed solely to exclude $2.4 billion in domestic income. The court emphasized that common law employment factors, not internal documents, control the analysis of entity legitimacy.

Illinois: Midwest Medical Equipment

The taxpayer claimed a substance-over-form argument to preserve a sales tax exemption when transactions were restructured through intermediaries. The court rejected the argument, finding the new contractual arrangement materially altered the purchaser and nature of the transaction.

Wisconsin: Skechers USA Inc.

Skechers formed an IP-holding subsidiary and paid royalties to it, claiming deductions. The state disallowed the deductions, and the court agreed, finding that the transaction lacked economic substance and was motivated solely by tax reduction. On appeal, the taxpayer argued post-formation substance developed, but the court focused on the purpose at the time of formation.

Minnesota: HMN Financial

A Minnesota Supreme Court case refused to let the Department of Revenue disregard transactions under an economic substance rationale without specific statutory authority. This case is an outlier, underscoring that not all states grant broad discretion to revenue agencies in applying ESD.

New York: Skidmore, Owings & Merrill LLP

A professional services firm formed an S-DISC to reduce federal and local tax on partner compensation. The court upheld denial of the claimed deduction, finding the S-DISC was designed solely for tax savings and lacked economic substance, even if it complied with federal form requirements.

Key Takeaways for Taxpayers and Advisors

The following best practices are critical for navigating the business purpose and economic substance doctrines:

1. Document Intent: Maintain contemporaneous records that reflect a non-tax business rationale for the transaction.

2. Support Business Substance: Show that the transaction alters economic rights, responsibilities, or operational structures in a meaningful way.

3. Anticipate Aggregation: Assume that all related steps will be analyzed collectively, not in isolation.

4. Beware of “Paper Entities”: Ensure new entities have capital, staff, assets, or operations—substance matters more than form.

5. Align Internal and External Communications: Avoid internal emails or memos that undermine the stated purpose.

6. State-Level Scrutiny Is Rising: Review transactions not just for federal exposure, but also for state-level audit risk.

Conclusion: Economic Substance Is No Longer Optional

The business purpose and economic substance doctrines are alive and well—and expanding in scope. In 2025, both federal and state authorities are closely examining transactions that lack commercial reality, and courts are showing little patience for tax structures designed to exploit technical compliance without substantive merit. Companies engaging in tax planning must ensure that their transactions can withstand scrutiny not just on form, but on the substance of what the transaction actually does in the real economy.

© 2025 Jeanette Moffa. All Rights Reserved.