Suppose someone offered you a business opportunity that would let you defer tax on your passive income, then later benefit from lower tax rates by converting ordinary income to capital gain. Would you invest?
In general, structuring business activities in a tax-efficient manner is part of good planning. However, when you enter into a transaction with no bona-fide business motive and that transaction changes nothing but your tax situation, you can run afoul of the economic substance rules.
These rules were not found in the tax code prior to the 2010 health care laws. Instead, they were applied by courts to individual cases. Now, economic substance is defined by a two-part test. When the rules apply, your economic position must change in a meaningful way and you must have a substantial business purpose for choosing a course of action.
What happens if you fail the economic substance test? You lose any tax benefits you claimed and you may be subject to a penalty of up to 40% of the underpayment caused by the loss of the benefits.
Please contact us before you decide to participate in ventures that purport to save tax dollars. We’re here to help you make prudent choices.