Every business owner wants to handle taxes wisely. But if there is no meaningful business reason behind a tax-saving move, trouble tends to follow. It is not enough for something to be technically allowed.
Every business owner wants to handle taxes wisely. Reducing one’s tax burden is good business sense, but the path from smart planning to risky behavior is shorter than most realize.
What may begin as a legitimate strategy can gradually become something else. The more a plan is built around avoiding taxes without real economic reasoning, the more likely it is to face scrutiny. In recent years, the IRS and the courts have paid closer attention to why a transaction was done, not just how it was structured.
Substance now outweighs form. If there is no meaningful business reason behind a tax-saving move, trouble tends to follow. It is not enough for something to be technically allowed; there needs to be a purpose that makes sense in the real world.
This blog looks at where that gray area begins, how to stay out of it, and what business owners should consider before making a move that might be hard to defend. Minimizing taxes makes sense; overlooking risk does not.
Why Intent and Substance Matter More than Ever
The difference between tax planning and tax avoidance is no longer just about technical details. Increasingly, it hinges on intent. Courts and the IRS are not only reviewing what was done but also why it was done and whether that reason holds up outside of tax savings.
A transaction might appear sound on paper, but if there is no business reason behind it, no real driver apart from reducing tax, it can quickly unravel under audit. The economic substance doctrine and the step transaction doctrine are two ways the IRS can dismantle strategies that look clever but serve no real commercial purpose.
In practice, this means that legality is not the only test. Defensibility matters just as much. A structure that seems to comply with the law might still be disallowed if it lacks substance. A tax strategy built on genuine business needs tends to stand up; one built only to exploit rules and “loopholes” rarely does.
When Strategies Cross the Line
Some tax strategies look effective until someone asks the first hard question. At that point, what seemed clever can fall apart if a business purpose is missing.
Consider a business owner who created several limited liability companies to divide income across entities. On the surface, it appears to reduce exposure. However, there was no operational difference, no separation in function, and no economic purpose beyond staying under the audit thresholds. When reviewed, it did not survive.
In another case, a C corporation reported large salaries paid to family members. The issue was not the relationship, but rather it was that the individuals did not perform any work. The payments were flagged and adjusted.
In a third example, a management company was formed to funnel profits away from the main business. It worked for a time. When challenged, though, the structure collapsed under scrutiny because it lacked supporting documentation and a real service relationship.
Across these examples, one truth stands out. If a structure begins to dissolve the moment someone asks about it, it probably should not exist in the first place.
Understanding Economic Substance
When the IRS or a court evaluates a tax position, they often begin with two fundamental questions. Does the transaction result in a meaningful change to the taxpayer’s economic position? And is there a substantial purpose beyond reducing taxes? These are not technicalities. They are the backbone of what is now known as the economic substance doctrine, and they carry considerable weight in enforcement.
A strategy might be allowable by the letter of the law, but that no longer guarantees safety. If a transaction exists only to lower tax liability without producing real-world economic effects, it may be set aside. This standard applies broadly. It can affect entity formations, related-party transactions, asset movements, and more. The doctrine is not designed to punish legitimate planning. Instead, it asks whether a business decision would make sense if there were no tax benefit attached to it.
Tax savings can be an outcome, but it cannot be the only motivation. The most defensible strategies are typically those with clear commercial objectives. Plans driven by growth, efficiency, or risk protection tend to hold up under scrutiny. Those built solely to engineer a lower tax bill tend to fall apart.
Ask the Right Questions before You Act
Not all tax advisers take the same approach. Some are cautious; others are more aggressive – sometimes in ways their clients do not fully understand until it becomes a problem. Before adopting any tax position, it helps to ask a few direct questions. The answers can reveal whether the strategy is built to last or built to be questioned.
Ask your CPA or attorney why the move makes sense from a business standpoint. Press for clarity:
- What is the commercial justification?
- Has the IRS raised concerns about this approach before?
- Has it been tested in court, and if so, how did it hold up?
Also, ask what documentation will be needed in the event of a review. A strong position should have a clear paper trail. Vague answers, missing rationale, or heavy reliance on templates are reasons to pause.
An adviser who knows the terrain will not simply say, “This works.” They will explain why it works, what risks are involved, and what needs to be done to support it. If that explanation is confusing or incomplete, it may be the plan that needs rethinking, not just the wording.
Documenting Positions the Right Way
Documentation is often the difference between a strategy that stands strong and one that collapses under review. But good documentation is not just about volume; it is about clarity, consistency, and credibility. A memo that explains the business reasoning behind a position will do far more than a stack of receipts or a spreadsheet with vague labels.
At a minimum, keep records that explain why a transaction occurred and what purpose it served beyond reducing taxes. Memos should outline the intent of an arrangement in plain terms. If there are payments between related parties, make sure they reflect actual services or obligations. Avoid labeling items in ways that distort their nature. For instance, do not describe a dividend as a “consulting fee” to justify a deduction. That kind of recharacterization tends to invite scrutiny, not avoid it.
Also, be wary of generic templates. The IRS has seen thousands of them. When language is copied without customization, it raises questions about whether the transaction was thought through or simply borrowed from another context. A genuine business strategy deserves a tailored explanation, written with the understanding that someone else may one day read what you wrote. If that explanation would sound hollow under review, the underlying strategy may need more than editing.
Understanding and Measuring Tax Risk
Not every tax strategy is free of risk, nor should it be. Risk, in itself, is not a flaw. It becomes a problem only when it is unacknowledged, misunderstood, or disproportionate to the benefit. A well-informed business owner can tolerate a degree of uncertainty, provided the exposure is clear and manageable.
Before moving forward with a complex position, ask whether the potential benefit justifies the risk:
- Are the savings significant enough to warrant attention?
- Is the strategy well documented?
- Have the compliance steps been followed in good faith?
These are not just legal questions. They are business ones, and they matter long before an audit begins.
Planning should never be based on generic templates or what worked for someone else. Every business is different. What is reasonable for one may be reckless for another. A tailored approach is generally the kind of tax strategy that holds up, and the risks you cannot afford to explain are often the ones you should not take.
Smart Planning Begins with Knowing Where the Line Is
Most business owners want the same outcome. They want to reduce their tax burden without triggering problems they are not equipped to handle. That goal is reasonable, but the approach matters as much as the result. Cutting corners or relying too heavily on technicalities may offer short-term savings but at the cost of long-term exposure.
Responsible planning means knowing the difference between creative and careless. It means asking the hard questions, even when the answer is not what you hoped for. The strongest strategies are the ones that make sense before they are challenged, not only after. And the advisers you trust should be able to explain them clearly, without hesitation or jargon.
A good tax strategy should work in daylight, not just on paper. If you are not comfortable explaining your position to someone who has never worked in tax, it might be time to revisit the plan.
Anthony J. Borrelli is a staff accountant at Maillie LLP in West Chester, Pa. He holds a B.S. in Accounting from the University of Pittsburgh and is committed to maintaining compliance and upholding the integrity of accounting processes. He can be reached at tonyjborrelli@gmail.com.
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Statements of fact and opinion are the authors’ responsibility alone and do not imply an opinion on the part of the PICPA's officers or members. The information contained herein does not constitute accounting, legal, or professional advice. For actionable advice, you must engage or consult with a qualified professional.
