Three Circuit Courts have now split with the Tax Court about whether the substance-over-form doctrine prohibits complex plans that route business income into Roth IRAs. The Ninth Circuit is expected to join the conversation soon.
The IRA Income Scheme
The schemes at issue used DISCs or FSCs to avoid the annual limits on Roth IRA contributions. DISCs (domestic international sales corporations) and FSCs (foreign sales corporations) are tax-favored entities that are intended to encourage exports.
Boiled down to their basics, here’s how the schemes worked:
- A group of related taxpayers owned a domestic corporation that had export income.
- The corporation allocated some of its export income to the DISC or FSC.
- The taxpayer’s Roth IRAs bought stock in the DISC or FSC.
- The DISC or FSC paid dividends on the stock to the IRAs.
The Scheme’s Tax Benefits
This complicated process yielded several tax benefits. Most importantly, it allowed a portion of the taxpayer’s business income to flow into the Roth IRA as dividend income from the DISC or FSC. As dividend income, it was not subject to the annual limit on direct Roth IRA contributions.
What is the Substance-Over-Form Doctrine?
The IRS uses the substance-over-form doctrine to challenge the tax benefits of a transaction when its economic substance is inconsistent with its form.
Imagine, for example, that a taxpayer structures a property transfer as a sale but, in economic reality, the transfer is a gift. The substance-over-form doctrine lets the IRS treat the transfer as a gift and deny any benefits associated with a sale, even if the transaction complies with all of the statutory requirements for a sale.
Other Substance Doctrines
The substance over form doctrine is related to and often intertwined with the:
- sham transaction,
- economic substance, and
- step transaction doctrines.
All of these “substance doctrines” are common-law theories of statutory interpretation that determine tax benefits based on practical economic realities rather than technical statutory compliance.
Tax Court’s Substance-Over-Form Analysis
The substance-over-form rift between the Tax Court and the Circuit Courts started with Summa Holdings, Inc., Dec. 60,335(M), TC Memo. 2015-119, which involved three related taxpayers and their C corporation. The individuals accumulated more than $3 million in their Roth IRAs by routing part of their corporation’s income through a DISC. Each step in the complex process complied with statutory requirements.
Tax Court’s Decision
Despite their technical compliance with the Code, the Tax Court concluded that the transactions
were used for the purpose of shifting millions of dollars into Roth IRAs in violation of the statutory contributions limits. In this situation recharacterization under substance over form principles is appropriate.
Accordingly, the IRS:
- basically ignored the DISC;
- imposed excise tax on the IRAs’ dividend income that exceeded the annual limit on direct Roth IRA contributions; and
- denied the C corporation’s deductions for commissions it purportedly paid to the DISC.
The individual taxpayers appealed the Tax Court’s decision to the First and Second Circuits. Their C corporation appealed to the Sixth Circuit. All three circuits reversed the Tax Court.
Sixth Circuit’s Substance-Over-Form Analysis
The Sixth Circuit was the first appeals court to issue an opinion, in Summa Holdings, Inc., 2017-1 USTC ¶50,155 (Summa II). The court accepted that the substance-over-form, economic substance and sham transaction doctrines are sometimes necessary to allow the IRS to look at economic realities rather than the labels used by taxpayers.
However, these substance doctrines do not allow the IRS to block tax benefits that Congress intended to grant. Here, the Code allowed the taxpayers to do everything they did. They simply lowered their tax liability by complying with two different sets of statutes that were intended to lower tax liability. Allowing the IRS to deny tax benefits that the statutes intended to grant took the substance-over-form doctrine too far.
Tax Court’s Substance-Over-Form Comeback
After the Sixth Circuit decided Summa II, the Tax Court returned to the substance-over-form doctrine in C. Mazzei, Dec. 61,130, 150 TC No. 7. The issues in Mazzei were similar to the issues in Summa Holdings, except that the taxpayers used a foreign sales corporation (FSC) rather than a DISC.
The taxpayers argued that the Sixth Circuit’s Summa II opinion was dispositive, but the Tax Court disagreed. First, the Sixth Circuit considered only the C corporation’s deduction for commissions it paid the DISC, but the Mazzei case concerned the excise tax on the individual taxpayers’ excess IRA contributions. In addition, although an FSC and a DISC both provided tax benefits to exports, they were governed by different sets of statutes.
These differences were enough for a divided court to distinguish Mazzei from Summa II.
Tax Court’s Decision
After dispensing with Summa II, the Tax Court acknowledged that FSCs were intended to provide tax savings. However, this fact did not preclude it from applying the substance-over-form doctrine to the taxpayers’ scheme.
Rather, the FSC statutes provided particular benefits in narrow circumstances. For instance, in an apparent nod to Summa II, the court noted that the statutes allowed the taxpayers’ corporation to deduct the commissions it paid to the FSC.
However, the FSC regime did not provide carte blanche for tax avoidance in general. Thus, the taxpayers’ transactions still had to have some substance. And there was no substance to the Roth IRAs’ purchase of the FSC stock. The IRAs:
- effectively paid nothing for the stock,
- put nothing at risk, and
- could not have expected any benefits.
Accordingly, the IRAs’ purported ownership of the FSC stock did not reflect the underlying intentions and expectations of the individuals who owned the IRAs. In addition, those individuals used their various entities to control every aspect of the transactions. As a result, they, rather than their IRAs, were the true owners of the FSC stock.
Similar to its position in Summa Holdings, the IRS basically ignored the FSC. This meant that the dividends that the FSC purportedly paid to the IRAs were actually dividends that the domestic corporation paid to the taxpayers, who then contributed them to the IRAs. Since those contributions far exceeded the annual IRA contribution limits, the taxpayers were liable for the excise tax on excess contributions.
First and Second Circuits Join Sixth Circuit’s Substance-Over Form Approach
After the Tax Court’s decision in Mazzei, the First and Second Circuits both weighed in on the appeals brought by the individual taxpayers in Summa Holdings. Like the Sixth Circuit in Summa II, they also rejected the application of the substance-over-form doctrine.
In C.C. Benenson, 2018 USTC ¶50,519, the First Circuit concluded that the IRS could not use the substance-over-form doctrine to disallow the taxpayers’ tax benefits. Their transactions complied with statutes that were intended to confer tax benefits. The court also distinguished the Tax Court’s Mazzei opinion as narrowly focused on the peculiarities of the FSC.
The Second Circuit agreed in J. Benenson, Jr., 2019-1 USTC ¶50,101. The court acknowledged that the step transaction doctrine might recharacterize one particular set of payments as excess IRA contributions. However, doing so would not affect the taxpayer’s final tax liability.
Up Next: The Ninth Circuit
The taxpayers in Mazzei have appealed the Tax Court’s decision to the Ninth Circuit. That court could take the opportunity to weigh in on the underlying disagreement over the reach of the substance-over-form doctrine.
However, given the particulars of the case, the court could also issue a fairly narrow opinion based on the FSC’s role in the transactions. The FSC provisions were repealed in 2000, so such a decision would have a much more limited impact.
By Kelley Wolf, JD, LLM