Ninth Circuit Reverses Tax Court, Says Form Is More Important than Substance Where Congress Says So by ROBERT S. HORWITZ
It was refreshing to read a Ninth Circuit decision that states in its opening paragraph that “the Tax Court erred by invoking substance-over-form principles to effectively reverse that Congressional judgment and disallow what the statute plainly allowed.” The decision is Mazzei v. Commissioner, 998 F.3d 1041 (9th Cir. 2021), rev’g 150 T.C. 138 (2018). The case involves the interaction of the Roth IRA provisions of the Internal Revenue Code (“I.R.C.”) with the since-repealed I.R.C. provisions for Foreign Sales Corporations (“FSC”), I.R.C. §§921-927. In its opinion, the Ninth Circuit provides an overview of the rules governing the tax treatment of FSCs, Roth IRAs and Domestic International Sales Corporations (“DISCs”), so that is where we will begin.
IRAs have been authorized by the I.R.C. since the 1970s. In the traditional IRA, the contributions (up to a statutory cap) are not taxable in the year paid to the IRA. Earnings in an IRA accumulate tax free. The beneficiary of the IRA pays tax when distributions are paid out. In 1997, Congress authorized the Roth IRA. Like a traditional IRA, earnings in a Roth IRA accumulate tax free. Unlike traditional IRAs, however, the contributions to Roth IRAs are not deductible and distributions are not taxed. There are strict rules limiting the amount contributed to Roth IRAs and excess contributions are subject to a 6% excise tax.
DISCs and FSCs were both statutorily authorized vehicles to allow U.S. corporations with foreign trade income to compete more effectively with foreign businesses. DISCs were authorized in 1971 and carved out an exception to the transfer pricing provisions of I.R.C. §482. Under the DISC provisions, a U.S. corporation that sold product overseas could set up a DISC and sell product to the DISC at a hypothetical transfer rate that produced a profit for both the corporation and the DISC when it resold the product. The transfer price was fixed under a statutory formula that allowed part of the corporation’s export income to be reallocated to the DISC and not subject to corporate income tax. The corporation could also pay commission to the DISC for export services, with the commissions computed under a formula. All commissions paid the DISC would be tax deductible by the corporation and were unrelated to the services actually provided by the DISC. The DISC was generally exempt from corporate income tax on its commission income. Thus, neither the corporation nor the DISC would pay tax on the export income allocated to the DISC. Tax would only be paid the IRS on DISC income when dividends were paid or deemed paid under the statute. The I.R.C. allows tax-exempt entities to own shares of a DISC, but dividends received by an exempt organization from a DISC are treated as unrelated business income subject to tax under I.R.C. §511 at corporate income tax rates.
In 1984, due to disputes over DISCs under the General Agreement on Trade and Tariffs, Congress enacted legislation authorizing the formation of FSC by U.S. corporations with foreign trade income. Unlike DISCs, FSCs must be formed under the laws of a foreign country or a U.S. possession. The FSC would be a shell corporation. The U.S. corporation would cycle part of its foreign trade income through the FSC in the form of tax deductible “commissions.” The commissions paid the FSC would be computed under a statutory formula and the FSC did not have to perform any services for the commissions; instead it could contract with the U.S. corporation or a related party to perform the services for which the commissions were ostensibly paid. Part of the “commissions” would be treated as foreign source income not effectively connected to a U.S. trade or business. The FSC would pay federal income tax on the rest of the “commissions.” The U.S. corporation would get to deduct the entire amount of “commissions” paid. The FSC would return the “commissions” back to the U.S. corporation or a related party as dividends, usually tax free. “As a result, the FSC’s taxable income was largely generated through related-party transactions that lacked meaningful economic substance, and the FSC taxation rules thus reflected a sharp departure from the normal principle that taxation is based on economic substance rather than on legal form.”
Due to the dividends received deduction for corporations, dividends paid by a FSC to its parent corporation are not subject to corporate income tax. If a shareholder of the FSC is an individual, dividends paid the individual are taxable income. If an IRA is a FSC shareholder, dividends paid to the IRA are exempt from tax since, unlike DISC dividends paid to an exempt shareholder, they are not treated as unrelated business taxable income. This meant that where a Roth IRA owned shares in a FSC:
- The U.S. corporation deducts from its income the “commissions” paid the FSC;
- The FSC pays a reduced federal income tax on the “commissions” it receives from the U.S. corporation;
- The Roth IRA pays no income tax on dividends it receives from the FSC; and
- The individual owner of the IRA pays no tax on authorized distributions.
So much for the overview of Roth IRAs, DISCs and FSCs. What does all this have to do with the Mazzies? The Mazzies patented an injector to add fertilizer to water used in agricultural irrigation systems in 1977 and set up Mazzie Injector Corp. The corporation grew rapidly and by the mid-1980s it was exporting to foreign distributors. In 1998, through a farmers’ trade association to which they belonged, the Mazzies set up a FSC and Roth IRAs that were shareholders in the FSC. The FSC entered into various agreements with a partnership formed by the Mazzies. Under these agreements, the FSC received commissions between 1998 and 2002 of $558,555 and paid dividends to the Roth IRAs of $533,057. The Roth IRAs did not pay tax on the dividends.
The IRS did not look favorably on the Mazzies’ use of a Roth IRA as shareholders of the FSC. It therefore issued notices of deficiency determining that the amounts paid by the FSC to the Roth IRAs should be deemed contributions in excess of the statutory limits and asserted excise taxes and penalties against the Mazzies. By a 12-4 vote, the Tax Court upheld the excise tax deficiencies but not penalties. The majority reasoned that the Roth IRAs put nothing at risk in the FSCs, that the Mazzies were the true owners of the FSCs and that the payments to the Roth IRS should be recharacterized as dividends to the Mazzies and as contributions to the Roth IRAs.
The Ninth Circuit noted that the IRS did not contend (a) that the Mazzies failed to follow any formalities of the I.R.C regarding either the FSC or the Roth IRAs or (b) that the commissions paid the FSC were improperly calculated under the statute. While the IRS tried to recharacterize the entire transaction, the Tax Court only recharacterized one transaction: the purchase of FSC stock by the Roth IRAs. The Ninth Circuit viewed the issue before it as “whether the Tax Court properly concluded that, under the substance-over-form doctrine, the Mazzies, rather than their Roth IRAs, were the owners of the FSC for federal tax purposes.”
The Ninth Circuit’s analysis of the Tax Court’s opinion begins by recognizing that a general principal in construing tax laws is that form should be disregarded for substance and that the emphasis should be on economic reality. This is “the formula within which all statutory provisions are to function.” But there is an exception to every rule so the substance over form doctrine “can be negated by Congress in express statutory language.” The Ninth Circuit viewed this as a case where statutory provisions elevate form over substance:
Put simply, the FSC statute expressly contemplates that, without itself performing any services, a FSC can receive “commissions” from a related entity and then (after paying a reduced level of tax) the FSC can pay the remainder as dividends to the same or another related entity. Under the scheme that Congress devised in the FSC statute, the taxation rules in certain respects plainly follow the form of the matter and not its substance.
The Tax Court’s reliance on substance-over-form rules was an “extremely restrictive view of the exemption reflected in the FSC statute” that “cannot be reconciled with what Congress has decreed with respect to FSCs.” The holding that the Roth IRAs were not the true owners of the FSC because they did not have the risks and benefits of ownership overlooked the fact that the statute allows FSCs to be set up to eliminate any risk from owning FSC stock: FSCs are shell companies with no operations and they generate value only because of the reduced tax rate on money “funneled through it” in accordance with strict statutory formulas. Such a shell corporation presents little risk to the owner because it will only be used if and when taxes can be saved by funneling funds through it:
The statute clearly envisions that the parties who pay money into the FSC and the parties who receive dividends out of it will be related. Given that reality, it would not make much economic sense to “capitalize” the FSC with more than a nominal amount of capital. As the dissenters noted, taking the Tax Court’s analysis seriously would lead to the illogical conclusion that “no one could ever own an FSC” because no owner would ever “put capital at risk” in the FSC.
The Ninth Circuit also castigated the Tax Court’s reliance on the anticipatory assignment doctrine. The FSC regime explicitly departs from that tax law doctrine, since it allows the U.S. corporation to assign part of its foreign sales income to the FSC in the form of “commissions” that the FSC did not earn.
Two “textual clues” supported the Ninth Circuit’s determination: since the FSC provisions exempt FSCs from §482, the provisions apply regardless of who the related party is that owns an FSC. Although Congress was aware that a tax-exempt entity can own shares in a FSC, unlike the DISC provisions, Congress did not make payments from a FSC to a tax-exempt entity like an IRA subject to taxation.
To end its analysis, the Ninth Circuit noted that its decision was supported by the decisions of the First, Second and Sixth Circuits in the Summa Holdings, Inc. v. Commissioner cases. The three cases, Summa Holdings v. Commissioner, 848 F.3d 779 (6th Cir. 2017), Benenson v Commissioner, 887 F.3d 511 (1st Cir. 2018), and Benenson v. Commisisoner, 910 F3d 690 (2nd Cir. 2018), involved a transaction where Roth IRAs owned stock in a corporation that, in turn, owned a DISC. The Tax Court, relying on substance-over-form principals, held that the payments to the DISC were not commissions but deemed dividends to Summa’s shareholders followed by contributions to their Roth IRAs. All three circuits reversed the Tax Court, ruling against the IRS. The Ninth Circuit joined “our sister circuits here in concluding that, when Congress expressly departs from substance-over-form principles, the Commissioner may not invoke those principles in a way that would directly reverse that congressional judgment.”
As noted at the beginning of this blog, it’s refreshing to see appropriate limits put on the Commissioner’s use of the substance over form doctrine and a Court reject the application of substance-over-form principles where the transaction is one that was contemplated by the statute. The lesson to be learned here is while the Commissioner’s power to apply judicial doctrines to protect the treasury is broad, it is not without its limits.
Robert S. Horwitz is a Principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division. He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending clients in criminal tax investigations and prosecutions.