Celia Mazzei v. Commissioner , 150 T.C. No. 7 ( 2018 )

150 T.C. No. 7UNITED STATES TAX COURT
CELIA MAZZEI, Petitioner v. COMMISSIONER OF
INTERNAL REVENUE, Respondent
ANGELO L. MAZZEI AND MARY E. MAZZEI, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 16702-09, 16779-09. Filed March 5, 2018.
Ps entered into a prepackaged plan to save taxes by routing
funds from their family business through a Bermuda-based foreign
sales corporation (FSC) and then into Roth IRAs created for this
purpose. Pursuant to this plan, in 1998 each P directly contributed
$2,000, the applicable contribution limit, to his or her newly created
Roth IRA, which then paid a nominal amount for stock in the FSC.
From 1998 to 2002 Ps routed payments totaling $533,057 from their
family business, through the FSC, and into their Roth IRAs.
Ps contend that we should respect the form of these
transactions as payments from Ps’ business to the FSC, followed by
payments of dividends by the FSC to the Roth IRAs. R contends that
the payments from the FSC to Ps’ Roth IRAs represented, in
substance, contributions from Ps to their Roth IRAs. R contends that
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because these payments exceeded Ps’ contribution limits for their
Roth IRAs, Ps are liable for excise taxes under I.R.C. sec. 4973.
Held: On the facts presented, Ps and not their Roth IRAs were
the owners, for Federal tax purposes, of the FSC stock; in substance
the FSC dividends were income to Ps, who contributed the funds to
their Roth IRAs. Summa Holdings, Inc. v. Commissioner, 848 F.3d
779 (6th Cir. 2017), rev’g T.C. Memo. 2015-119, distinguished.
Held, further, pursuant to I.R.C. sec. 4973 Ps are liable for
excise taxes on excess contributions to their Roth IRAs.
Held, further, R’s imposition of additions to tax under I.R.C.
sec. 6651(a)(1) and (2) is not sustained.
Lewis Richard Walton and Lewis Richard Walton, Jr., for petitioners.
Erin Kathleen Salel, Kathleen A. Tagni, and Miles B. Fuller, for respondent.
CONTENTS
FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
I. WGA’s FSC/IRA Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
II. Petitioners’ Contribution Limits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
III. Petitioners’ Entrance Into WGA’s FSC/IRA Program . . . . . . . . . . . . . 10
A. Operations Procedure Memorandum. . . . . . . . . . . . . . . . . . . . . . 12
B. Commission Agreement. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
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C. Services Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
D. Management Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
E. Shareholders’ Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
F. Compliance Guide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
IV. Operations of the FSC/IRA Program . . . . . . . . . . . . . . . . . . . . . . . . . . 15
V. Procedural Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
I. Burden of Proof . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
II. Statutory Framework: Roth IRAs and Excess Contributions . . . . . . . . 19
III. The Parties’ Arguments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
IV. General Principles: Substance Over Form. . . . . . . . . . . . . . . . . . . . . . 24
V. The FSC Provisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
A. Relaxed Transfer Pricing Rules . . . . . . . . . . . . . . . . . . . . . . . . . . 30
B. Effective Tax Rate Cut for Qualifying Income . . . . . . . . . . . . . . 33
C. Application of FSC Rules to Petitioners’ Transactions. . . . . . . . 35
D. The Limited Scope of the FSC Provisions . . . . . . . . . . . . . . . . . 36
VI. The Payments to the Roth IRAs Were Contributions. . . . . . . . . . . . . . 38
A. The Roth IRAs Were Exposed to No Risk. . . . . . . . . . . . . . . . . . 43
B. The Roth IRAs Could Expect No Upside Benefits . . . . . . . . . . . 47
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C. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
VII. Petitioners’ Counterarguments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
A. Summa Holdings II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
B. Petitioners’ Ownership Argument . . . . . . . . . . . . . . . . . . . . . . . . 55
C. Petitioners’ Congressional Purpose Arguments . . . . . . . . . . . . . 57
VIII. Response to Dissent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
A. Our Analysis Does Not Sham or Disregard Any Entities. . . . . . 59
B. Our Analysis Properly Considers the Facts as a Whole. . . . . . . . 59
C. The Substance Inquiry Is Appropriate. . . . . . . . . . . . . . . . . . . . . 60
D. Our Approach Appropriately Considers Value. . . . . . . . . . . . . . 63
E. The Dissent’s Hypothetical Misconceives Our Analysis. . . . . . . 65
F. The Dissent’s Approach Lacks Support in the Code. . . . . . . . . . 67
IX. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
X. Additions to Tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
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THORNTON, Judge: By notice of deficiency, respondent determined
excise tax deficiencies for Angelo and Mary Mazzei for 2002-07, and additions to
tax under section 6651(a)(1) and (2):1
Additions to tax
Year Deficiency Sec. 6651(a)(1) Sec. 6651(a)(2)
2002 $6,637 $1,493 $1,659
2003 9,408 2,116 2,352
2004 10,523 2,367 (1)
2005 11,349 2,553 (1)
2006 13,759 3,095 (1)
2007 15,914 3,580 (1)
1
Amounts to be determined.
In a separate notice of deficiency, respondent determined excise tax
deficiencies for Celia Mazzei for 2002-07, and additions to tax under section
6651(a)(1) and (2):
1
All section references are to the Internal Revenue Code (Code) in effect for
the relevant year, unless otherwise indicated. All Rule references are to the Tax
Court Rules of Practice and Procedure. Monetary amounts are rounded to the
nearest dollar.
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Additions to tax
Year Deficiency Sec. 6651(a)(1) Sec. 6651(a)(2)
2002 $4,889 $1,100 $1,222
2003 6,148 1,383 1,537
2004 6,372 1,433 (1)
2005 6,817 1,533 (1)
2006 7,850 1,766 (1)
2007 8,616 1,938 (1)
1
Amounts to be determined.
While residing in California, petitioners timely petitioned this Court with
respect to both notices of deficiency. These cases have been consolidated for trial,
briefing, and opinion. The issues for decision are (1) whether petitioners are liable
for excise taxes under section 4973 for 2002-07 and (2) whether petitioners are
liable for section 6651(a)(1) and (2) additions to tax.
FINDINGS OF FACT
Angelo Mazzei graduated from college with a science degree in industrial
technology and a minor in business administration. In 1977 he filed his first
patent application for an “injector that mixes chemicals with water (for use
primarily in agriculture).”2 Mr. Mazzei got patent No. 4,123,800--“Mixer
2
Mr. Mazzei’s injectors use a venturi to introduce various additives to a
moving stream of fluid (i.e., his injectors use the same principle employed in a
carburetor).
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Injector”--and in 1978, seeing business potential in his idea, he and his wife, Mary
Mazzei, formed the Mazzei Injector Corp. (Injector Corp.), an S corporation.3
Initially Mrs. Mazzei was very active in the business and was Injector
Corp.’s bookkeeper. She still discusses the business with Mr. Mazzei but is no
longer an employee. Mr. and Mrs. Mazzei’s daughter, Celia Mazzei, has taken a
much more active role in the business. After graduating from college with a
degree in mathematics, she became vice president of research and development for
Injector Corp. and still works with her father to invent new products. She now
owns 10% of both ALM Corp., see infra p. 9, and Injector Corp.
After its inception in 1978 Injector Corp. grew quickly and by its second
year started working with distributors to market and sell its products. In or about
1984 Injector Corp. started selling overseas through foreign distributors.
Although sales have fluctuated, by 1998 export sales provided a reliable stream of
income. Today, Mr. Mazzei has patents in the United States and several foreign
countries including Canada and Japan. He has also adapted his injectors for
several different industries, including water treatment, wine production, and spa
manufacturing.
3
An S corporation is a domestic corporation taxed under subchapter S of
chapter 1 of the Code. A C corporation is a corporation taxed under subchapter C
of chapter 1 of the Code. Injector Corp. elected S corporation status in 1989.
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I. WGA’s FSC/IRA Program
The same year Mr. Mazzei got his patent, he joined the Western Growers
Association (WGA)--a trade association for farmers. Sometime in the 1990s
WGA began creating and selling interests in foreign sales corporations (FSCs) to
its members. FSCs were foreign corporations which elected to be taxed under
now-repealed sections 921-927.4 WGA’s FSCs were located in Bermuda and
managed by a company called Quail Street Management (Quail Street).5 To
participate in WGA’s FSC/individual retirement account (IRA) program, the
individual shareholders or owners of WGA’s corporate or passthrough members
had to have self-directed section 408 IRAs (traditional IRAs), which the
shareholders or owners used to purchase stock in one of WGA’s FSCs. When
4
In response to a World Trade Organization (WTO) ruling that declared the
FSC regime a prohibited export subsidy, Congress phased out the FSC provisions.
See Appellate Body Report, United States--Tax Treatment for “Foreign Sales
Corporations”: Recourse to Article 21.5 of the DSU by the European
Communities, WTO Doc. WT/DS108/AB/RW (adopted Jan. 14, 2002). An active
FSC existing on September 30, 2000, could generally continue to receive the usual
FSC benefits for transactions occurring in the ordinary course of trade or business
before January 1, 2002, or occurring after December 31, 2001, if pursuant to a
contract in effect on September 30, 2000. See FSC Repeal and Extraterritoral
Income Exclusion Act of 2000, Pub. L. No. 106-519, 114 Stat. 2423. WGA shut
down its FSC/IRA program as a result of the repeal.
5
WGA had formed Quail Street for use in insurance programs for WGA
members. The same handful of employees that managed those programs absorbed
the FSC activities into their routines.
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section 408A Roth IRAs (Roth IRAs) were added to the Code in August 1997, see
Taxpayer Relief Act of 1997, Pub. L. No. 105-34, sec. 302, 111 Stat. at 825, WGA
changed its program, substituting Roth IRAs for traditional IRAs. WGA marketed
its FSC/IRA program to its members, emphasizing that the FSC/IRA structure
would provide tax benefits without any loss of control over the business.
II. Petitioners’ Contribution Limits
Contributions to a Roth IRA are limited according to a statutory formula.
See sec. 408A(c)(2). The limitation for any year decreases as the taxpayer’s
modified adjusted gross income (MAGI) increases; if MAGI is high enough, the
limitation is reduced to zero. See sec. 408A(c)(3).
Petitioners’ pre-1998 contribution limits were customarily zero, but as a
result of some restructuring, petitioners claim that they each had a respective
contribution limit of $2,000 for 1998. Their restructuring is a bit mysterious even
after trial. Mr. and Mrs. Mazzei each started with 45% of Injector Corp. Celia
Mazzei owned the remaining 10%. Petitioners organized another S corporation,
ALM Corp., owned in the same proportions. ALM Corp. and Injector Corp. then
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formed an LLC named Mazzei Injector Co. (Injector Co.), which was treated for
tax purposes as a partnership.6
Respondent describes this restructuring but has not challenged it, so we
deem respondent to have waived or conceded any issue with respect to it.
Accordingly, we find that each petitioner’s contribution limit was $2,000 for 1998.
Each petitioner’s contribution limit was zero for 1999, 2000, 2001, and 2002.7
III. Petitioners’ Entrance Into WGA’s FSC/IRA Program
In February 1998 Injector Co. applied to WGA’s FSC/IRA program.
Injector Co.’s application to the program valued its annual export sales at
approximately $1.5 million. Once Injector Co. was accepted into the program,
each petitioner opened a self-directed Roth IRA and contributed $2,000. Each
6
According to respondent, petitioners had Injector Co. adopt a tax year
ending on January 31 and report all the injector-related sales activities, while
Injector Corp. maintained its calendar tax year and reported only expenses.
Because income passed through from a partnership is reported by partners for the
year in which the partnership’s tax year closes, petitioners claimed that the
disparity in tax years coupled with the selective separation of sales activity
reporting from expense reporting resulted in a net loss flowing through to
petitioners from their S corporations in 1998. Consequently, each petitioner
claimed that his or her respective MAGI was low enough to permit contribution of
$2,000 to his or her respective Roth IRA in 1998.
7
Petitioners’ returns for 1999-02 show that each petitioner’s MAGI was
sufficiently large to reduce the sec. 408A(c)(2) contribution limit to zero. The
parties have not disputed this point.
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petitioner then directed his or her respective Roth IRA to buy one-third of a new
account inside one of WGA’s FSCs.
Under former section 927(g), if an FSC “maintain[ed] a separate account for
transactions with each shareholder”, each separate account was to be treated as a
separate corporation. By virtue of this provision, multiple WGA members could
share one of WGA’s FSCs without intermingling their finances. Each of
petitioners’ three Roth IRAs formally purchased 33-1/3 shares of one of WGA’s
FSCs at $5 per share; altogether, the Roth IRAs paid $500 for 100 shares. The
shares formally purchased by petitioners’ Roth IRAs were all attributable to a
single, new, and empty “separate account”. There were no other shares
attributable to this separate account. When we refer to “petitioners’ FSC” or “the
FSC”, we mean petitioners’ separate account, treated as a separate corporation
under section 927(g).
Injector Co. received a packet of program materials that included: (1) an
operations procedure memorandum; (2) a foreign trade commission, sale, license,
lease, and services agreement (commission agreement); (3) an export-related
services agreement (services agreement); (4) a management agreement; (5) a
shareholders’ agreement; and (6) a compliance guide prepared by Price
Waterhouse, LLP, describing tax and recordkeeping issues associated with the
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IRA/FSC program. Each agreement was executed early in 1998.8 We will briefly
discuss each item.
A. Operations Procedure Memorandum
The operations procedure memorandum provided an overview of the packet
and a general explanation of how the FSC/IRA program was to operate.
B. Commission Agreement
The commission agreement provided that petitioners’ FSC would perform a
variety of export-related activities for Injector Co.; in exchange, Injector Co. was
to pay a commission. The commission agreement specified that Injector Co.
retained the power to decide whether to pay a commission. For example, the
agreement specified that any services commission
shall be agreed upon by the parties and may vary from time to time by
mutual agreement, so as to provide the maximum [F]ederal income
tax benefits to * * * [Injector Co.] and [the] FSC * * *. * * *
[Injector Co.] shall have the final decision as to whether [the] FSC is
considered to have solicited or promoted a transaction with a
customer and may prospectively or retroactively add or delete
transactions entitling [the] FSC to a commission.
8
The commission and services agreements were signed by Mr. Mazzei (as
president of Injector Co.) and by Donald G. Dressler (as vice president of the
FSC). The management agreement was signed by Mr. Mazzei (as president of
Injector Co.) and by Donald G. Dressler (as vice president of the FSC) and also by
Mark Moffat (president of Quail Street). The shareholders’ agreement was signed
twice by Mr. Dressler (as vice president of the FSC and as vice president of Quail
Street).
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(Identical provisions existed for other types of payments.)
C. Services Agreement
The services agreement, which was executed simultaneously with the
commission agreement (as required by the commission agreement), provided that
all of the activities contracted to the FSC had to be delegated back to Injector Co.,
in exchange for a fee which could not exceed the commission paid by Injector Co.
D. Management Agreement
The management agreement provided that Injector Co. would pay a fee to
Quail Street to administer its participation in the IRA/FSC program. The
management agreement specified that (1) the fee would be equal to 0.001 of the
FSC’s foreign trading gross receipts9 and that (2) the fee would be at least $3,500
and at most $10,000.
E. Shareholders’ Agreement
The shareholders’ agreement provided that “[e]arnings in the form of
commissions on business originated by each shareholder shall be credited to the
9
“Foreign trading gross receipts” was defined in sec. 924. See infra note 23.
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respective shareholder’s separate account.”10 This agreement also required each
shareholder to pay its share of any annual maintenance costs for the FSC.11
Additionally, the shareholders’ agreement specified that the $500 purchase
price for 100 shares of FSC stock included $1 of “paid-in capital” and $499 of
“paid-in surplus”. The shareholders’ agreement also restricted the sale of the FSC
stock in at least two ways: (1) any shareholder that wished to sell its stock needed
the approval of the FSC’s directors12 and (2) the sale price for the FSC stock was
set as the “paid-in capital” amount, i.e., $1.
F. Compliance Guide
The compliance guide advised Injector Co. on how to report its activities in
its accounting records and on its tax returns.
In the aggregate, the agreements described above did not require the FSC to
perform any export-related activities for Injector Co., and any payments to the
FSC were optional (excepting a few management and operational fees paid to
10
As noted, petitioners’ three Roth IRAs owned shares in a single “separate
account” inside one of WGA’s FSCs, and that account was treated as a separate
corporation under sec. 927(g).
11
The record is not clear, but it would appear that Injector Co., rather than
the Roth IRAs, may have paid these fees.
12
The operations procedure memorandum suggests that the FSC’s directors
were to be “provide[d]” by the FSC’s management company, i.e., Quail Street.
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Quail Street). That is, Injector Co. retained, at all times, the right not to make
commission payments to the FSC.
IV. Operations of the FSC/IRA Program
Every quarter, Quail Street asked Injector Co. for a report of its foreign sales
for the period. This request included a template worksheet for reporting sales.
Injector Co. bookkeepers were to complete the report and return it to Quail Street.
Quail Street would then compute the maximum commission payment allowed
under section 925(b) and associated temporary regulations, see infra pp. 29-34,
and send a letter inviting petitioners to fund their IRAs. In relevant part, the letter
said:
Based on the recent export sales and cost information that you
reported, we calculate the amount of [$X] is due [i.e., for Federal
corporate tax on the FSC]. To reimburse us for the quarterly FSC tax
that we paid to the IRS on your behalf, your estimated FSC tax
payment of [$X] should be wired to the address below. If you also
wish to fund your IRA accounts at this time, you may wire an
additional [$Y] at this time, for a total of [$X + $Y].
Injector Co. made regular payments to the FSC, and in total between 1998
and March 2002 the FSC paid $533,057 to petitioners’ Roth IRAs:
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Export Payments Tax paid Amount deposited
year to FSC by the FSC into IRAs
1998 $157,966 $7,211 $150,754
1999 139,682 6,377 133,306
2000 138,095 6,304 131,791
2001 122,812 5,607 117,206
Total 533,057
(For further explanation of these amounts, see infra pp. 35-36.)
Petitioners participated in WGA’s FSC/IRA program with respect to export
transactions occurring from 1998-2001, but some of the payments from the FSC to
the Roth IRAs were made in the year after the export transactions to which they
were attributable. The final payments from the FSC were paid out in March 2002
as WGA wound up its FSC/IRA program.
As of the close of each year at issue, petitioners’ Roth IRAs had the
following balances:13
13
The record does not show, nor have the parties argued, that (1) any
amounts other than the payments from the FSC to the Roth IRAs were deposited
into the Roth IRAs (other than the initial $2,000 contributions) at any time or that
(2) any amounts were withdrawn from the Roth IRAs before the end of 2007.
According to respondent, the sum of petitioners’ account balances at the close of
2002 was less than the $533,057 paid by the FSC because of investment losses in
the Roth IRA accounts.
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Year Angelo Mazzei Mary Mazzei Celia Mazzei
2002 $59,878 $50,753 $81,484
2003 81,082 75,722 102,473
2004 96,650 78,746 106,206
2005 96,790 92,369 113,504
2006 110,493 118,835 130,847
2007 118,856 146,389 143,601
V. Procedural Background
Before entering into these transactions, petitioners presented the transaction
paperwork to their accountant, Mr. Bedke, a tax partner at an accounting firm
(where he had practiced for 29 years). Petitioners had been Mr. Bedke’s clients
for several years before they sought his advice about their FSC transactions, and
he was familiar with their business. Mr. Bedke prepared petitioners’ tax returns
for each year at issue. Mr. Bedke had no connection with WGA and no interest in,
or expectation of profits from, petitioners’ transactions. Mr. Bedke and another
partner at his firm reviewed petitioners’ information and advised them that their
business could use an FSC. He also advised them that it was not prohibited for a
Roth IRA to invest in an FSC.
In December 2003 the IRS issued Notice 2004-8, 2004-1 C.B. 333, to
advise taxpayers that the IRS considered some transactions using Roth IRAs to be
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abusive tax-avoidance transactions.14 With their Forms 1040, U.S. Individual
Income Tax Return, for the tax years 2004-07, petitioners filed protective
disclosures using Form 8886, Reportable Transaction Disclosure Statement, which
disclosed that they participated in a program potentially covered by Notice 2004-8,
supra. Petitioners did not, however, file Forms 5329, Additional Taxes on
Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.
For 2002-07 respondent prepared substitute Forms 5329 for each petitioner
under section 6020(b). In the notice of deficiency respondent determined that the
section 4973 excise tax on excess contributions was due from each petitioner for
each of the years at issue.
OPINION
From 1998 to 2002 petitioners indirectly transferred $533,057 from their
business to their Roth IRAs by routing these funds through an FSC. Respondent
determined that in substance these transfers represented contributions by
petitioners to their Roth IRAs. If respondent is correct, then petitioners owe
excise taxes under section 4973 for excess contributions to their Roth IRAs.
14
Notice 2004-8, 2004-1 C.B. 333, 334, identifies as potentially abusive an
arrangement in which an individual who owns a preexisting business such as a
corporation or sole proprietorship causes the business to engage in transactions
with another corporation, substantially all the shares of which are owned by one or
more Roth IRAs maintained for the benefit of the individual.
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Petitioners assert that respondent erred in recharacterizing the transfers as
something other than dividends from the FSC directly to the Roth IRAs. If
petitioners are correct, then they are not liable for the section 4973 excise taxes.
I. Burden of Proof
The Commissioner’s determinations in a notice of deficiency are generally
presumed correct, and the taxpayer bears the burden of proving those
determinations erroneous by a preponderance of the evidence. Rule 142(a); Welch
v. Helvering, 290 U.S. 111, 115 (1933). Petitioners have not argued that the
burden should be shifted to respondent.
II. Statutory Framework: Roth IRAs and Excess Contributions
A Roth IRA is “a trust created or organized in the United States for the
exclusive benefit of an individual or his beneficiaries”. See secs. 408(a), 408A(a).
Contributions to a Roth IRA are not deductible, income that accrues is tax-free,
and qualified distributions are not included in a taxpayer’s gross income. Sec.
408A(c)(1), (d)(1); Taproot Admin. Servs., Inc. v. Commissioner, 133 T.C. 202,
206 (2009), aff’d, 679 F.3d 1109 (9th Cir. 2012).
As noted, contributions to a Roth IRA are limited according to a statutory
formula. See sec. 408A(c). Contributions in excess of the yearly limitation are
not directly prohibited, but section 4973(a) imposes a 6% tax on the lesser of
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excess contributions remaining in a Roth IRA or the fair market value of the
account at the close of the taxable year. The tax not only applies for the year a
taxpayer made an excess contribution but continues to apply for each year until the
taxpayer removes an amount corresponding to the excess contribution. Sec.
4973(b)(2).
In 1998 each petitioner directly contributed $2,000 to his or her respective
Roth IRA, thereby maxing out each petitioner’s contribution limit for that year. In
all relevant years thereafter--1999 to 2002--each petitioner’s contribution limit
was zero.
In addition to making initial $2,000 contributions to their respective Roth
IRAs in 1998, petitioners also indirectly transferred $533,057 from their business
to their Roth IRAs between 1998 and 2002 by routing those funds through an
FSC. It is undisputed that, if those payments constituted contributions to the Roth
IRAs, they exceeded petitioners’ contribution limits under section 408A and were
therefore excess contributions subject to section 4973 excise taxes for the years at
issue, 2002-07. Consequently, the determinative question is whether the payments
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from the FSC to the Roth IRAs were “contributions” under sections 408A and
4973.15
Because petitioners’ Roth IRAs experienced investment losses, the fair
market value of each account in each year at issue was less than the total amount
of payments from the FSC to each account. Accordingly, if the payments from the
FSC were contributions, the amount of excise tax due from each petitioner for
each year from 2002-07 is 6% of the fair market value of his or her respective
Roth IRA account at yearend.16
15
The income tax treatment of the payments from the FSC to the Roth IRAs
is not before us because any income tax issues from 1998-2001 are barred by the
sec. 6501 statute of limitations. See Mazzei v. Commissioner, T.C. Memo. 2014-
55, at *12 (“[F]or income tax purposes the applicable respective periods of
limitations for taxable years 1998 through 2001 during which the Mazzei
partnership/Western Growers FSC transactions had taken place had expired by the
time respondent learned of those transactions during respondent’s
examination[.]”).
Because petitioners did not file Forms 5329, the periods of limitations for
excise tax under sec. 4973 never began to run. See Paschall v. Commissioner, 137
T.C. 8, 15-17 (2011). Therefore the excise taxes respondent seeks to assess
against petitioners for tax years 2002-07 are not barred by the statute of
limitations.
16
That is, the deficiencies listed supra pp. 5-6 are computed by taking 6% of
the yearend balances listed supra p. 17.
- 22 -
III. The Parties’ Arguments
Respondent contends that the payments to the Roth IRAs were contributions
within the meaning of sections 408A and 4973. Broadly invoking the doctrine of
substance over form, respondent asks us “to recharacterize petitioners’ entire
scheme” on the basis of all the facts and circumstances. Respondent wants us to
recharacterize the entire FSC/IRA program as a device for making contributions to
petitioners’ Roth IRAs.
Petitioners contend that the payments to the Roth IRAs were not
contributions. They insist that the substance over form doctrine is “archaic” and
that we must respect the form of their transactions, which they say Congress has
sanctioned.
We think both parties’ arguments fall short, relying too much on broad
generalizations and hypotheses. Respondent makes vague references to
“substance” but fails to explain in any detail how the substantive economic facts
of petitioners’ cases support the broad recharacterization he has requested.
Similarly, petitioners make vague references to various statutes but fail to explain
exactly how those statutes apply to the facts of these cases or exactly why those
statutes should be thought to excuse a lack of substance.
- 23 -
The Court of Appeals for the Ninth Circuit--to which any appeal of these
cases would ordinarily lie--has cautioned:
Reference to the vague terms “form” and “substance,” which Judge
Learned Hand pointedly referred to as “anodynes for the pains of
reasoning,” is * * * inadequate to determine the tax treatment of a
particular transaction. Instead, courts must make a more specific
inquiry, finding what the facts are and deciding whether those facts
fall within the intended scope of the Internal Revenue Code provision
at issue.
Stewart v. Commissioner, 714 F.2d 977, 988 (9th Cir. 1983) (quoting
Commissioner v. Sansome, 60 F.2d 931, 933 (2d Cir. 1932), rev’g 22 B.T.A. 1171(1931)), aff’g T.C. Memo. 1982-209.
With that admonition in mind, we resolve these cases on their particular
facts, applying the text of the relevant Code provisions. For the reasons discussed
below, we reject petitioners’ broadest argument--that the substance doctrines have
no place in our analysis. We also reject respondent’s request for a complete
recharacterization of all petitioners’ transactions. Instead, we resolve these cases
on a narrower factual basis: We conclude on the basis of the facts in the record
that petitioners, and not their Roth IRAs, were the substantive owners of the FSC
stock at all relevant times. Consequently, we conclude that in substance the
payments from the FSC were income to petitioners rather than to their Roth IRAs
and then excess contributions by petitioners to their Roth IRAs.
- 24 -
IV. General Principles: Substance Over Form
The Supreme Court and lower courts (including this Court) have repeatedly
affirmed the substance over form inquiry.17 We recently acknowledged that courts
applying the so-called economic substance, sham transaction, and substance over
form doctrines have not always used consistent terminology. CNT Inv’rs, LLC v.
Commissioner, 144 T.C. 161, 193 (2015) (“The doctrines’ substantive similarities
would not, alone, generate uncertainty for taxpayers * * * if courts applying the
doctrines did so using consistent terminology. We have not.”). But
17
E.g., Frank Lyon Co. v. United States, 435 U.S. 561 (1978); Cooper v.
Commissioner, 877 F.3d 1086, 1091 (9th Cir. 2017) (“A bedrock principle of tax
law * * * is that substance controls over form.”), aff’g 143 T.C. 194 (2014);
Santander Holdings USA, Inc. v. United States, 844 F.3d 15 (1st Cir. 2016); Bank
of N.Y. Mellon Corp. v. Commissioner, 801 F.3d 104 (2d Cir. 2015), aff’g 140
T.C. 15 (2013) and T.C. Memo. 2013-225; Harbor Bancorp v. Commissioner, 115
F.3d 722, 729 (9th Cir. 1997) (“It is axiomatic that tax law follows substance and
not form.”), aff’g 105 T.C. 260 (1995); Stewart v. Commissioner, 714 F.2d 977,
987-988 (9th Cir. 1983) (explaining that in making a substance over form
argument, the Commissioner “may rely on a body of law” including the economic
substance and business purpose tests), aff’g T.C. Memo. 1982-209; John Hancock
Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. 1 (2013); Lazarus v.
Commissioner, 58 T.C. 854, 864 (1972) (“In laying the facts of petitioners’ case
alongside the controlling statutory provisions, we are reminded that the substance
of a transaction rather than the form in which it is cast is determinative of the tax
consequences unless it appears from an examination of the statute that form is to
govern.”), aff’d, 513 F.2d 824 (9th Cir. 1975); Block Developers, LLC v.
Commissioner, T.C. Memo. 2017-142, at *27 (“We have applied substance-over-
form again and again[.]”); Polowniak v. Commissioner, T.C. Memo. 2016-31, at
*18 (“Generally, the substance and not the form of a transaction determines its tax
consequences.”); Repetto v. Commissioner, T.C. Memo. 2012-168 (same).
- 25 -
notwithstanding some fluidity in terminology, these so-called “doctrines” simply
reflect a body of caselaw describing different aspects of a well-recognized and
accepted general inquiry into the practical economic realities underlying claimed
tax attributes.18
The Court of Appeals for the Ninth Circuit has stated that it “generally
applies a two-pronged inquiry addressing the objective nature of the transaction
(whether it has economic substance beyond tax benefits) and the subjective
motivation of the taxpayer (whether the taxpayer had a non-tax business purpose
for the transaction).” Reddam v. Commissioner, 755 F.3d 1051, 1057 (9th Cir.
2014), aff’g T.C. Memo. 2012-106; see also Bank of N.Y. Mellon Corp. v.
Commissioner, 801 F.3d 104, 115 (2d Cir. 2015), aff’g 140 T.C. 15 (2013) and
T.C. Memo. 2013-225. As the Court of Appeals has also noted, however, “the
economic substance doctrine is not a rigid two-step analysis, but instead focuses
holistically on whether the transaction had any practical economic effects other
than the creation of income tax losses.” Reddam v. Commissioner, 755 F.3d at
18
E.g., Frank Lyon, 435 U.S. at 573 (“In applying this doctrine of substance
over form, the Court has looked to the objective economic realities of a transaction
rather than to the particular form the parties employed.”); Gilman v.
Commissioner, 933 F.2d 143, 148 (2d Cir. 1991) (“Whether the terminology used
was that of ‘economic substance, sham, or section 183 profit motivation’ was not
critical; what was important was reliance on objective factors in making the
analysis.”), aff’g T.C. Memo. 1989-684.
- 26 -
1060 (internal quotation marks and citations omitted) (quoting Sacks v.
Commissioner, 69 F.3d 982, 988 (9th Cir. 1995), rev’g T.C. Memo. 1992-596);
see also Bank of N.Y. Mellon Corp. v. Commissioner, 801 F.3d at 115 (“[T]he test
is not a rigid two-step process with discrete prongs; rather, we employ a ‘flexible’
analysis where both prongs are factors to consider in the overall inquiry into a
transaction’s practical economic effects.”). “[B]usiness purpose and economic
substance are simply more precise factors to consider in the application of this
court’s traditional sham analysis”. Reddam v. Commissioner, 755 F.3d at 1059
(quoting Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir. 1988), aff’g 85 T.C.
968 (1985)).19
Moreover, this general inquiry is merely a commonsense application of the
plain language of the Code to the particular economic facts of each case. As the
19
The dissent, see dissenting op. pp. 95-97, characterizes the substance
inquiry in a way that differs from the precedents of the Court of Appeals for the
Ninth Circuit, which we have discussed, see supra pp. 23-26, and from the
precedents of many other circuits and of this Court, see supra note 17. Whereas
these precedents describe one general substance inquiry as a facts and
circumstances inquiry into the practical economic effects of a transaction for the
purpose of determining whether the economic facts fall within the meaning of the
Code, e.g., Stewart v. Commissioner, 714 F.2d at 988, the dissent attempts to draw
a sharp distinction between the substance over form and the economic substance
doctrines, characterizing the former as a doctrine about fact-finding and the latter
as a doctrine about questions of law. We think that the precedents of the Court of
Appeals for the Ninth Circuit require us to carefully consider the law, the facts,
and the application of law to fact, all in the light of economic reality.
- 27 -
Court of Appeals for the First Circuit recently put it: “The [F]ederal income tax is,
and always has been, based on statute. The economic substance doctrine, like
other common law tax doctrines, can thus perhaps best be thought of as a tool of
statutory interpretation”. Santander Holdings USA, Inc. v. United States, 844 F.3d
15, 21 (1st Cir. 2016) (fn. ref. omitted); see also Summa Holdings, Inc. v.
Commissioner, 848 F.3d 779, 785 (6th Cir. 2017), rev’g T.C. Memo. 2015-119.20
We have recently applied the substance over form doctrine in several cases
similar to petitioners’. See Block Developers, LLC v. Commissioner, T.C. Memo.
2017-142; Polowniak v. Commissioner, T.C. Memo. 2016-31; Repetto v.
Commissioner, T.C. Memo. 2012-168, 103 T.C.M. (CCH) 1895 (2012). In all
those cases, the taxpayers directed their Roth IRAs to purchase interests in a newly
formed partnership or C corporation, which then purportedly provided services, or
20
In Summa Holdings, Inc. v. Commissioner, 848 F.3d 779, 788 (6th Cir.
2017), rev’g T.C. Memo. 2015-119, the Court of Appeals for the Sixth Circuit
mused that the substance over form inquiry might be criticized as a “one-way
street” in the Commissioner’s direction. But as the Court of Appeals for the Ninth
Circuit noted long ago, if a transaction is unreal, “then it is not * * * [the taxpayer]
but the Commissioner who should have the sole power to sustain or disregard the
effect of the fiction since otherwise the opportunities for manipulation of taxes are
practically unchecked.” Maletis v. United States, 200 F.2d 97, 98 (9th Cir. 1952).
“The practical reason for such a rule is that otherwise the taxpayer could
commence doing business * * * [using a particular form] and, if everything goes
well, realize the income tax advantages therefrom; but if things do not turn out so
well, may turn around and disclaim the business form he created”. Id.- 28 -
patent licenses, to the taxpayers’ operating businesses in exchange for cash. In
Repetto, we held that funds routed through a newly formed C corporation to the
taxpayers’ Roth IRAs represented, in substance, excess contributions because “the
preponderance of credible evidence compels a finding that in substance the
services agreements and the resulting payments were nothing more than a
mechanism for transferring value to the Roth IRAs.” Repetto v. Commissioner,
103 T.C.M. (CCH) at 1901.21 In Polowniak and Block Developers, we likewise
looked to substance over form in holding that the transactions at issue in those
cases resulted in excess contributions to the taxpayers’ respective Roth IRAs.
Although petitioners’ transactions are similar to those considered in
Repetto, Polowniak, and Block Developers, a principal difference is that
petitioners used an FSC instead of a partnership or C corporation. Petitioners
suggest that because their transactions included an FSC, we are not permitted to
examine the substance of any part of their transactions. We disagree. As we
discuss in greater detail below, the scope and effect of the FSC provisions are
21
The Court of Appeals for the Sixth Circuit described the result in Repetto
with approval, as follows: “[W]hen a family sets up an ordinary corporation
owned by Roth IRAs and pays the corporation fees for sham ‘services’ that it
never performed, the Commissioner may rightly refuse to recognize the Roth
IRA’s gains as investment earnings and may reclassify them as contributions.”
Summa Holdings, Inc. v. Commissioner, 848 F.3d at 785-786.
- 29 -
more limited than petitioners suggest and do not foreclose our application of
normal substance principles to petitioners’ transactions, at least in deciding who
actually owned the FSC stock.
An understanding of the actual, limited scope of the FSC provisions, and
how they applied to petitioners’ transactions, requires some explanation. We turn
to those matters before proceeding with our analysis of the substance of
petitioners’ transactions.
V. The FSC Provisions
Before they were phased out,22 FSCs were foreign corporations electing to
be taxed under former sections 921-927, which provided advantageous income tax
treatment for export income routed through an FSC. This tax advantage was
achieved in two ways. First, through a series of highly technical rules, the FSC
provisions allowed taxable income to be allocated to the FSC by relaxing the
section 482 transfer pricing rules that generally apply in allocating income and
deductions among related taxpayers. Second, the FSC provisions effectively
lowered the tax rate for qualifying export-related taxable income allocated to the
FSC.
22
See supra note 4.
- 30 -
A. Relaxed Transfer Pricing Rules
Section 925(a) provided relaxed transfer pricing rules for the sale of export
property by a domestic exporting business (which the regulations call the “related
supplier”, see, e.g., sec. 1.925(a)-1T(b), Temporary Income Tax Regs., 52 Fed.
Reg. 6444-6445 (Mar. 3, 1987)) to a related FSC (sale 1), provided that the FSC
resold that property to a foreign customer (sale 2). In particular, section 925(a)
permitted an FSC and its related supplier to use any price they wished for sale 1,
provided that the taxable income derived by the FSC from sale 2 did not exceed
the greatest of: 1.83% of the “foreign trading gross receipts”23 of sale 2, sec.
925(a)(1);24 23% of the combined taxable income of the FSC and its related
supplier from sale 1 and sale 2, sec. 925(a)(2); and the taxable income of the FSC
as computed after applying the section 482 method to sale 1, sec. 925(a)(3).25
23
Foreign trading gross receipts were defined in sec. 924 to include gross
receipts from export sales or commission transactions.
24
The amount computed under sec. 925(a)(1) could not exceed twice the
amount computed under sec. 925(a)(2)--i.e., 46% of the combined taxable income
of the FSC and its related supplier from sale 1 and sale 2. Sec. 925(d).
25
The FSC regulations referred to the first two methods as “administrative
pricing methods” and to the third method as the “section 482 method”. See, e.g.,
sec. 1.925(a)-1T(b)(1), Temporary Income Tax Regs., 52 Fed. Reg. 6444 (Mar. 3,
1987). Collectively they are referred to as “transfer pricing methods”. Id.Sec. 925(a) and (c) provided that the FSC and its related supplier could
(continued...)
- 31 -
More simply, section 925(a)(1) and (2) allowed the FSC and its related
supplier to set the sale 1 price at any amount so long as it was above a certain
threshold. The threshold varied depending on the profit margin of the overall
export transaction (by profit margin, we mean the aggregate taxable income from
sale 1 and sale 2 divided by the gross proceeds from sale 2). Essentially, if the
profit margin was below 3.98%, the FSC and its related supplier could assign a
maximum of 46% of the combined income to the FSC (by adjusting the sale 1
transfer price). If the profit margin was between 3.98% and 7.96%, the maximum
amount of taxable income assignable varied inversely from 46% to 23%,
respectively. If the profit margin exceeded 7.96%, they could assign a maximum
of 23% of the combined taxable income to the FSC.26 The FSC and its related
25
(...continued)
apply the sec. 925(a)(1) and (2) methods only if certain requirements were met.
See sec. 1.925(a)-1T(b)(2)(ii), Temporary Income Tax Regs., 52 Fed. Reg. 6444-
6445 (Mar. 3, 1987). These minimal requirements, however, could be contracted
to another party (or back to the related supplier). See sec. 925(c); sec. 1.925(a)-
1T(b)(2)(ii), Temporary Income Tax Regs., supra. That is, the FSC and its related
supplier could essentially contract around the sec. 925(c) requirements (as
happened in petitioners’ cases). Respondent has not argued that the sec. 925(c)
requirements were not met in these cases. We therefore deem any such argument
to have been waived or conceded.
26
If the profit margin on an overall export transaction (i.e., taxable income
from sale 1 and sale 2 over gross receipts from sale 2) was below 3.98%, then
1.83% of gross receipts (i.e., 1.83% of the gross proceeds of sale 2) would always
(continued...)
- 32 -
supplier could also choose to deal at arm’s length (but presumably would do so
only if that provided a better result than the section 925(a)(1) and (2) methods).
Section 925(b) allowed the FSC and its related supplier to depart from the
section 925(a) paradigm and achieve similar tax results (which is what happened
in petitioners’ cases). See, e.g., sec. 1.925(a)-1T(d)(2), Temporary Income Tax
Regs., 52 Fed. Reg. 6447 (Mar. 3, 1987). The related supplier was permitted to
pay the FSC a “commission” for services (relating to an export transaction) that
were not, in substance, performed by the FSC (although the FSC could perform
such services if it wished). Id. That is, for the purpose of computing “the taxable
income” of the FSC and its related supplier under section 925(a), the FSC and its
related supplier were allowed to set and pay a commission for services (that might
not actually have been rendered), so long as the taxable income derived from the
26
(...continued)
exceed 46% of combined taxable income (0.0398 × 0.46 = 0.0183), meaning that
sec. 925(a)(1), as capped by sec. 925(d), see supra note 24, would always provide
the most advantageous assignment of taxable income to the FSC (assuming that
the sec. 482 method did not provide a better result). If the profit margin was
greater than 7.96%, then 23% of combined taxable income would always exceed
1.83% of gross receipts (0.0796 × 0.23 = 0.0183), meaning that sec. 925(a)(2)
would always provide the most advantageous assignment. If the profit margin was
between 3.98% and 7.96%, then 1.83% of gross receipts would always be between
46% and 23% of combined taxable income, meaning that sec. 925(a)(1) would
always provide the most advantageous assignment (and the sec. 925(d) cap would
not apply).
- 33 -
commission payment by the FSC did not exceed the amount computed under
section 925(a). See sec. 925(b). In general, the related supplier would carry out
the export sale itself (i.e., a sale corresponding to sale 2, above) and then pay a
commission to the FSC equal to the taxable income that would have been
attributed to the FSC, if the section 925(a) paradigm had been followed. The
commission payment was deductible by the related supplier and constituted
foreign trading gross receipts to the FSC.
B. Effective Tax Rate Cut for Qualifying Income
If a corporation qualified as an FSC under section 922, its “exempt foreign
trade income” (EFTI) was not taxed by the United States (more precisely, EFTI
was treated as foreign source income which was not effectively connected with the
conduct of a trade or business within the United States). See secs. 864(c), 881,
882, 884, 921(a).27
EFTI was generally the sum of: sixteen twenty-thirds of however much
“foreign trade income” of the corporation was attributable to transactions utilizing
the section 925(a)(1) and (2) methods; and 32% of any remaining foreign trade
income--i.e., income computed under the section 482 method pursuant to section
925(a)(3). See secs. 923(a), 925(a) and (b); see also former sec. 291(a)(4).
27
Respondent agrees that petitioners’ FSC qualified under sec. 922.
- 34 -
Foreign trade income was the gross income attributable to foreign trading gross
receipts. Sec. 923(b).28
In sum, section 925 allowed part of the income from an export transaction to
be assigned to an FSC, and section 921(a) excluded part of the assigned income
from the tax base, resulting in an effective tax rate cut for export income.
Moreover, if the relaxed transfer pricing rules of section 925(a)(1) and (2) were
used instead of the normal section 482 rules, then the lower the profit margin on a
particular export transaction, the lower the effective marginal tax rate for that
transaction (because as the profit margin decreased, the amount of taxable income
assignable to the FSC increased).
28
Sec. 924(b) required that, for receipts to be treated as foreign trading gross
receipts, the FSC had to be managed outside the United States, see sec. 924(c), and
economic processes with respect to the receipts had to take place outside of the
United States. There was an exception, however, for “small FSCs”, which did not
have to meet either requirement. Secs. 922(b), 924(b)(2), 927(f). Petitioners
claim, and respondent does not dispute, that their FSC was a small FSC.
If the FSC received or accrued any (1) foreign trade income that was neither
EFTI nor sec. 923(a)(2) nonexempt income, (2) interest, dividends, royalties or
other investment income, or (3) carrying charges, that other income was taxed as
income effectively connected with a United States trade or business. Sec. 921(d).
Dividends from an FSC to a corporate parent--unlike most dividends from a
foreign subsidiary--were generally not taxed because the parent received a 100%
dividends received deduction for dividends from an FSC. See sec. 245(c).
- 35 -
C. Application of FSC Rules to Petitioners’ Transactions
Pursuant to section 925(a)(2) and (b), petitioners assigned to their FSC 23%
of the combined income from Injector Co.’s export sales (column 2, below).29 The
taxable income of their FSC was equal to seven twenty-thirds of the amount so
assigned (column 3). See sec. 923(a)(3). For each year from 1998 to 2001, the
taxable income of the FSC was less than $50,000, so the FSC was subject to tax at
a 15% corporate rate (column 4). See sec. 11(b)(1)(A). The difference between
the amount assigned to the FSC and the FSC tax was paid, nominally, as a
dividend to petitioners’ Roth IRAs (column 5).30
29
All of Injector Co.’s export sales in 1998-2001 had a profit margin over
7.96%. Petitioners used commission transactions, and the FSC performed few if
any services, so the sec. 925(a)(3) method, i.e., the normal sec. 482 method, was
not used. Therefore, up to 23% of the combined income from Injector Co.’s
export sales was assignable to the FSC through commission transactions. See
supra note 26.
30
Any fees paid to Quail Street were built into the combined income
calculation, and in practice some of the dividends may have been paid in the year
after the commission transactions occurred.
- 36 -
(1) (2) (3) (4) (5)
Income FSC
Combined assigned taxable
Year income to FSC income FSC tax Dividends
1998 $686,808 $157,966 $48,077 $7,211 $150,754
1999 607,315 139,682 42,512 6,377 133,306
2000 600,414 138,095 42,029 6,304 131,791
2001 533,967 122,812 37,378 5,607 117,206
Total 533,057
D. The Limited Scope of the FSC Provisions
There were three parts to petitioners’ transactions. (1) Petitioners created
self-directed Roth IRAs, which nominally purchased stock in an FSC. Petitioners’
business, Injector Co., simultaneously executed a series of agreements with the
FSC.31 (2) Petitioners’ business made a series of commission payments to the FSC
under section 925(b). (3) After withholding taxes, the FSC paid the balance of the
payments to petitioners’ Roth IRAs.
Petitioners claim that the substance doctrines do not apply to any of the
three parts of their transactions because the FSC statutes approve of the FSC form
without regard to substance. But nothing in these statutes or the associated
regulations suggests any application to the first and third parts of petitioners’
transactions.
31
Purchase and entrance into all contracts were each conditioned on the
other, and so we treat this as one step.
- 37 -
As illustrated above, it is true that sections 921-927 allowed a limited safe
harbor from section 482 for the second part of petitioners’ transactions--the
commission payments to the FSC. But sections 921-927 modify or relax the
normal rules only for the purpose of computing the income taxes of the FSC and
its related supplier and only for specific transactions between the FSC and its
related supplier. In particular, section 925(a) clearly states that it allows “the
taxable income of such FSC and [the related supplier]” to be based on a transfer
price computed under the three transfer pricing methods provided. Regardless of
whatever lack of substance is excused by section 925, the plain terms of section
925 extend that excuse, specifically, only for the purpose of computing “the
taxable income” of “such FSC” and its related supplier.
No part of the FSC statutes and regulations states, or even implies, that
purchases or transfers of FSC stock, or any transactions at the shareholder level or
between the FSC and its owners, are exempt from application of the substance
doctrines, which are our normal “tool[s] of statutory interpretation”. Santander
Holdings USA, Inc. v. Commissioner, 844 F.3d at 21. Therefore, the normal
substance doctrines apply in these cases, at least for the purpose of determining
- 38 -
the economic realities of the relationships among petitioners, their Roth IRAs, and
the FSC.32
VI. The Payments to the Roth IRAs Were Contributions.
Under the plain terms of section 408A, value may enter a Roth IRA in only
two ways: as a contribution, see sec. 408A(c), or as income on an investment held
by the Roth IRA, see secs. 408A(a), 408(e)(1). Respondent argues that the
payments were contributions by petitioners, whereas petitioners argue that the
FSC paid dividends, i.e., a form of income, directly to the Roth IRAs. The critical
question, then, is whether the funds transferred from the FSC to petitioners’ Roth
IRAs were contributions (as respondent claims) or income (as petitioners claim) to
the Roth IRAs.
On the record before us, it is evident that the payments from the FSC were
dividends to someone--either to petitioners or to their Roth IRAs. An old and
well-developed body of law explains how we are to decide who, in substance,
32
The regulations support the conclusion that although an FSC may lack
substance in one sense it is not exempt from normal application of the Code in
other situations. For instance, transactions between an FSC and entities other than
the related supplier are still subject to the normal transfer pricing rules. Sec.
1.925(a)-1T(e)(2), Temporary Income Tax Regs., 52 Fed. Reg. 6448 (Mar. 3,
1987), provides: “In applying section 482 to a transfer by a FSC to a related party,
the parties [i.e., the FSC and its related supplier] are treated as if they were a single
entity carrying on all the functions performed by the FSC and its related supplier
with respect to the transaction.”
- 39 -
receives income under the Code. “In an ordinary case attribution of income is
resolved by asking whether a taxpayer exercises complete dominion over the
income in question.” Commissioner v. Banks, 543 U.S. 426, 434 (2005) (citing
Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955)). In cases where
a right to receive income is allegedly transferred before the income arises, courts
have held that a taxpayer received income if the taxpayer controlled the source of
the income, even where the taxpayer did “not have dominion over the income at
the moment of receipt.” Id. In other words, where a taxpayer formally transfers a
right to income to another,
the question becomes whether the assignor retains dominion over the
income-generating asset, because the taxpayer “who owns or controls
the source of the income, also controls the disposition of that which
he could have received himself and diverts the payment from himself
to others as the means of procuring the satisfaction of his wants.”
* * * Looking to control over the income-generating asset, then,
preserves the principle that income should be taxed to the party who
earns the income and enjoys the consequent benefits.
Id. at 434-435 (quoting Helvering v. Horst, 311 U.S. 112, 116-117 (1940)).33
33
The dissent questions the applicability of Commissioner v. Banks, 543
U.S. 426 (2005), because Banks involved contingency fees rather than “dividends
or corporations”. See dissenting op. p. 89. But Banks is not so tightly confined.
As the Supreme Court explained in Banks, its holding is based on the anticipatory
assignment of income doctrine, the principle that a “taxpayer cannot exclude an
economic gain from gross income by assigning the gain in advance to another
party.” Id. at 433. The Supreme Court has called this “the first principle of
(continued...)
- 40 -
In petitioners’ cases, the “income-generating asset” was the FSC.34
Petitioners suggest that when their Roth IRAs formally purchased the FSC, the
Roth IRAs thereby acquired the right (represented by the FSC stock) to receive
income from the FSC. But a formal purchase does not necessarily mean that for
tax purposes the Roth IRAs should be treated as the recipients of income from the
FSC; the question is who had power and control over the FSC or over receipt of
the dividend income. As the Supreme Court has stated: “The crucial question
remains whether the assignor retains sufficient power and control over the
assigned property or over receipt of the income to make it reasonable to treat him
as the recipient of the income for tax purposes.” Commissioner v. Sunnen, 333
U.S. 591, 604 (1948). “[T]axation is not so much concerned with the refinements
of title as it is with actual command over the property taxed--the actual benefit for
which the tax is paid.” Corliss v. Bowers, 281 U.S. 376, 378 (1930).
33
(...continued)
income taxation”, id. at 434, a principle first enunciated in such cases as Lucas v.
Earl, 281 U.S. 111 (1930), and Corliss v. Bowers, 281 U.S. 376, 378 (1930). The
assignment of income doctrine has been applied to efforts to shift income not only
among individuals but also among entities. See generally Boris I. Bittker &
Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts, para. 75.2
(Westlaw 2018).
34
The dissent argues that the FSC was not an income-generating asset. We
disagree. Although the FSC may be an unusual entity in some respects, it still
generates dividends, which are income.
- 41 -
As described above, section 925 effectively allowed assignment of income
relating to export transactions from the related supplier to the FSC. Respondent
does not dispute this. But the question is not whether income could be assigned to
the FSC. Rather, the question is: Who owned and controlled the FSC in
substance?
In cases involving the substance of ownership, the Court of Appeals for the
Ninth Circuit has looked to Frank Lyon Co. v. United States, 435 U.S. 561 (1978),
and to Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir. 1990), aff’g in part,
rev’g in part Larsen v. Commissioner, 89 T.C. 1229 (1987), and aff’g Casebeer v.
Commissioner, T.C. Memo. 1987-628, Moore v. Commissioner, T.C. Memo.
1987-626, and Sturm v. Commissioner, T.C. Memo. 1987-625. See Sacks v.
Commissioner, 69 F.3d at 988 (“Our analytic task is to decide whether Mr. Sacks’
sale and leaseback was more like Frank Lyon, or more like Casebeer.”).
In Frank Lyon, a bank sold a building to the taxpayer, who leased the
building back to the bank. The taxpayer financed the purchase of the building
with a recourse loan from a third-party lender. The Commissioner took the
position that the sale and leaseback arrangement had no substance, and that the
true owner of the building was the bank. As the Court of Appeals for the Ninth
Circuit has stated:
- 42 -
The Supreme Court held for the taxpayer * * *. In so holding, the
Court said “most significantly” the * * * [taxpayer], and not the bank,
was personally liable on the loan to the third party lender. The * * *
[taxpayer’s] personal liability was significant because he had a “real
and substantial risk” such that, “should anything go awry” in the plan
to have the bank’s rent always cover the obligation on the note, the
* * * [taxpayer’s] capital and assets were exposed. It also mattered to
the decision that the depreciation deductions were not created ex
nihilo by paper shuffling; the bank would have been entitled to them
if the investor had not purchased the real estate.
Sacks v. Commissioner, 69 F.3d at 987 (internal citations omitted).
The Court of Appeals for the Ninth Circuit examined a similar arrangement
in Casebeer but reached the opposite result because when the court “penetrated the
papers ostensibly selling and leasing back the computers, it became clear that the
investors had nothing at risk and nothing to gain except tax benefits. The
computer company retained all of the benefits and risks of ownership.” Id. at 988.
The taxpayer in Casebeer used a nonrecourse financing arrangement (unlike the
taxpayer in Frank Lyon, who used a recourse financing arrangement).
Finally, in Sacks, another sale and leaseback case, the Court of Appeals for
the Ninth Circuit again focused on the benefits and risks of ownership to
determine whether a sale transaction had “practical economic effects” in addition
to the shifting of tax benefits. Id. Sacks focused on whether the claimed
purchaser was personally liable (recourse or nonrecourse liability), whether the
- 43 -
price paid represented fair market value, and whether “part of the speculative risk”
was shifted to the claimed purchaser. Id. at 990-992.35
Consistent with the approach of Frank Lyon, Casebeer, and Sacks, we ask
whether petitioners’ Roth IRAs were exposed to any downside risk or could have
expected any upside benefits from their claimed ownership of the FSC. In doing
so, we consider all the facts and circumstances, keeping in mind that “[t]he high
stakes in tax cases, and the high intelligence of tax lawyers, make[] it impossible
to have a simple checklist or rigid formula for determining whether a transaction is
a sham.” Id. at 988. In sum, we examine the entire transaction to decide whether
substantive ownership and control of the benefits and burdens represented by the
FSC stock were transferred to the Roth IRAs.
A. The Roth IRAs Were Exposed to No Risk.
In 1998 each petitioner contributed a small sum of cash to his or her
respective self-directed Roth IRA. An even smaller portion of that cash--$500 in
total--was purportedly used by the Roth IRAs to purchase the FSC stock from
WGA. Petitioners suggest that because a small sum was paid to set up the entity,
35
Sacks v. Commissioner, 69 F.3d 982, 988 (9th Cir. 1995), rev’g T.C.
Memo. 1992-596, also briefly discussed another factor: whether the taxpayer’s
business was genuine. We think that this factor is inapplicable because--as
petitioners argue--an FSC need conduct little if any substantive business of its
own.
- 44 -
that sum is a substantive investment which the Roth IRAs stood to lose. We
disagree.
A “de minimis risk does not necessarily give substance to a transaction that
is otherwise without risk.” John Hancock Life Ins. Co. (U.S.A.) v. Commissioner,
141 T.C. 1, 94 (2013) (citing ASA Investerings P’ship v. Commissioner, 201 F.3d
505, 514-515 (D.C. Cir. 2000), aff’g T.C. Memo. 1998-305). Petitioners have not
shown, and the record does not suggest, that the Roth IRAs ever paid any costs or
fees other than the initial $500 amount. Moreover, the FSC was a corporate entity;
the Roth IRAs were protected from liability by the FSC’s corporate shield, and
nothing in the record suggests that creditors would have been likely to pierce the
corporate veil (nor does the record suggest that the FSC had any creditors, other
than possibly Injector Co.). Therefore, on the basis of the entire record, we
conclude that the $500 price represented at most a de minimis risk which was
insufficient to give substance to the Roth IRAs’ purported ownership of the FSC
stock.36
36
The dissent argues that we are wrong to ask whether the Roth IRAs put
anything at risk; it says that under our reasoning, “no one could ever own an FSC
because FSCs never put capital at risk.” See dissenting op. p. 91. But it is
incorrect to suggest that an FSC could never put capital at risk; nothing in the
Code prevents an FSC shareholder from capitalizing its FSC. In any event, we are
not concerned with whether the FSC had capital at risk; we ask whether the
(continued...)
- 45 -
In any event, petitioners have failed to show that the negligible $500
“purchase price” of the FSC stock amounted to anything more than a fee paid to
WGA to set up a new and empty FSC. Nothing in the record suggests that the
prearranged $500 “price” bore any relationship to the actual value of what was
purportedly purchased, i.e., the FSC stock. At trial the parties agreed that the
stock in the FSC was worth only $100 when it was purchased. We note, however,
that whether the value of the stock was $500 or $100 at the moment of purchase,
the shareholders’ agreement (which was entered into simultaneously with the
purchase) specifies that, if the Roth IRAs were to sell their FSC stock, the total
sale price for all 100 shares was to be $1, rather than $500 or $100. The fixed
discrepancy between the predetermined $500 purchase price and the immutable $1
sale price strongly suggests that all but the nominal amount of $1 was a fee for
36
(...continued)
putative FSC shareholders, i.e., the Roth IRAs, bore any risk. We examine
whether the Roth IRAs were exposed to risk because Frank Lyon, Casebeer, and
Sacks each analyzed the taxpayer’s financing arrangements to determine whether
the alleged owner was exposed to real economic risk. In accord with these
precedents, we acknowledge that the presence of recourse liability (or something
similar) would make ownership more likely. But the Roth IRAs were never
exposed to appreciable economic risk; the full extent of their exposure was the
negligible amount paid for the FSC stock. Petitioners’ cases are therefore more
similar to Casebeer (where the court held against a taxpayer who used nonrecourse
financing) than to Frank Lyon or Sacks (where the courts held for taxpayers who
used recourse financing).
- 46 -
access to the FSC rather than a payment for property. Cf. Hewlett-Packard Co. v.
Commissioner, 875 F.3d 494 (9th Cir. 2017) (differentiating between fees and
bona fide losses), aff’g T.C. Memo. 2012-135. Consequently, considering the
FSC stock in the light of the shareholders’ agreement, we conclude that the Roth
IRAs paid only $1 for the FSC stock. The rest was a fee. Petitioners have not
cited, nor are we aware of, any authority for the proposition that such a fee is
capable of lending substance to a series of transactions.37
Petitioners also suggest that their transactions have substance because the
Roth IRAs were eventually exposed to risk with respect to investments purchased
37
The dissent asserts that under our reasoning petitioners “couldn’t have
owned the FSC either”, because petitioners also put nothing at risk. See
dissenting op. p. 91. This is incorrect; petitioners were exposed at all times to the
underlying business risk, i.e., that their investment in their export business would
decline. The Roth IRAs were not exposed to that risk because they never made an
investment (they paid only a nominal amount for the FSC stock and never
capitalized the FSC) and because no fixed right to receive commission payments
was ever transferred to the FSC (i.e., if a fixed right to receive a portion of the
export income had been transferred to the FSC, the value of the FSC stock would
have varied with the export market and the Roth IRAs would have been exposed
to the risk that the right to receive income held by the FSC would decline with the
export market).
In any event, in these cases we are examining whether the purchase
transaction was sufficient to transfer substantive ownership to the Roth IRAs; risk
is just one factor to be considered. Even if petitioners bore little risk with respect
to the FSC, they owned the FSC because they controlled every aspect of its
existence through the contractual powers retained by Injector Co. (discussed in the
next section); the Roth IRAs (unlike, for example, the taxpayer in Frank Lyon) put
nothing at risk to alter this ownership equation.
- 47 -
with alleged dividends received from the FSC. But any contribution is exposed to
risk when a Roth IRA subsequently invests it. The subsequent risk does not
transform the initial contribution into income. The relevant question here is
whether the FSC stock was owned, for tax purposes, by the Roth IRAs. The fact
that the Roth IRAs were eventually exposed to risk on investments made with cash
derived from these transactions is irrelevant.
B. The Roth IRAs Could Expect No Upside Benefits.
Because petitioners were in complete control of their Roth IRAs, their
business, and their FSC, all of these parties were related for all practical economic
purposes. Consequently, we apply heightened scrutiny to these transactions. See
Brown v. United States, 329 F.3d 664, 673 (9th Cir. 2003) (“The parties are
related, so heightened scrutiny is appropriate.” (citing Kornfeld v. Commissioner,
137 F.3d 1231, 1235 (10th Cir. 1998), aff’g T.C. Memo. 1996-472)). In doing so,
we ask what benefits an independent holder of the FSC stock could realistically
have expected on the basis of the “objective nature” of the FSC stock. Reddam v.
Commissioner, 755 F.3d at 1057.
Injector Co. retained complete control over whether any of its export
receipts would flow to the FSC in any year. The commission agreement between
petitioners’ business and the FSC states: “At all times * * * [petitioners’ business]
- 48 -
shall have the discretion as to when and how much it wishes to pay FSC and no
account receivable shall ever exist between FSC and * * * [petitioners’ business].”
Consequently, no independent holder of the FSC stock would have been entitled
to, or would have expected, any upside; Injector Co. retained complete control
over whether any payments would ever be made.
Furthermore, Injector Co.’s control over upside profits extended beyond the
discretion to direct commission payments to the FSC. The commission agreement
also allowed Injector Co. to reach into the FSC and take back any payments that
had already been made--i.e., under the commission agreement, petitioners’
business controlled any profits even after those profits had been paid to the FSC.38
38
More specifically, the commission agreement provided that any amount
paid to the FSC by petitioners’ business
shall be agreed upon by the parties and may vary from time to time by
mutual agreement, so as to provide the maximum [F]ederal income
tax benefits to * * * [petitioners’ business] and [the] FSC * * *. * * *
[Petitioners’ business] shall have the final decision as to whether [the]
FSC is considered to have solicited or promoted a transaction with a
customer and may prospectively or retroactively add or delete
transactions entitling [the] FSC to a commission. [Emphasis added.]
(Similar provisions also existed for sale, license, and lease commissions.) The
duration of the power to retroactively delete transactions is not specified, but
nothing in the record rules out the possibility that petitioners’ business could have
deleted a transaction even after the associated commission had been paid to the
FSC. In other words, Injector Co. retained the power to decide--after the
(continued...)
- 49 -
On these facts, no independent holder of the FSC stock could realistically
have expected to receive any benefits (before or after tax) due to its formal
ownership of the FSC stock; Injector Co. retained control over any benefits at all
relevant times.
C. Conclusion
In form, petitioners’ Roth IRAs purchased FSC stock for $1 and the FSC
simultaneously entered into a series of contracts with Injector Co., which were
executed as part of the plan of purchase. As described, the Roth IRAs effectively
paid nothing for the FSC stock, put nothing at risk, and from an objective
perspective, could not have expected any benefits. From that nominal initial
investment, petitioners claim that their Roth IRAs earned dividends totaling
$533,057 over four years.
Considering all the facts in the record, however, it is evident that the Roth
IRAs’ formal purchase of the FSC stock for $1 did not reflect the underlying
38
(...continued)
commissions were paid--that the FSC was not entitled to a commission with
respect to a particular export transaction. Deletion of the export transaction would
have had the effect of converting the associated commission payment into a loan
from Injector Co. to the FSC under a section of the commission agreement
detailing the treatment of overpayments.
- 50 -
reality; i.e., petitioners’ capacity (through Injector Co.)39 and clear intention to
direct Injector Co. to make large commission payments to the FSC. The form of
the transactions the Roth IRAs entered into does not reflect the underlying related-
party expectations and intentions. Petitioners’ transactions attempt to utilize this
mismatch between substance and form to defeat the contribution limits. We have
not found any textual support in the Code or the regulations that would allow such
a mismatch between the form and substance of a purchase by these Roth IRAs.
We therefore disregard the purchase.
Furthermore, because petitioners (through various passthrough entities)
controlled every aspect of the transactions in question, we conclude that they, and
not their Roth IRAs, were the owners of the FSC stock for Federal tax purposes at
all relevant times.40 The dividends from the FSC are therefore properly
recharacterized as dividends from the FSC to petitioners, followed by petitioners’
contributions of these amounts to their respective Roth IRAs. All of these
payments exceeded the applicable contribution limits and were therefore excess
39
Petitioners’ export receipts had fluctuated to some degree over the years,
but they had reliable and established export receipts when they entered these
transactions.
40
We note that, because no income tax issues are presented in these cases,
we need not and do not consider whether the FSC was owned by and through one
of petitioners’ passthrough entities rather than directly by petitioners.
- 51 -
contributions. We therefore uphold respondent’s determination of excise taxes
under section 4973.
VII. Petitioners’ Counterarguments
A. Summa Holdings II
Petitioners argue that the reasoning of the Court of Appeals for the Sixth
Circuit in Summa Holdings, Inc. v. Commissioner (Summa Holdings II), 848 F.3d
779--which reversed in part Summa Holdings, Inc. v. Commissioner (Summa
Holdings I), T.C. Memo. 2015-119--applies to petitioners’ cases and precludes
application of the substance over form doctrine. We disagree. We are not bound
to follow Summa Holdings II in these cases, which are appealable to the Court of
Appeals for the Ninth Circuit in the absence of a stipulation to the contrary. See
sec. 7482(b)(1)(A), (2). In any event, the holding in Summa Holdings II pertained
to a related but different issue.
In Summa Holdings I a domestic international sales corporation (DISC) was
used generally in the same way the FSC was used in these cases.41 Individual
41
DISCs are U.S. corporations electing to be taxed under secs. 991-997.
Secs. 991-997 were enacted in 1971 and substantially modified in 1984 by the
same act that introduced FSCs to the Code. See Deficit Reduction Act of 1984,
Pub. L. No. 98-369, secs. 801-805, 98 Stat. at 985-1003; Revenue Act of 1971,
Pub. L. No. 92-178, secs. 501-507, 85 Stat. at 535-553. FSCs were created to
replace the pre-1984 version of DISCs. See generally Boris I. Bittker & James S.
(continued...)
- 52 -
taxpayers owned Roth IRAs and a business (which was organized as a C
corporation). The Roth IRAs nominally owned stock in a DISC. The C
corporation made payments to the DISC (under a set of statutes and regulations
somewhat similar to those of the FSC regime), and the DISC made payments to
the Roth IRAs, which the taxpayers claimed were dividend income to the IRAs.
Holding for the Commissioner, we concluded that in substance the payments to the
Roth IRAs were contributions and not income from the DISC.
The taxpayers before this Court in Summa Holdings I were individual
taxpayers (who resided in the First and Second Circuits) and their C corporation
(which had its principal place of business in the Sixth Circuit). All of these
taxpayers appealed. The only taxpayer before the Court of Appeals for the Sixth
Circuit in Summa Holdings II was the C corporation; consequently the issue
before that court was limited to whether the commissions paid to the DISC were
deductible by the taxpayers’ business, i.e., the C corporation. The Court of
41
(...continued)
Eustice, Federal Income Taxation of Corporations and Shareholders, para. 15.23
(Westlaw 2018). The FSC statutes were repealed in 2000, see supra note 4, but
the DISC provisions remain in the Code, as amended. In general, DISCs continue
to allow a deferral benefit; i.e., qualifying export-related income held in a DISC is
not subject to current taxation. See secs. 991-997. DISC shareholders are,
however, subject to an annual interest charge on taxes deferred by the DISC. Sec.
995(f).
- 53 -
Appeals for the Sixth Circuit decided that the commissions were deductible but
appropriately did not consider the issue of whether the payments to the Roth IRAs
were contributions. That shareholder-level issue is among the issues currently
before the Courts of Appeals for the First and Second Circuits, to which the
individual taxpayers in Summa Holdings I have appealed (under the names
Benenson v. Commissioner, Nos. 16-2066 and 16-2067, and Benenson v.
Commissioner, No. 16-2953, respectively). Accordingly, as the case presently
before us involves only the shareholder-level issue (any corporate-level issues are
barred by the statute of limitations), the holding in Summa Holdings II is not
directly on point; that opinion did not analyze the payments to the Roth IRAs, the
facts specifically relating to those payments, or the ownership of the DISC stock
for tax purposes.
Moreover, there are differences between DISCs and FSCs that make these
cases different from Summa Holdings II. Payments to a DISC that are distributed
to individual shareholders generally escape corporate-level taxation (which is not
true in the FSC case, as FSCs pay corporate-level tax), and payments from a DISC
to a Roth IRA are generally subject to an unrelated business income tax under
section 995(g). See secs. 401(a), 408(a), 408A(a), 501(a), 511, 995(g); see also
- 54 -
sec. 1.921-2(c), Q&A-6, Income Tax Regs. (explaining how FSCs differ from
DISCs).
Petitioners attempt to analogize their cases to the DISC situation, arguing
that because Congress acknowledged ownership of DISCs by IRAs when it added
section 995(g), see H.R. Rept. No. 101-247, at 1425-1426 (1989), 1989
U.S.C.C.A.N. 1906, 2895-2896, it must also have approved generally of avoidance
of the contribution limits via related-party transactions, not only for DISCs, but
also for FSCs. We disagree.
Section 995(g) responds specifically to DISC mechanics (rather than to
elements common to both DISCs and FSCs), which--before enactment of section
995(g)--allowed the income routed through a DISC to an IRA to escape both
corporate- and shareholder-level taxes entirely. Congress determined that this was
too much of a benefit and in response passed section 995(g), which taxes DISC
dividends to IRAs. See H.R. Rept. No. 101-247, at 1425, 1989 U.S.C.C.A.N. at
2895 (“This treatment was intended to prevent taxable entities from seeking to
exempt active business income from tax[.]”). FSC mechanics are different--unlike
DISCs, FSCs pay a (lowered) corporate income tax.
In any event, although section 995(g) may contemplate ownership of DISCs
by IRAs in general, in these cases we are not concerned with the ownership of
- 55 -
FSCs in general; rather our concern is whether, on the particular facts and
circumstances of these cases, petitioners’ Roth IRAs owned the FSC in substance.
As we have found, these cases involve related-party transactions which did not in
substance transfer any investment to the Roth IRAs. Section 995(g) therefore does
not resolve the issue before us.42
B. Petitioners’ Ownership Argument
Petitioners also argue that Swanson v. Commissioner, 106 T.C. 76 (1996),
Hellweg v. Commissioner, T.C. Memo. 2011-58, 101 T.C.M. (CCH) 1261 (2011),
and Ohsman v. Commissioner, T.C. Memo. 2011-98, indicate that Roth IRAs may
own FSC stock and that therefore the form of their transactions must be respected.
But respondent has not disputed that Roth IRAs may sometimes own FSC stock,
and nothing in our holding today suggests otherwise. Those three cases do not
specifically address whether related-party transactions which do not in substance
transfer any investment to a Roth IRA can give rise to income for the Roth IRA.
42
The dissent, see dissenting op. p. 81, similarly argues that, because the
DISC and FSC regulations do not prohibit ownership by individuals or entities
other than the related supplier, ownership of FSC stock by Roth IRAs is permitted
under the Code in every circumstance. The dissent’s argument fails for the same
reason petitioners’ arguments fails: Allowance for ownership of FSC stock by
Roth IRAs in general does not mean that the Code allows petitioners’ specific
purchase transactions.
- 56 -
Rather, those cases address issues that are not specifically presented in petitioners’
cases.
In Swanson v. Commissioner, 106 T.C. at 86-92, the Court rejected the
Commissioner’s arguments that sections 408(e)(2) and 4975 prohibit (1) a new
entity from issuing all of its stock to an IRA or (2) an entity wholly owned by an
IRA from issuing dividends to the IRA. But respondent has not asserted that
sections 408(e)(2) and 4975, which address certain prohibited transactions, apply
to these cases. Respondent argues these cases under section 4973, which pertains
to excess contributions. Consequently petitioners’ reliance on Swanson is
misplaced.
In Hellweg and Ohsman the Court rejected the Commissioner’s attempt to
recharacterize the taxpayers’ transactions for the purposes of the section 4973
excise tax without asserting adjustments to the taxpayers’ income tax. In Hellweg
v. Commissioner, 101 T.C.M. (CCH) at 1267, we stated: “Our decision does not
prevent the Service from recharacterizing the [t]ransaction consistently for income
tax and excise tax purposes.” As we decided in an earlier Memorandum Opinion
denying petitioners’ motion for summary judgment, Mazzei v. Commissioner, T.C.
Memo. 2014-55, any income tax issues are barred by the statute of limitations, and
so Hellweg and Ohsman are inapplicable.
- 57 -
C. Petitioners’ Congressional Purpose Arguments
Petitioners argue that recharacterizing ownership of the FSC stock and the
payments to the Roth IRAs would frustrate the congressional purpose of the FSC
provisions. But nothing in the FSC provisions suggests that either the plain
language of the Code (which we have discussed in detail above), or any purpose of
the FSC regime, would be contravened or frustrated by determining ownership of
the FSC stock in accord with substance and characterizing the payments to the
Roth IRAs in accord with that substance. Petitioners have not identified, nor are
we aware of, any specific legislative purpose for the FSC provisions other than to
provide a lower corporate rate for qualifying export-related income--something
petitioners achieved, irrespective of who owned the FSC stock. There was no
discernible legislative purpose to allow taxpayers to use FSCs to defeat the
contribution limits for Roth IRAs, as petitioners seek to do.
Petitioners also suggest that we cannot recharacterize these transactions
because that would run contrary to the congressional purpose behind section
408A. They seem to suggest that we cannot make a substance inquiry because
there could never be a nontax business purpose for contributing assets to an IRA;
the only reason to contribute assets to an IRA is to take advantage of a
congressionally sanctioned tax reduction mechanism. Petitioners’ argument might
- 58 -
have more force if they were claiming that their transactions resulted in
contributions; then we might agree that there need be no nontax business purpose
for those contributions. But petitioners claim that their transactions gave rise, not
to contributions, but to income to the Roth IRAs. We have therefore tested
petitioners’ income claim in accord with well-established caselaw by asking
whether the FSC was owned in substance by the Roth IRAs. Our analysis merely
applies the factors laid out in cases like Sacks v. Commissioner, 69 F.3d at 982.
Finally, petitioners argue that any recharacterization of their transactions is
prohibited by section 1.926(a)-1T(a), Temporary Income Tax Regs., 52 Fed. Reg.
6458 (Mar. 3, 1987), which provided: “Any distribution by an FSC (or former
FSC) to its shareholder with respect to its stock will be includible in the
shareholder’s gross income in accordance with the provisions of section 301.” But
that regulation does not indicate that we should depart from well-established
principles in deciding who, as a matter of substance, the FSC “shareholders” really
were, considering the practical economic realities of the transactions and taking
into account the actual benefits and risks of ownership.
- 59 -
VIII. Response to Dissent
A. Our Analysis Does Not Sham or Disregard Any Entities.
The dissent reflects throughout an incorrect belief that our analysis shams or
disregards the FSC or the Roth IRAs. To be clear, we do not disregard, sham,
ignore, or otherwise challenge the reality of the FSC or the Roth IRAs as such
under the Code. Instead, we examine the purchase, by the Roth IRAs, of the FSC
stock. The dissent does not explain why our analysis of this purchase is incorrect.
Its entire argument relates to why we should not sham the entities, which in fact
we do not do.43
B. Our Analysis Properly Considers the Facts as a Whole.
The dissent argues that the Court cannot look at the nominal amount paid by
the Roth IRAs for the FSC stock, or at the Roth IRAs’ related-party expectations,
intentions, and plan, or at the common control present in petitioners’ transactions
because, it says, any one of these things could be unobjectionable if considered in
isolation in some hypothetical scenario. But our analysis does not depend upon
any one of these factors in isolation. Rather, considering all the facts and
43
For example, the dissent cites Moline Props. v. Commissioner, 319 U.S.
436 (1943), and discusses business purpose, arguing that we should respect the
FSC. See dissenting op. p. 92. But we do respect the FSC. We do not apply a
business purpose test to the FSC. Moline Props. is therefore irrelevant.
- 60 -
circumstances, we conclude that the purchase of the FSC stock by the Roth IRAs,
together with the contracts that were entered into in consideration of that purchase,
created an untenable discrepancy between the form petitioners claimed and the
related-party substance underlying their transactions. In focusing on the various
factors individually, the dissent forgets that the analysis, according to the Court of
Appeals for the Ninth Circuit, must be “holistic[]”. Reddam v. Commissioner, 755
F.3d at 1060.
C. The Substance Inquiry Is Appropriate.
The dissent argues that the substance doctrines, however characterized, do
not apply to petitioners’ circumstances because, it says, the Code permits
petitioners to do what they did. We strongly disagree. The Code does not
explicitly or implicitly authorize the Roth IRAs’ purchase on these facts.
Having examined the Roth IRA and FSC provisions, we have not found--
nor has the dissent offered--any textual evidence to support the notion that a
discrepancy between substance and form in the purchase of FSC stock should be
ignored. Attempting to defend such a notion, the dissent says that FSCs are not
“meant to do anything except transfer value to get tax benefits”, see dissenting op.
p. 80, and that “Congress set up both the FSC structure and Roth IRAs not to have
- 61 -
any purpose other than tax reduction or avoidance”, see id. p. 97. These overbroad
statements reflect a misunderstanding of how the FSC provisions work.
It is true that sections 921-927 provided FSCs a particular type of tax
benefit, i.e., effective rate reduction for export income. But that does not mean, as
the dissent apparently thinks, that the purpose of FSCs is “tax avoidance” writ
large. As we have explained, section 925 provides carefully worded exceptions to
normal transfer pricing rules. These exceptions allow “the taxable income of such
FSC and [the related supplier]” to be based on a transfer price computed under the
three transfer pricing methods provided. These special transfer pricing methods
apply only if the related supplier has qualifying export receipts or makes an
export-related sale to the FSC. Insofar as an FSC does anything, therefore, other
than receiving qualifying export commissions or purchasing qualifying export
property from a related supplier, the FSC is treated no differently for tax purposes
from the way it would be treated if it were a C corporation. See, e.g., sec.
921(d).44 Consequently, contrary to the dissent’s suggestion, and far from being a
44
For example, if a related supplier had no export income in a particular
year, the FSC would not be able to price commissions under sec. 925; the special
transfer pricing rules would not apply. Or if an FSC and a related supplier
attempted to make commission payments unrelated to exports without the FSC
actually rendering real services to the related supplier, those commission payments
would lack substance--under the normal substance doctrines. Nothing in the Code
(continued...)
- 62 -
carte blanche exception from the substance doctrines for all FSC transactions, the
text of section 925 extends exceptions, specifically, to a very narrow set of
circumstances, i.e., (1) commission payments, sales, etc. that are (2) related to
export sales in a very clearly defined way (3) between parties that are related
(under the section 482 definition of a related party), one of which is a qualifying
FSC.
There is no dispute that the requirements for applying the section 925
pricing methods were met with respect to the commission payments between
Injector Co. and the FSC. But that is not the issue here. The issue is whether the
form of the purchase of FSC stock by the Roth IRAs must accord with its
substance. And because by its own terms section 925 does not apply to FSC stock
purchase transactions, there is no basis in the text of the FSC provisions, or
elsewhere in the Code for that matter, to conclude that we should turn a blind eye
to the substance of such transactions.
In short, the dissent leaps from an unsupported belief that the purpose of
sections 921-927 is “tax avoidance” to a conclusion that this generalized purpose
precludes the substance inquiry whenever FSCs happen to be involved, even
44
(...continued)
suggests that an FSC is not allowed to perform normal (i.e., non-sec. 925)
transactions in addition to sec. 925 transactions.
- 63 -
though that interpretation would extend the exception provided in section 925
beyond its stated terms.
D. Our Approach Appropriately Considers Value.
The dissent suggests that there is something incorrect in asking whether
what the Roth IRAs paid for the FSC stock bore any relation to the future value of
the FSC. But fair market value is the present value of future expected cashflows.
See, e.g., Estate of O’Connell v. Commissioner, 640 F.2d 249, 252 (9th Cir. 1981)
(“[E]xpected future earnings * * * are the true indicators of present worth[.]”
(citing Rev. Rul. 59-60, 1959-1 C.B. 237)), aff’g in part, rev’g in part on another
issue T.C. Memo. 1978-191.45
We have merely examined the disconnect between the claimed fair market
value of the FSC stock and the related-party value of the same stock, considering
that petitioners controlled every aspect of their transactions throughout. The
question is whether the formal purchase price and contracts, which were entered
into without the benefit of arm’s-length pressure, capture the economic deal
45
The dissent also discusses shareholder basis, see dissenting op. pp. 91-92,
which is entirely beside the point. Basis is, as the dissent points out, cost paid.
But the fact that basis follows from cost does not mean that cost paid was equal to
fair market value.
- 64 -
adequately enough to justify basing the tax treatment of the transactions on
petitioners’ formal characterization of the deal.
To be clear, on the basis of the paperwork that was executed, there was no
chance that commission payments would be made, in the absence of related-party
control. The contracts do not require or even incentivize Injector Co. to make
commission payments, and so neither the FSC nor an independent holder of the
FSC stock, from a formal perspective, could expect to receive anything.
Petitioners’ transactions pay only if the same parties control both Injector Co. and
the Roth IRAs; i.e., payment on the contracts at issue, in the absence of related-
party control, would be gratuitous from Injector Co.’s or the FSC’s perspective.
The FSC stock therefore had no fair market value, if all one considers is the
claimed form of the transactions.46
46
This complete lack of formal value is precisely why petitioners’ situation
differs from that presented in Sacks v. Commissioner, 69 F.3d 982. In Sacks there
was a possibility of after-tax return on the formal transaction. By contrast, as we
have noted, see supra p. 49, no independent holder of the FSC stock, considering
all the formal aspects of the deal that petitioners made, could expect to receive any
benefits, before or after tax. Sacks stands for the proposition that a taxpayer can
take tax effects or incentives into account when considering whether to make an
investment. By contrast, the tax benefits petitioners claim here depend on
commission payments actually being made, and the contracts the parties to these
transactions entered into do not require or even incentivize any such commission
payments. Consequently, unlike the situation in Sacks, even the after-tax return is
zero from an arm’s-length examination of the form petitioners claim to have
(continued...)
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Meanwhile, the substantive value, i.e., the value considering economic
reality, of the FSC stock to the Roth IRAs was extremely high at the moment of
purchase, considering petitioners’ capacity and intention to direct commission
payments from Injector Co. to the FSC. Our analysis has nothing to do with
investment “hopes”, see dissenting op. p. 92, and everything to do with the
economic reality of these transactions, including the established capacity and clear
intention to make payments. Comparing the nonexistent claimed value of the FSC
stock with the high substantive economic value of the stock to these parties, we
find a disconnect between substance and form in the stock purchase, which as
described is not sanctioned by section 925 (or any other section). The formal FSC
stock price and contracts do not reflect the economic reality of the purchase of that
stock.
E. The Dissent’s Hypothetical Misconceives Our Analysis.
The dissent claims, bizarrely, that our analysis could “wreak havoc” on
many, “perhaps hundred of thousands”, of small corporations. See dissenting op.
p. 94. The dissent’s unfounded fears reflect a serious misunderstanding, as
evidenced by what the dissent says next:
46
(...continued)
adopted.
- 66 -
By the majority’s reasoning, someone who created a business,
incorporated it, issued himself 100% of the stock in exchange for a
small capital investment, and continued to run the day-to-day
operations wouldn’t really own his corporation--especially if it was a
success. We’d have to disregard the corporation because the initial
investment was too small and didn’t accurately predict the business’s
future earnings.
See dissenting op. p. 94. This is nonsense. The dissent’s hypothetical scenario
would not involve a mismatch between substance and form. At the initial point of
capitalization, the fair market value and the substantive economic value would be
identical and equal to the capital investment. As the day-to-day operations
commenced, that initial value would begin to change in concert with changing
expectations regarding future cashflows. The fair market value and the
substantive economic value of the stock would remain identical, whether the
business was a success or not. Petitioners’ situation is different because at the
moment of purchase petitioners’ formal characterization of the purchase did not
match the underlying substantive and related-party economics.47
47
The dissent, see dissenting op. pp. 100-104, attempts to contrast our
approach with that of Cottage Sav. Assoc. v. Commissioner, 499 U.S. 554 (1991),
Gitlitz v. Commissioner, 531 U.S. 206 (2001), Austin v. Commissioner, T.C.
Memo. 2017-69, and Caterpillar Tractor Co. v. United States, 218 Ct. Cl. 517(1978). None of these cases addresses the substance of ownership arising from a
purchase in a related-party context. For example, the Commissioner did not
challenge the purchase transaction in Austin; as the Court found, “the company
funded the ESOP with a $500,000 loan * * * [and t]hese funds were used to
(continued...)
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F. The Dissent’s Approach Lacks Support in the Code.
The dissent concludes by declaring that “the great textualist
counterrevolution” makes our approach “untenable”. See dissenting op. p. 98.
Yet the cornerstone of the dissent’s analysis appears to be its highly generalized
claim that the purpose of a Roth IRA or an FSC is tax avoidance. See id. pp. 87,
93. We are unaware of any support, textual or otherwise, for such a generalized
claim with respect to sections 408A and 921-927.
Rather than taking up arms on one side or another of some grand
“counterrevolution”, and far from ignoring the text of the Code, we mind the
teaching of the Court of Appeals for the Ninth Circuit, making a “more specific
inquiry” and “deciding whether * * * [the] facts fall within the intended scope of
the Internal Revenue Code provision[s] at issue.” Stewart v. Commissioner, 714
F.2d at 988. For the reasons explained, petitioners have failed to show that their
facts fall within the scope of the Code provisions at issue.
47
(...continued)
purchase (on the basis of an outside appraisal) 5,000 shares of the company’s
common stock.” Austin v. Commissioner, at *8. There was no dispute as to
whether the ESOP owned the shares in substance. See also Cottage Sav. Assoc. v.
Commissioner, 499 U.S. at 568 (“[T]here is no contention that the transactions in
this case were not conducted at arm’s length, or that Cottage Savings retained de
facto ownership of the participation interests[.]”).
- 68 -
IX. Conclusion
We are mindful that “[a]ny one may so arrange his affairs that his taxes shall
be as low as possible; he is not bound to choose that pattern which will best pay
the Treasury; there is not even a patriotic duty to increase one’s taxes.” Helvering
v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), rev’g 27 B.T.A. 223 (1932), aff’d,
293 U.S. 465 (1935). But this does not mean that we should ignore the substance
of the taxpayer’s transactions. As the Supreme Court stated in Higgins v. Smith,
308 U.S. 473, 477 (1940):
A taxpayer is free to adopt such organization for his affairs as he may
choose[,] * * * [but o]n the other hand, the Government may not be
required to acquiesce in the taxpayer’s election of that form * * *.
The Government may look at actualities and upon determination that
the form employed for doing business or carrying out the challenged
tax event is unreal or a sham may sustain or disregard the effect of the
fiction as best serves the purposes of the tax statute.
We have not found, nor have petitioners or the dissent identified, support in
the Code or the regulations for their claim that the Roth IRAs’ purchase of the
FSC stock need have no substance. As the Court of Appeals for the Sixth Circuit
recently put it: “When someone calls a dog a cow and then seeks a subsidy
provided by statute for cows, the obvious response is that this is not what the
statute means.” Summa Holdings II, 848 F.3d at 787-788 (quoting Joseph
- 69 -
Isenbergh, “Musings on Form and Substance in Taxation: Federal Taxation of
Incomes, Estates, and Gifts”, 49 U. Chi. L. Rev. 859, 865 (1982)).
When the courts decide how to classify a transaction, they focus,
quite appropriately, on the transaction’s workaday realities, not the
labels used by the taxpayers. Take “income.” If a taxpayer receives
something of value, * * * he can call it whatever he wants--this, that,
or something else. What the taxpayer cannot do is claim that the label
he affixes on the transaction precludes it from being “income” under
the Code or prevents the courts from treating it as “income” under the
Code.
Id. at 785. Similarly, petitioners cannot label substantive contributions to their
Roth IRAs “income” and thereby successfully claim exemption from the section
4973 excise tax on excess contributions.48
X. Additions to Tax
Respondent asserts that petitioners are liable for additions to tax under
section 6651(a)(1) and (2) for each year at issue. Respondent has the burden of
production. Sec. 7491(c).
Section 6651(a)(1) imposes an addition to tax for failure to timely file a tax
return. Respondent has met his burden of production because petitioners
48
The dissent points out that there is nothing wrong with “rich people
buying cows they don’t otherwise need in order to get * * * cow subsidies”. See
dissenting op. p. 100. But whether we call the operative principle economic
substance or substance over form, the Code at least requires us to ask whether the
taxpayer actually bought the cows, or just claims to have done so.
- 70 -
stipulated that they did not file their Forms 5329 for each year at issue. See
Paschall v. Commissioner, 137 T.C. 8, 15-17 (2011).49
Section 6651(a)(2) imposes an addition to tax for failure to timely pay a tax
shown on a return. Because petitioners failed to file their Forms 5329, respondent
prepared substitutes for return (SFRs) under section 6020(b) for each year and for
each petitioner. These SFRs are treated as petitioners’ returns for purposes of
determining the addition to tax under section 6651(a)(2). See sec. 6020(b);
Wheeler v. Commissioner, 127 T.C. 200, 208-209 (2006), aff’d, 521 F.3d 1289(10th Cir. 2008). Petitioners have not disputed the validity of the SFRs, nor have
they argued that they have paid any portion of the amounts shown on the SFRs.
Respondent has therefore met his burden to show that petitioners are liable for the
section 6651(a)(2) addition to tax for failure to pay a tax shown on a return for
each year at issue.
Petitioners can avoid these additions to tax by showing that their nonfiling
and nonpayment were due to reasonable cause and not willful neglect. See sec.
6651(a)(1) and (2). Willful neglect is defined as “a conscious, intentional failure
or reckless indifference.” United States v. Boyle, 469 U.S. 241, 245 (1985).
49
Additions to tax under sec. 6651 are not subject to sec. 6751, under sec.
6751(b)(2)(A).
- 71 -
Petitioners argue that their failures to file and pay were not due to willful neglect,
and respondent has not contested that point. We therefore deem respondent to
have conceded that petitioners’ failures to file and pay were not due to willful
neglect.
A failure to timely file or pay is due to reasonable cause if a taxpayer can
show good-faith reliance on professional advice. Pizza Pro Equip. Leasing, Inc. v.
Commissioner, 147 T.C. ___, ___ (slip op. at 52) (Nov. 17, 2016). Reliance on
professional advice is reasonable cause if: (1) the adviser was a competent
professional with sufficient expertise to justify reliance; (2) the taxpayer provided
necessary and accurate information to the adviser; and (3) the taxpayer actually
relied on the adviser’s judgment in good faith. Id. (quoting Neonatology Assocs.,
P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002),
and explaining that “[w]hile Neonatology Assocs. dealt with section 6662
accuracy-related penalties, we have applied its tripartite analysis to section 6651
additions to tax as well.”); Charlotte’s Office Boutique v. Commissioner, 121 T.C.
89, 109-111 (2003), aff’d, 425 F.3d 1203 (9th Cir. 2005).
Petitioners contend that they relied on their accountant Mr. Bedke. They
assert that Mr. Bedke advised them that the FSC transactions were valid. At the
time of trial, Mr. Bedke was a tax partner at an accounting firm where he had
- 72 -
practiced for 29 years. We find that he was a competent professional with
sufficient expertise to justify reliance.
Petitioners had been Mr. Bedke’s clients for several years, and he was
therefore familiar with their business. Mr. Bedke prepared petitioners’ tax returns
for each year at issue. Petitioners presented the FSC transaction paperwork to Mr.
Bedke, who testified that he and another partner reviewed the information and
determined that petitioners qualified to use an FSC. He also advised them that it
was not prohibited for a Roth IRA to invest in an FSC. Upon review of the entire
record, we are satisfied that petitioners provided the necessary information to Mr.
Bedke.
A taxpayer cannot rely on professional advice if the professional was a
promoter of the transaction. Neonatology Assocs., P.A. v. Commissioner, 115
T.C. at 98. A promoter is “an adviser who participated in structuring the
transaction or is otherwise related to, has an interest in, or profits from the
transaction.” 106 Ltd. v. Commissioner, 136 T.C. 67, 79 (2011) (quoting Tigers
Eye Trading, LLC v. Commissioner, T.C. Memo. 2009-121), aff’d, 684 F.3d 84(D.C. Cir. 2012). Mr. Bedke had no connection to WGA and no interest in, or
profits from, petitioners’ transactions. We therefore find that Mr. Bedke was not a
promoter.
- 73 -
Finally, we conclude that petitioners justifiably relied on Mr. Bedke’s
advice. Mr. Bedke represented petitioners for a number of years before they came
to him seeking advice about the FSC transactions. Mr. Bedke examined the
transactions with another partner and advised petitioners that they could use the
FSC/IRA program.
Accordingly, petitioners are not liable for section 6651(a)(1) or (2)
additions to tax.
To reflect the foregoing,
Decisions will be entered for
respondent as to the deficiencies and
for petitioners as to the additions to
tax.
Reviewed by the Court.
MARVEL, VASQUEZ, GALE, GOEKE, GUSTAFSON, PARIS,
KERRIGAN, LAUBER, NEGA, PUGH, and ASHFORD, JJ., agree with this
opinion of the Court.
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PARIS and PUGH, JJ.: We agree with the opinion of the Court and write
separately to emphasize the following points.
The opinion of the Court should not be construed as a requirement that an
FSC have some substance beyond that prescribed by statute. The opinion of the
Court does not disregard the Roth IRAs or the FSC. It does not address any
income tax issues that may arise in other cases. It does not say that Roth IRAs
may never own FSCs. It does not disturb the benefits that flow from the formation
of the FSC.
The sole issue we decide today is who in substance owned this FSC--
petitioners or their Roth IRAs. The opinion of the Court focuses on the substance
of a single step: the purported purchase of FSC stock by the Roth IRAs for the
nominal price of $1, viewed together with the contracts that were entered into by
petitioners, their Roth IRAs, and Injector Co., all in consideration of that nominal
purchase.
The opinion of the Court concludes that petitioners, not their Roth IRAs,
owned the FSC that was set up by and through Western Growers Association
(WGA). This conclusion is based upon the following specific facts:
(1) petitioners each contributed $2,000 to their Roth IRAs for 1998 and zero for
1999 through 2002 (amounts equal to petitioners’ respective section 408A(c)
- 75 -
contribution limits for those years); (2) with these initial contributions petitioners
caused their self-directed Roth IRAs to formally purchase the FSC’s stock from
WGA for the stated price of $5 per share for a total of $500 for 100 shares, of
which the opinion of the Court concludes $499 of the purchase price was a fee
rather than an investment, see op. Ct. p. 45-46; (3) at all times under the stated
terms of the contracts between the FSC and Injector Co. petitioners controlled--
through Injector Co.--the profits to be earned by the FSC and therefore the amount
of distributions from the FSC to the Roth IRAs; (4) when the FSC stock was
purchased, petitioners had an established capacity to make large commission
payments to the FSC because of established export receipts; and (5) petitioners
intended to fund their Roth IRAs through the FSC/Roth IRA program using a
portion of those export receipts (and petitioners did in fact fund their Roth IRAs to
the fullest extent permitted throughout the years the FSC/Roth IRA program was
in place).
On these specific facts the opinion of the Court concludes that the nominal
$1 purchase price the Roth IRAs paid for the FSC stock did not reflect the
substance of the transaction in the light of petitioners’ established capacity and
intention to direct large commission payments from Injector Co. to the FSC. See
op. Ct. p. 49-50. The Roth IRAs’ formal lack of control over whether commission
- 76 -
payments would be made was the basis for the nominal price that was set for the
FSC stock. But in substance there was an established expectation and intention
that commission payments would be made, and the Roth IRAs were directed to
purchase the FSC stock on the basis of that expectation and intention. The formal
basis for the purchase price therefore did not reflect the substance of the related-
party transaction. Consequently, the opinion of the Court disregards the Roth
IRAs’ purchase and concludes that in substance petitioners, who retained
substantive control throughout all aspects of this transaction, owned the FSC.
For these reasons we agree with the opinion of the Court.
THORNTON, GOEKE, and LAUBER, JJ., agree with this concurring
opinion.
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HOLMES, J., dissenting: In Summa Holdings, Inc. v. Commissioner
(Summa II), 848 F.3d 779, 781 (6th Cir. 2017), rev’g T.C. Memo. 2015-119, the
Sixth Circuit--in the course of reversing our decision in a case nearly identical to
this one--warned that a court that construes the Tax Code against its language and
in favor of judge-made doctrine acts like Caligula, who famously posted tax laws
in fine print and so high that Romans could not read them. See Suet. Cal. 41.
It is our custom to reconsider an issue when a circuit court reverses us. And
today we have to choose either a well-reasoned opinion by a highly respected
judge in America’s heartland, or Caligula.
We pick Caligula.
I gingerly dissent.1
1
Caligula didn’t care if dissents were respectful or not. See, e.g., Suet. Cal.
20 (forcing unsuccessful orators to blot out their writings with sponges or their
tongues), 27 (burning author alive for using double entendre), and 28 (ordering a
senator torn to pieces and then having the pieces dragged through the streets).
Our Court is somewhat more collegial. When a majority disagrees with the
opinion of the judge who tries the case, the case may be reassigned and rewritten.
See sec. 7460; Succession of McCord v. Commissioner, 461 F.3d 614, 622 (5th
Cir. 2006), rev’g 120 T.C. 358 (2003). These disputes are almost always about the
law and not about factfinding. As the trial judge in these cases, I have reviewed
Judge Thornton’s opinion of the Court and agree with his findings of facts (with
one exception, see infra note 9). I specifically agree with his findings regarding
the Mazzeis’ liability for a penalty, which I would have made on the basis of my
own observations of the testimony and other evidence received during trial if I had
(continued...)
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I first review the DISC and Roth IRA regimes that led up to Summa II and
take a look at that decision. I next explain what the parties here said about why it
should or shouldn’t control and point out the biggest problems in the Court’s
reasoning. Finally, I explain why we should have decided the cases differently.
I.
As the majority explains, contributions to a Roth IRA aren’t deductible,
earnings accrue in the account tax-free, and qualified distributions from the
account aren’t part of a taxpayer’s gross income. Sec. 408A(a), (c)(1), (d)(1) and
(2)(A); Taproot Admin. Servs., Inc. v. Commissioner, 133 T.C. 202, 206 (2009),
aff’d, 679 F.3d 1109 (9th Cir. 2012). Once funds make it into a Roth IRA, they’re
generally never taxed again, no matter how they’re invested or how much they
grew through distributions or capital appreciation. But there’s a limit on how
much a taxpayer can contribute, see sec. 408A(c)(2), and the Code taxes excess
contributions 6% each year they remain in an account, sec. 4973(a); see also
Paschall v. Commissioner, 137 T.C. 8, 18 (2011).2
1
(...continued)
not concluded that this series of transactions worked on its merits.
2
A somewhat complicated formula sets the annual contribution limits. See
(continued...)
- 79 -
Because Roth IRAs offer substantial tax benefits, it’s not surprising that
taxpayers look for ways to get more money into them. That’s what the taxpayers
did in Repetto v. Commissioner, T.C. Memo. 2012-168, 2012 WL 2160440,
Polowniak v. Commissioner, T.C. Memo. 2016-31, and Block Developers, LLC v.
Commissioner, T.C. Memo. 2017-142. In each of those cases, the taxpayers had
their Roth IRAs purchase shares in a newly formed C corporation3 or interests in
an LLC,4 had their preexisting businesses pay those new entities for nonexistent
services or licenses, and then had the entities distribute the payments--as dividends
or partnership distributions--into the Roth IRAs. See Block Developers, at *8-
*14; Polowniak, at *4-*7; Repetto, 2012 WL 2160440, at *3-*5.
2
(...continued)
sec. 408A(c)(2). When the Mazzeis began their FSC plan, the limit was generally
$2,000 per year. See secs. 408A(c), 219(b)(1)(A). Today that limit is generally
$5,500. See secs. 408A(c), 219(b)(5)(A)-(C).
3
“C corporation” is tax jargon for a corporation not taxed under subchapter
S of the Code. A C corporation’s net income is taxed twice--first at the corporate
level, and again at the individual level when the shareholders receive distributions
of profits in the form of dividends.
4
LLC stands for limited liability company. LLCs are creatures of state
statute and are a form of business ownership that allows one or more people or
organizations to invest in an entity that provides them with limited liability. An
LLC with more than one member is generally taxed as a partnership by default.
Sec. 301.7701-3(b)(1)(i), Proced. & Admin. Regs.
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The Commissioner doesn’t like this sort of thing. See Notice 2004-8, 2004-
1 C.B. 333; Summa Holdings, Inc. v. Commissioner (Summa I), T.C. Memo.
2015-119, at *15-*16. He says that non-arm’s-length payments from a preexisting
business to a related Roth IRA-owned entity are really distributions to
shareholders followed by contributions to the Roth IRA. See Notice 2004-8,
2004-1 C.B. 333. In Repetto, Polowniak, and Block Developers we agreed. See
Block Developers, at *30; Polowniak, at *21-*22; Repetto, 2012 WL 2160440, at
*9-*11;. In each of those cases we disregarded a Roth IRA-owned C corporation
or LLC because it didn’t actually do anything--each entity was “nothing more than
a mechanism for transferring value to the Roth IRAs.” Repetto, 2012 WL
2160440, at *9; see also Block Developers, at *30-*31; Polowniak, at *21-*22.5
Because distributions (such as dividends or capital gains) to an IRA are unlimited,
and contributions are very limited, the Commissioner usually benefits from
recasting “distributions” as “contributions”.
Some types of entities aren’t meant to do anything except transfer value to
get tax benefits. A domestic international sales corporation (DISC) is set up to
5
In reaching its holding in Block Developers, LLC v. Commissioner, T.C.
Memo. 2017-142, at *30, this division of the Court stressed that “the substance-
over-form doctrine is not something the Commissioner can use to pound every
Roth IRA transaction he doesn’t like.”
- 81 -
receive commission payments--usually in exchange for nothing--from a business
that exports so that it can then distribute them to the business’s shareholders as
income that was left untaxed at the corporate level. Secs. 991, 995(a) and (b)(1);
sec. 1.994-1(a)(2), Income Tax Regs.; see Summa II, 848 F.3d at 782; Addison
Int’l, Inc. v. Commissioner, 887 F.2d 660, 666 (6th Cir. 1989), aff’g 90 T.C. 1207(1988); Hellweg v. Commissioner, T.C. Memo. 2011-58, 2011 WL 821090, at *5.
FSCs were very similar--barely-there entities through which businesses could
funnel “foreign trading gross receipts” to largely escape corporate-level tax. See
secs. 924(a), 921-927, 245(c); sec. 1.925(a)-1T(a)(3), Temporary Income Tax
Regs., 52 Fed. Reg. 6444 (Mar. 3, 1987). Unlike other types of corporations,
DISCs and FSCs don’t need a business purpose--they’re intentionally nothing
more than ways to reduce exporters’ effective tax rates. See, e.g., Summa II, 848
F.3d at 786 (DISCs are “shell corporations * * * that have no economic substance
at all”); cf. Block Developers, at *31 (LLCs “meant to have a real business
purpose”). And the regulations made clear that DISCs and FSCs did not have to
be owned by the operating business that was actually exporting goods. See sec.
1.922-1(f), Income Tax Regs. (method for counting individuals, corporations,
estates, trusts, and partnerships for FSC’s 25-shareholder limit); sec. 1.992-
2(b)(1)(iii), Income Tax Regs. (DISC election methods for shareholders who are
- 82 -
individuals, minors, estates, and trusts). This meant that owners of closely held
exporting businesses could set up DISCs or FSCs that they themselves--or a
family trust, or the owner’s children, or other parties related to them--owned.
So what happens when an operating business makes payments to a DISC--
which is nothing but a vehicle for tax reduction--and the DISC then pays
dividends to a Roth IRA--a type of account also designed to produce tax benefits?
That’s essentially the situation we addressed in Summa I; and except for the fact
that it involved a DISC rather than an FSC, it’s the Mazzeis’ situation, too. In
Summa I, at *22, we recharacterized the payments--which had no nontax business
purpose--as dividends followed by contributions to the Roth IRAs. We decided
that “substance over form principles” allowed us to do that even though the
taxpayers had complied with the actual text of the Code. See id. at *17-*22.
II.
The Sixth Circuit said we were wrong. Summa II, 848 F.3d at 782, 790. In
reversing us, it emphasized that DISCs necessarily lack economic substance. Id. at
789. And it found that section 995(g)--which makes tax-exempt entities pay
unrelated business income tax (UBIT) on distributions they receive from DISCs--
- 83 -
“made clear” that IRAs could own DISCs.6 Id. at 782. It therefore concluded that
the Code specifically allowed the taxpayers there to do what they did, and that
neither the Commissioner nor the courts had any reason to use substance-over-
form principles to recharacterize the transactions. Id. at 782, 784, 790.
Summa II said that substance-over-form principles exist to prevent
taxpayers from calling a transaction something it’s not in order to avoid tax. See
id. at 785-86. And it carefully considered cases where courts applied those
principles appropriately. Id. at 785-86. For example, it discussed Diedrich v.
Commissioner, 457 U.S. 191, 196-97 (1982), where the Supreme Court held that a
donor who transferred property on the condition that the recipient pay the gift tax
on it really just sold the property for the amount of the tax. Summa II, 848 F.3d at
785. It also approved of disregarding “sham” transactions that use “nominally
independent” entities to disguise economic reality. See id. (citing Wells Fargo &
6
Summa II may be pushing it a bit when it says that by enacting section
995(g) Congress “made clear” that IRAs could own DISCs. Pension plans and
charities seem to have been the types of tax-exempt shareholders Congress had in
mind. See H.R. Rept. No. 101-247, at 1425-26 (1989), 1989 U.S.C.C.A.N. 1906,
2895-96. And Congress certainly wasn’t thinking about Roth IRAs, which it
didn’t create until almost a decade after section 995(g) became effective. See
Taxpayer Relief Act of 1997, Pub. L. No. 105-34, sec. 302, 111 Stat. at 825.
Nevertheless, and if only through a maze of cross-references, section 995(g) does
allow both traditional and Roth IRAs to own DISCs, see secs. 401(a), 408(a),
408A(a), 501(a), 511, and Congress hasn’t decided to change it.
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Co. v. United States, 641 F.3d 1319, 1325 (Fed. Cir. 2011), and Richardson v.
Commissioner, 509 F.3d 736, 741 (6th Cir. 2007), aff’g T.C. Memo. 2006-69).7
Summa II, at 786, put Reppetto in this category.
Substance-over-form principles become worrisome, according to Summa II,
when the Commissioner recharacterizes into higher-tax forms transactions that
have economic substance and comply with the Code. Id. The court traced the
Commissioner’s claim to this power to an expansive reading of Commissioner v.
Court Holding Co., 324 U.S. 331, 333 (1945), where the Supreme Court said that a
corporation that distributed a building to shareholders who immediately sold it
really just sold the building to the buyer directly.8 See Summa II, 848 F.3d at 786.
Summa II noted that when applying Court Holding “the line between disregarding
7
Other examples the court discusses approvingly include Gregory v.
Helvering, 293 U.S. 465, 468-69 (1935) (recharacterizing purported
“reorganization” that was just shuffling shares from one entity to another to avoid
capital gains tax), and Knetsch v. United States, 364 U.S. 361, 365-66 (1960)
(recharacterizing a “loan” that had no business function or true obligation to pay).
8
Commissioner v. Court Holding Co., 324 U.S. 331 (1945), perhaps
shouldn’t take too much blame for the Commissioner’s claim. That decision
turned on the fact that the corporation had negotiated the sale and received a
deposit from the buyer before the shareholders realized what the tax consequences
would be and distributed the building to themselves. Id. at 333. Explaining Court
Holding in a later case, the Supreme Court said that the sale there was really
complete before the disregarded distribution occurred. United States v.
Cumberland Pub. Serv. Co., 338 U.S. 451, 453 (1950). In that case, the Court
recognized an asset distribution followed by the sale of those assets. Id. at 456.
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a too-clever-by-half accounting trick and nullifying a Code-supported tax-
minimizing transaction can be elusive.” Id. at 787. It also acknowledged that the
Sixth Circuit itself has struggled with this distinction: For example, quoting
Estate of Kluener v. Commissioner, 154 F.3d 630, 636 (6th Cir. 1998), aff’g in
part, rev’g in part T.C. Memo. 1996-519, the court said that “the Commissioner
may recharacterize transactions, even those with economic substance, if they have
no ‘valid, non-tax business purpose.’” Summa II, 848 F.3d at 787. And in
Aeroquip-Vickers, Inc. v. Commissioner, 347 F.3d 173, 183 (6th Cir. 2003), rev’g
Trinova Corp. v. Commissioner, 108 T.C. 68 (1997), the Summa II Court recalled,
the Sixth Circuit declined to treat a series of transactions as a reorganization
because the taxpayer was motivated primarily by tax savings. See Summa II, 848
F.3d at 787.
Summa II also surveyed cases from other circuits that likewise “straddle the
line between holding that the transactions were a sham and suggesting that the
Commissioner has a broad power to recharacterize transactions that minimize
taxes.” Id. The court pointed to Feldman v. Commissioner, 779 F.3d 448, 457
(7th Cir. 2015), aff’g T.C. Memo. 2011-297, which disregarded a sham loan meant
only to avoid income tax; Southgate Master Fund, LLC v. United States, 659 F.3d
466, 491-92 (5th Cir. 2011), which disregarded a partnership; and Rogers v.
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United States, 281 F.3d 1108, 1113-18 (10th Cir. 2002), which recharacterized a
“loan” that had no hope for repayment. See Summa II, 848 F.3d at 787. The court
emphasized, however, that even those cases don’t hold that a “tax-avoidance
motive alone may nullify an otherwise Code-compliant and substantive set of
transactions.” Id.
Following this survey, the court said that “[t]he substance-over-form
doctrine * * * makes sense only when it holds true to its roots--when the
taxpayer’s formal characterization of a transaction fails to capture economic
reality and would distort the meaning of the Code in the process.” Id. The court
reiterated that identifying such transactions can be tricky, but that the ones before
it were “clearly on the legitimate side of the line.” Id. at 788. It pointed out that
the “Commissioner’s effort to reclassify [the taxpayer’s] transactions as dividends
followed by Roth IRA contributions does not capture economic reality any better
than describing them as DISC commissions followed by dividends,” and that
substance-over-form principles don’t allow the Commissioner to recharacterize a
transaction merely to increase the amount of tax due. Id.
Summa II concluded with the holding that substance-over-form principles
can’t override “statutory provisions whose only function is to enable tax savings”
under the Code. Id. at 789. And it found that DISCs were in that category,
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meaning that they didn’t need economic substance to be respected. Id. It
explained that “[t]he point of [DISCs] is tax avoidance. The Commissioner cannot
place ad hoc limits on them by invoking a statutory purpose * * * that has little
relevance to the text-driven function of these portions of the Code.” Id. In other
words, the talisman of a statute’s purpose “cannot be invoked to save the statute
from itself.” Id. There’s no denying these provisions created a sort of loophole in
the Code, but the Sixth Circuit said in Summa II that it is Congress’s job to sew it
up. Id. at 790.
III.
After the Sixth Circuit released Summa II we told the parties here to submit
supplemental briefs. The Mazzeis and the Commissioner agreed that the only
difference between these cases and Summa II was that the Mazzeis used an FSC
instead of a DISC. The Commissioner said this difference shouldn’t affect our
analysis, and he admitted that the Mazzeis followed all of the necessary
formalities. He nevertheless said we should ignore Summa II because it’s from a
different circuit and only the commission payments’ deductibility was properly
before the court there. He said we should instead follow Court Holding, look at
the transaction as a whole, and decide the cases based on his views of the statute’s
intent, not the Code’s plain language.
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The Mazzeis urged us to follow Summa II’s reasoning. They said they
should get the FSC and Roth IRA tax benefits the Code explicitly provides and
that the Commissioner shouldn’t get to rewrite statutes based on his musings about
congressional intent. And they said that their use of an FSC instead of a C
corporation was enough to distinguish these cases from Repetto.
The majority mostly sides with the Commissioner and finds that the
Mazzeis were the FSC’s substantive owners at all relevant times.9 See op. Ct.
p. 23. Its journey to this problematic conclusion begins promisingly enough--with
an astute explanation of the transaction at issue. It points out that like the
taxpayers in Repetto, Polowniak, and Block Developers, the Mazzeis used a type
of corporation to route money from their operating business into their Roth IRAs.
It even highlights the single relevant difference between those cases and the ones
9
If this is a finding of fact, it is one with which I as the trial judge, would
disagree. It appears, however, that the question of “substantive” ownership might
be something of a mixed question of law and fact. If so, it would appear that this
“finding” is actually a conclusion of law based on the underlying facts specific to
these cases about the Mazzeis’ operation of their FSC, operating company, and
Roth IRAs. See Casebeer v. Commissioner, 909 F.2d 1360, 1365 (9th Cir. 1990)
(determination that transaction lacked economic substance is factual finding
reviewed only for clear error on appeal), aff’g in part, rev’g in part 89 T.C. 1229(1987), and aff’g T.C. Memo. 1987-625, T.C. Memo. 1987-626, and T.C. Memo.
1987-628; but see Sacks v. Commissioner, 69 F.3d 982, 986 (9th Cir. 1995)
(determination that transaction a sham is reviewed for clear error on underlying
facts and de novo for correctness of legal standard), rev’g T.C. Memo. 1992-596.
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before us: The Mazzeis used an FSC, not a DISC, and not a C corporation or an
LLC.
The majority acknowledges, see op. Ct. p. 32, that the Code requires us to
respect certain payments a business makes to an FSC in exchange for nothing,
even though we wouldn’t do that for most types of corporations. It also
acknowledges that the Code lets businesses deduct these payments even though
they aren’t “ordinary and necessary.” See sec. 162. It recognizes that we treat
these payments as income to the FSC, and it finds that the FSC here paid tax on
this income.10 It also realizes that the funds the FSC paid out were dividends.
Up to this point the majority’s approach isn’t much different from that of
Summa II. But once it turns to the Roth IRAs’ ownership of the FSC, things get
weird.
The majority creates a “dominion and control” test to determine who really
gets FSC dividends. See op. Ct. p. 39. In support of its novel approach it doesn’t
cite any cases about dividends or corporations--instead, it relies only on
Commissioner v. Banks, 543 U.S. 426, 434 (2005), which says that the portion of
a judgment that goes to an attorney’s contingency fee is still income to the litigant.
There, the Supreme Court said contingency fees are anticipatory assignments of
10
I specifically agree with these findings of fact.
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income even though the amount is uncertain, because the client at all relevant
times controlled the “income-generating asset”--namely, the cause of action
resulting from his injury. Id. at 434-35.
Analogizing these cases to Banks, the majority calls the FSC an income-
generating asset. See op. Ct. p. 40. That’s wrong. Injector Co. was the operating
business that actually generated income. The FSC was a congressionally
sanctioned vehicle for reducing Injector Co.’s effective tax rate on exports. All
the FSC did was accept payments for nothing and distribute a large portion of
them as dividends.
After mistakenly identifying the FSC as an income-generating asset, the
majority applies constructive-ownership tests from a series of sale-leaseback cases
where courts said the party that incurred risk was the true owner, namely: Frank
Lyon Co. v. United States, 435 U.S. 561, 581, 584 (1978); Casebeer v
Commissioner, 909 F.2d 1360, 1370 (9th Cir. 1990), aff’g in part, rev’g in part 89
T.C. 1229 (1987), and aff’g T.C. Memo. 1987-625, T.C. Memo. 1987-626, and
T.C. Memo. 1987-628; and Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995),
rev’g T.C. Memo. 1992-596.11 Trying to apply this principle here, the majority
11
These are curious cases to cite in support of applying substance-over-form
principles. In Frank Lyon Co. v. United States, 435 U.S. 561, 584 (1978), the
(continued...)
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says that the Roth IRAs didn’t actually own the FSC because they’d paid so little
for it. See op. Ct. p. 43-44. But the Mazzeis also put nothing at risk to get the
FSC, so by the majority’s reasoning they couldn’t have owned the FSC either. In
fact, no one could ever own an FSC because FSCs never put capital at risk.
The majority then asks another question: Did what the Roth IRAs paid for
the FSC have any relation to its future value? The majority says it didn’t, which it
finds is another sign that the Roth IRAs didn’t own the FSC. See op. Ct. p. 45.
11
(...continued)
Supreme Court said “so long as the lessor retains significant and genuine attributes
of the traditional lessor status, the form of the transaction adopted by the parties
governs for tax purposes.” Casebeer primarily holds that the taxpayers there
weren’t entitled to section 465 deductions because they were “protected against
loss” under the meaning of section 465(b)(4). 909 F.2d at 1370. Sacks is perhaps
an even weaker authority for the majority. There we allowed the Commissioner to
recharacterize a transaction because the taxpayer would not have entered into it
but for tax credits without which the transaction wouldn’t have been profitable.
See Sacks v. Commissioner, T.C. Memo. 1992-596, 1992 WL 252948, at *35,
rev’d, 69 F.3d 982. The Ninth Circuit reversed us and explained:
If the Commissioner were permitted to deny tax benefits when the
investments would not have been made but for the tax advantages,
then only those investments would be made which would have been
made without the Congressional decision to favor them. The tax
credits were intended to generate investments in alternative energy
technologies that would not otherwise be made because of their low
profitability. Yet the Commissioner in this case at bar proposes to
use the reason Congress created the tax benefits as a ground for
denying them.
Sacks, 69 F.3d at 992 (internal citations omitted).
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But the Code doesn’t require a founding shareholder to take as his basis what he
hopes the earnings on his investment will be--it requires him to take as his basis
only the cost or amount of whatever he contributed. Secs. 351, 358(a); see also
sec. 1012 (basis is cost). And the Code certainly doesn’t treat his corporation as a
sole proprietorship if it turns out to be profitable. What the Mazzeis’ Roth IRAs
paid for the FSC stock is meaningless--which might be why the Commissioner
didn’t challenge it.
Still trying to shoehorn these cases into a sale-leaseback framework, the
majority then says that because Injector Co. controlled how much cash went into
the FSC, an unrelated Roth IRA couldn’t have expected any upside benefits from
its small investment. See op. Ct. pp. 47-49. That’s true, but proves too much--any
commonly controlled corporations between which the owners could readjust
contractual rights at any time would be in the same situation.
The majority’s application of sale-leaseback analysis also misses a larger
point. The Supreme Court tells us to respect a corporation for tax purposes as
long as it’s a real business or its purpose is the “equivalent of business activity.”
Moline Props., Inc. v. Commissioner, 319 U.S. 436, 439 (1943). And the
regulations say that an FSC--a corporation--can receive commissions based not on
the normal transfer-pricing rules but on a statutory formula unrelated to economic
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reality. See, e.g., sec. 925(a); sec. 1.925(a)-1T(a)(1), Temporary Income Tax
Regs., 52 Fed. Reg. 6443-44 (Mar. 3, 1987). So as long as an FSC complies with
the statute, we respect it as if it had a real business purpose--it doesn’t do
anything, but the Code and regulations give it the “equivalent of business
activity.” The same is essentially true for Roth IRAs--they have no nontax
purpose, but the Code grants them tax benefits if they comply with certain
formalities. Sec. 408A; see Summa II, 848 F.3d at 789 (point of Roth IRA is tax
avoidance). And here the Commissioner concedes that the Mazzeis observed
those formalities.
Moline Properties was about income tax, see 319 U.S. at 438, not the excise
taxes at issue here, but that doesn’t change anything. In Hellweg we held that we
have to treat transactions the same way for excise tax as we do for income tax.
2011 WL 821090, at *9. There we refused to recharacterize distributions from a
DISC to a Roth IRA for excise-tax purposes because the Commissioner didn’t also
make income-tax adjustments.12 Id. So if we would respect FSCs and Roth IRAs
12
The Commissioner here also doesn’t seek to redetermine income tax, but
only because the statute of limitations has run--he says if it hadn’t, he’d
redetermine the income tax too. We previously decided this was enough of a
distinction from Hellweg to let these cases go forward on the excise-tax issue
alone. Mazzei v. Commissioner, T.C. Memo. 2014-55, at *12-*13.
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for income-tax purposes, we also would have to respect them for excise-tax
purposes.
The majority’s dominion-and-control test would wreak havoc on many--
perhaps hundreds of thousands--of small individually- or family-owned
corporations were we ever to apply it for anything other than disposing of these
cases. By the majority’s reasoning, someone who created a business, incorporated
it, issued himself 100% of the stock in exchange for a small capital investment,
and continued to run the day-to-day operations wouldn’t really own his
corporation--especially if it was a success. We’d have to disregard the corporation
because the initial investment was too small and didn’t accurately predict the
business’s future earnings.
The majority’s attempt to distinguish Summa II is also problematic. It says
that Summa II had before it only the domestic company’s commission payments to
the DISC and that it therefore doesn’t offer any guidance regarding the FSC’s
payment of dividends to the Roth IRAs. See op. Ct. pp. 52-53. But Summa II
examined the whole transaction when it questioned whether substance-over-form
principles applied. See 848 F.3d at 784, 788. It had to because the Commissioner
didn’t just recharacterize an individual component of the transaction--he
recharacterized the whole thing. See id. at 782.
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The majority also finds it significant that the Mazzeis used an FSC instead
of a DISC. It points out that these entities work differently--DISC payments to an
IRA are subject to UBIT, see sec. 995(g), whereas FSCs pay some income tax at
the corporate level, see sec. 921(a); sec. 1.921-2(c), Q&A-6, Income Tax Regs.
But those differences don’t affect who actually owns them--especially under the
majority’s dominion-and-control test. The Commissioner himself doesn’t even
think the Mazzeis’ use of an FSC instead of a DISC makes a difference--he just
doesn’t want us to follow Summa II.
IV.
A.
The Commissioner may be trying to sew the wrong label onto these cases,
as he uses in his briefs much the same language courts use in their opinions when
they invoke the economic-substance doctrine. There’s overlap between substance-
over-form principles and economic-substance doctrine, but one way of thinking
about substance-over-form is that it is a rule of tax law that directs courts to decide
ambiguous questions of fact by looking to the realities of a situation and not the
labels parties put on them. (If a kennel and a taxpayer agree that a tail is a leg, a
taxpayer might say he has a five-legged dog. But unless the Code or regulations
tell us differently, his dog still has only four legs for tax law.)
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One way of thinking about economic-substance doctrine is that it is a rule of
tax law that directs courts to decide questions of law by construing ambiguous
parts of the Code by looking to the economic realities of the situation and not the
labels parties put on them. “Partnership”, under state law, may be defined as any
entity that identifies itself as a partnership in paperwork filed with the secretary of
state. But when, without more specificity, the Code says “partnership” courts look
for a common intention to collectively pursue a joint economic outcome. See, e.g.,
Superior Trading, LLC v. Commissioner,137 T.C. 70, 81-82 (2011) (disregarding
partnership where parties lacked common intention to collectively pursue joint
economic outcome), aff’d, 728 F.3d 676 (7th Cir. 2013); Markell Co., Inc. v.
Commissioner, T.C. Memo. 2014-86, at *31 (disregarding partnership where there
was little proof that business was a joint venture).
That is at least a plausible way of understanding the doctrine’s origin in
Gregory v. Helvering, 293 U.S. 465, 469-70 (1935), where the Court held that
when Congress gave tax benefits to “reorganization[s]”, it meant only transactions
that actually changed a taxpayer’s economic reality or had nontax consequences,
even though Congress didn’t exactly say so. Today the economic-substance
doctrine is part of the Code. Sec. 7701(o). But the Code also warns us that it isn’t
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always relevant. See id. (beginning “[i]n the case of any transaction to which the
economic substance doctrine is relevant”).
Neither of these doctrines helps the Commissioner here. These cases are not
about substance over form, because the Mazzeis’ FSC is exactly what it purports
to be: a corporation (or, more accurately, an account within a corporation)
organized precisely in accord with the statutory rules. The Commissioner doesn’t
dispute this. Their Roth IRAs were likewise just what they purported to be--the
Commissioner doesn’t dispute this either.
The economic-substance doctrine also doesn’t apply here. If it is a rule of
statutory construction, there’s little to construe here--Congress set up both the FSC
structure and Roth IRAs not to have any purpose other than tax reduction or
avoidance. The Code defines both with great precision--they are not terms like
“partnership” or “reorganization” or “interest” where courts have long imported
meaning from outside tax law and done so with an eye to economic effects and
nontax motivation.
B.
What’s really going on here is that the Commissioner doesn’t like that the
Mazzeis took two types of tax-advantaged entities and made them work together.
He admits as much when he says that substance-over-form principles should
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prevent “consequences unintended by Congress.” He wants to be able to
recharacterize any transaction that in his opinion achieves a result Congress didn’t
anticipate, even if that transaction complies with the Code.
There’s a difference, though, between an argument that a transaction is
inconsistent with congressional intent and an argument that the Commissioner can
recharacterize a transaction unless a taxpayer can show that Congress intended to
let him do what he did. One is an argument about what a statute means, the other
is an assertion that the IRS or the courts have a general power to recast
transactions to reduce tax benefits unless Congress denied that power for the
transaction at issue.
That’s what is going on here. The majority’s approach--perhaps more
common in tax law than in any other legal specialty--is to abandon general
principles of statutory construction in favor of using judge-made doctrines that
undermine or ignore the text of the Code to recast transactions to avoid “abuse”.
And here “abuse” means something like a result inconsistent with a judge’s notion
of a Code section’s purpose. The great textualist counterrevolution of the last few
decades makes this untenable. A unanimous Supreme Court held in its first
opinion of the current term:
- 99 -
[W]e resist speculating whether Congress acted inadvertently. See
Henson v. Santander Consumer USA Inc., 582 U.S. , -
(2017) (slip op., at 9-10) (“[W]e will not presume with [respondents]
that any result consistent with their account of the statute’s
overarching goal must be the law but will presume more modestly
instead ‘that [the] legislature says . . . what it means and means . . .
what it says.’” (quoting Dodd v. United States, 545 U.S. 353, 357
(2005))); Magwood v. Patterson, 561 U.S. 320, 334 (2010) (“We
cannot replace the actual text with speculation as to Congress’
intent.”). * * *
Hamer v. Neighborhood Hous. Servs. of Chi., 583 U.S. , , 138 S. Ct. 13, 20
(2017).
We should instead adopt the Sixth Circuit’s view of this--that substance-
over-form simply lets courts look at what’s really going on regardless of the labels
taxpayers use. See Summa II, 848 F.3d at 785; see also Gregory, 293 U.S. at 469-
70. That way taxpayers can’t get tax benefits just by calling something something
it’s not. As the majority points out, if a taxpayer called dogs cows and then
claimed subsidies for cows, substance-over-form principles would let us deny
those subsidies. See op. Ct. p. 68; see also Summa II, 848 F.3d at 787-88 (quoting
Joseph Isenbergh, “Musings on Form and Substance in Taxation: Federal
Taxation of Incomes, Estates, and Gifts,” 49 U. Chi. L. Rev. 859, 865 (1982)).
- 100 -
But rich people buying cows they don’t otherwise need in order to get the cow
subsidies isn’t the same thing. See id.13
The economic substance doctrine doesn’t help the Commissioner here
either. If that doctrine is one of statutory construction, Congress specifically
turned it off for FSCs when it told us that the commissions they receive--and by
extension the dividends they pay--don’t need a basis in economic reality. See
secs. 245(c), 925; sec. 1.925(a)-1T(a)(3), Temporary Income Tax Regs, 52 Fed.
Reg. 6444 (Mar. 3, 1987). And Congress likewise didn’t require IRAs to have any
purpose other than tax-advantaged saving. I would therefore hold that we have no
basis for recharacterizing the transaction here--there’s no statutory ambiguity and
Congress said economic substance isn’t necessary. And as we have already held,
if we couldn’t recharacterize a transaction for income-tax purposes, we can’t
recharacterize it for excise-tax purposes. Hellweg, 2011 WL 821090, at *9.
13
Professor Isenbergh goes on to say that “[m]any of the difficulties that
bedevil that pursuit of ‘substance’ and ‘form’ in taxation stem from the
assimilation of these two patterns.” Joseph Isenbergh, “Musings on Form and
Substance in Taxation: Federal Taxation of Incomes, Estates, and Gifts,” 49 U.
Chi. L. Rev. 859, 865-66 (1982). He then explains that we shouldn’t use the
“rubric of form and substance” to conflate instances of mislabeling--where
recharacterization is appropriate--and cases where a transaction “falls within the
statute, but results in a bad thing” because “[m]any bad things * * * are precisely
what they purport to be, and therefore cannot be swept aside as shams.” Id. at 866.
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C.
We should always remember that there are times in tax law where courts
ought to put form over substance, and should respect transactions that have no
nontax purpose. That’s what happened in Cottage Savings Assoc. v.
Commissioner, 499 U.S. 554 (1991), where the Supreme Court respected a
transaction that created different legal rights on paper--and tremendous tax losses
--but didn’t change the taxpayer’s economic reality. In Moline Properties the
Supreme Court similarly respected the corporation the taxpayer put his real estate
into at the suggestion of a creditor even though the corporation had no books or
bank accounts. 319 U.S. at 438-39. And in Sacks the Ninth Circuit respected a
transaction the taxpayer entered into to get renewable-energy credits without
which the transaction wouldn’t have been profitable. 69 F.3d at 992.
In cases like these, courts apply the language of the Code even when
taxpayers discover that two sections interact to provide benefits Congress likely
didn’t intend, or even foresee. The Supreme Court said as much in Gitlitz v.
Commissioner, 531 U.S. 206 (2001). There, it held that the Code’s plain language
let an insolvent S corporation14 exclude discharge-of-indebtedness income while
14
An S corporation is a corporation governed under the laws of subchapter
S of the Internal Revenue Code. S corporations generally don’t pay federal
(continued...)
- 102 -
simultaneously letting the S corporation’s solvent shareholders treat it as income
that increased their bases against which they could take deductions. Id. at 216,
218. Lower courts had worried that this was a “double windfall” that Congress
didn’t intend, but the Supreme Court held that “[b]ecause the Code’s plain text
permits the taxpayers * * * to receive these benefits, we need not address this
policy concern.” Id. at 219-20.
We ourselves applied similar reasoning in Austin v. Commissioner, T.C.
Memo. 2017-69, at *31-*35, where we refused to say that an employee stock
ownership plan’s (ESOP’s) 100% ownership of an S corporation lacked economic
substance even though all of the S corporation’s income flowed into the ESOP tax
free. There we noted that scholars questioned “the wisdom of Congress’ decision
to create the statutory framework of which petitioners took advantage. But that
framework did exist.” Id. at *32. The ESOP was what it was supposed to be--a
way to increase “retirement income security”--so we upheld the structure despite
its unintended benefits. Id. at *34. We even cited Summa II’s proclamation that
“[t]he Commissioner cannot fault taxpayers for making the most of the tax-
14
(...continued)
income tax but are, like partnerships, passthrough entities that channel income and
deductions to their owners. See Gitlitz, 531 U.S. at 209.
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minimizing opportunities Congress created.” Id. at 32 (citing Summa II, 848 F.3d
at 790).
Caterpillar Tractor Co. v. United States, 218 Ct. Cl. 517 (1978), also follows
this approach. There, the Court of Claims said a corporation qualified as a DISC
even though all of the export sales its commission payments came from were to a
related Western Hemisphere trade corporation (WHTC)--another type of export-
encouraging entity that no longer exists. Id. at 522.15 This resulted in a “double
benefit” that the Commissioner said Congress didn’t intend and that a regulation
forbade. Id. at 528. But the Court upheld the structure because it “fit[] solidly
within the literal language of the statute.” Id. at 527. It also noted that the
taxpayer was doing what the Code allowed, not hiding the actual transaction
behind a fictitious structure or label. See id. at 530.
As did the taxpayers in Gitlitz, Austin, and Caterpillar Tractor, so did the
Mazzeis here--they grabbed for two benefits that the Code’s text plainly allows.
Whether there is legislative history that shows anyone intended FSCs and Roth
IRAs to work so well together for taxpayers like the Mazzeis shouldn’t matter.
Substance-over-form principles don’t give courts free rein to choose results that fit
15
WHTCs were defined in sections 921-922, but were phased out from
1976-1980. See Tax Reform Act of 1976, Pub. L. No. 94-455, sec. 1052, 90 Stat.
1647-48.
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their view of good tax policy. They simply tell us to treat things as what they
really are, no matter what taxpayers call them. When Congress created FSCs and
Roth IRAs, it said they didn’t need economic substance and taxpayers who used
them didn’t need to have a nontax purpose. As long as taxpayers comply with
statutory formalities, such entities are what they purport to be, and we have to
respect them, even when they work together. Here the Mazzeis followed the
formalities and didn’t play with labels. When it comes to FSCs and Roth IRAs,
that’s enough.
FOLEY and BUCH (join only Parts I through IV) and MORRISON (joins
only Parts I through III), JJ., agree with this dissent.