Ninth Circuit to Scrutinize Tax Court’s Invocation of Substance-Over-Form Doctrine in Light of Apparently Conflicting Decisions From Three Different Courts of Appeals

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January 15, 2019

We present here a guest post from our colleague Nicholas Metcalf.

In Mazzei v. Commissioner, a divided Tax Court (12-4) relied on the substance-over-form doctrine to disregard transactions between the taxpayers, their Roth IRAs, and an FSC purportedly owned by the Roth IRAs. The Mazzei decision is at odds with three recent appellate decisions that rejected the IRS’s use of the substance-over-form doctrine to recharacterize similar transactions.

The Mazzei Decision.  The taxpayers—a husband, wife, and their daughter—owned and operated a company (“Injector Co.”) that sold and distributed injectors in both the United States and foreign markets. The husband was a member of the Western Growers Association (“WGA”), a trade association, which, among other things, created and sold interests in FSCs to its members before FSCs were phased out beginning in 2000. The taxpayers had joined the WGA FSC program, opened and funded Roth IRAs, and directed each Roth IRA to purchase 33-1/3 shares of a WGA FSC for $5 per share.

Pursuant to several agreements, each year Injector Co. had the option of paying the taxpayers’ FSC a commission based on the FSC rules set forth in former Code sections 921-927. When Injector Co. paid a commission, that commission was deductible to Injector Co. The commissions earned by the taxpayers’ FSC were taxed at a preferential rate, and the FSC issued dividends to the Roth IRAs for the remainder of the commission payment. Earnings on Roth IRA accounts and withdrawals upon retirement are generally tax-free. From 1998 through 2002, Injector Co. paid over half a million dollars in commissions to the taxpayers’ FSC, which then distributed the after-tax balance to the taxpayers’ Roth IRAs. The IRS was unhappy with the tax benefits achieved by this structure and asserted that the amounts transferred from Injector Co. to the Roth IRAs (through the FSC) were in substance dividends to the taxpayers and contributions to their Roth IRAs—a recharacterization that yielded substantial excise tax liabilities under Code section 4973. The taxpayers maintained that the payments at issue were income to the Roth IRAs (not contributions from the taxpayers) and therefore did not trigger the excise tax.

The Tax Court majority opinion resolved the case in the government’s favor by concluding that the taxpayers, not the Roth IRAs, were the “substantive owners” of the FSC. The Tax Court stated that the proper recipient of a dividend is determined under Commissioner v. Banks, 543 U.S. 426, 434 (2005), “by asking whether a taxpayer exercises complete dominion over the income in question.” The majority and dissent disagreed on the starting point for this inquiry, however, with the majority holding that the FSC was the income-generating asset, while the dissent concluded that Injector Co. was the income-generating asset because it generated the commission payments.

To determine who had dominion and control, the majority evaluated the purported ownership of the taxpayers’ FSC shares by the Roth IRAs from the perspective of an unrelated party. The Tax Court concluded that the Roth IRAs did not have the benefits and burdens of ownership because: (1) they were not subject to any risk given the negligible sum paid for the FSC shares (the court had found that all but $1 of the purchase price was actually a “fee” for access to the FSC); and (2) Injector Co. retained complete control over the decision to pay commissions to the FSC and therefore a FSC shareholder could not count on any upside benefits. The court concluded that “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.” Hence, the majority ruled that the substance of the transaction did not match its form, and it disregarded the Roth IRAs’ purported ownership. Instead, the Tax Court held that the substantive owners of the FSC shares were the taxpayers, and therefore it recharacterized the transactions as dividends from the FSC to the taxpayers, followed by contributions from the taxpayers to the Roth IRAs. Those contributions were subject to excise taxes because they exceeded the applicable contribution limits.

The Sixth Circuit Decision in Summa Holdings.  The fact pattern in Mazzei was similar to the fact pattern in Summa Holdings v. Commissioner (“Summa I”), T.C. Memo. 2015-119, where the IRS also relied on the substance-over-form doctrine to recharacterize transactions between taxpayers, Roth IRAs, and a Domestic International Sales Corporation (“DISC”). As in Mazzei, the IRS argued in Summa I that the Roth IRA-DISC transactions should be recharacterized as deemed dividends from Summa to its shareholders followed by $1.1 million in contributions to the Roth IRAs—triggering excise taxes for excess contributions. The Tax Court agreed.

The taxpayers in Summa I appealed, and those appeals went to three different circuits because of the diverse residences of the taxpayers. While Mazzei was still pending in the Tax Court, the Sixth Circuit reversed the Summa I decision. Summa Holdings, Inc. v. Commissioner (“Summa II”), 848 F.3d 779 (6th Cir. 2017). The Sixth Circuit’s opinion opened with an acerbic reference to Caligula and his reported penchant for posting tax laws “in such fine print and so high that his subjects could not read them.” The Sixth Circuit analogized Caligula’s tax policy to the Commissioner’s exercise of the power to recharacterize transactions using the substance-over-form doctrine and thus produce different tax outcomes from those called for by the plain language of the Code. The court explained that the Summa transactions produced their intended results under a technical reading of the Code, stating that “[i]f this case dealt with any other title of the United States Code, we would stop there, end the suspense, and rule for Summa Holdings and the Benensons.” Recognizing that the Internal Revenue Code is treated differently, however, the court went on to consider the IRS’s arguments under the non-statutory anti-abuse doctrines of substance over form and economic substance. The court rejected those arguments, holding that neither the Commissioner’s perception of the transactions’ “substance” nor Congressional intent could justify recharacterizing the original transactions.

The Tax Court’s Response to the Sixth Circuit.  The Tax Court in Mazzei then ordered supplemental briefs to address Summa II, even though that decision was not directly controlling under the Golsen rule because appeal in Mazzei lies to the Ninth Circuit. The parties agreed that the only difference between the Mazzei transactions and the Summa transactions was the use of an FSC rather than a DISC. And the government agreed that the differences between an FSC and a DISC had no impact on the tax consequences of the transaction. The government argued, however, that Summa II was wrongly decided and urged the Tax Court to recharacterize the Mazzei transactions notwithstanding the Sixth Circuit’s decision.

When the Tax Court is reversed on an issue by an appellate court, custom dictates that the next case addressing that issue is considered in court conference where all the Tax Court judges evaluate the case and vote on whether to follow the appellate decision. In Mazzei, Judge Holmes was the trier of fact, and it is clear that his initial report would have upheld the taxpayer’s position following Summa II. Judge Holmes drafted a report to that effect that was submitted to court conference, but the majority disagreed with Judge Holmes’ report. The case was then reassigned to Judge Thornton who wrote the majority opinion joined by eleven other Tax Court Judges. Five of those twelve judges (including Judge Thornton) also joined a concurring opinion authored by Judges Paris and Pugh that sought to “emphasize” certain points in the interest of reducing the chances that the majority opinion would be given a broad reading. Finally, Judge Holmes issued a dissenting opinion joined in part by three other Judges.

The majority in Mazzei found that Summa II was not directly on point because it addressed only corporate-level issues with the Summa structure, not shareholder-level issues involving payments to Roth IRAs. (Those shareholder-level issues were the subject of appeals from Summa I to the First and Second Circuits). The majority also distinguished Summa II on the basis of the differences between DISCs and FSCs, though even the government had stated that those differences were immaterial. Specifically, the majority noted that Code section 995(g) “expressly contemplates that tax-exempt entities like traditional IRAs may own DISC shares,” which supported the Sixth Circuit’s determination that the Summa structure did not violate congressional intent. Summa II, at 848 F.3d at 782-784. By contrast, in Mazzei the taxpayers had to rely on caselaw to support the assertion that Roth IRAs can own FSCs (though that assertion was not contested by the IRS).

The Concurring and Dissenting Opinions in Mazzei.  The Mazzei concurring opinion stressed that the majority opinion did not require that FSCs have economic substance, did not disregard the Roth IRAs or the FSC, and did not hold that Roth IRAs could not own shares in FSCs. Rather, the concurrence emphasized that the majority opinion focused on one step in the transaction: “the purported purchase of FSC stock by the Roth IRAs for the nominal price of $1.” On the specific facts of the Mazzei transaction, the Roth IRAs’ purchase price 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.”

The dissent sharply (and colorfully) disagreed with the majority’s distinction of Summa II. The opinion began by noting the Sixth Circuit’s reversal in Summa II, describing it as “a case that was nearly identical to this one.” In an homage to the Sixth Circuit’s reference to Caligula, the dissent criticized the majority’s decision as follows: “[T]oday we have to choose either a well-reasoned opinion by a highly respected judge in America’s heartland, or Caligula. We pick Caligula.” The dissent explained that the majority’s distinction of Summa II was unpersuasive because DISCs and FSCs were “very similar—barely-there entities” that were “intentionally nothing more than ways to reduce exporters’ effective tax rates.”

More fundamentally, the dissent questioned the majority’s derivation of a dominion and control test from Commissioner v. Banks, which involved attorney contingency fees rather than dividends or corporate payments, and in any event disagreed with the majority’s determination that the FSC was the “income-generating asset.” Instead, the dissent concluded that Injector Co. generated the income at issue. The dissent asserted that the majority was failing to give effect to a determination made by Congress because the taxpayers’ FSC was simply a “congressionally sanctioned vehicle for reducing Injector Co.’s effective tax rates on exports.” Expressing concern over the broader potential ramifications of the decision, the dissent cautioned that the dominion and control test established by the majority could be used to attack other taxpayers who made small initial investments in their corporations and did not accurately predict future earnings.

The dissent also questioned whether the IRS was actually attempting to invoke the economic-substance doctrine rather than the substance-over-form doctrine. The dissent explained that while there is overlap between the two doctrines, “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.” And “[o]ne way of thinking about the 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.” But the dissent concluded that the substance-over-form doctrine was not applicable because it was uncontested that the taxpayers’ FSC was “exactly what it purports to be: a corporation . . . organized precisely in accord with the statutory rules.” And the economic substance doctrine also was not applicable because the provisions at issue were defined with “great precision” in the Code and “Congress set up both the FSC structure and Roth IRAs not to have any purpose other than tax reduction or avoidance.”

The dissent broadly criticized the majority for “abandon[ing] 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 . . . a result inconsistent with a judge’s notion of a Code section’s purpose.” The dissent cited the Supreme Court’s decision in Cottage Savings Ass’n v. Commissioner, 499 U.S. 554 (1991), noting that “there are times in tax law where courts ought to put form over substance, and should respect transactions that have no nontax purposes.” Along the same line, it described the Supreme Court’s decision in Gitlitz v. Commissioner, 531 U.S. 206 (2001), as approving the proposition that “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.” Because “[s]ubstance-over-form principles don’t give courts free rein to choose results that fit their view of good policy,” the dissent concluded that the Tax Court should have respected the Mazzei transaction because the taxpayers complied with the statutory formalities and the entities were what they purported to be—Roth IRAs and an FSC.

The First and Second Circuits Contradict Mazzei’s Shareholder-Level Distinction. After the Tax Court decided Mazzei, both the First and Second Circuits issued decisions addressing the shareholder-level issues presented in Summa I and, like the Sixth Circuit, they reversed the Tax Court. See Benenson v. Commissioner, 887 F.3d 511 (1st Cir. 2018); Benenson v. Commissioner, 910 F.3d 690 (2d Cir. 2018). Both courts agreed with the Sixth Circuit that the IRS could not recharacterize the Summa transactions using the substance-over-form doctrine and that the taxpayers were not liable for excise taxes on excess contributions to the Roth IRAs. The First Circuit stated that the substance-over-form doctrine was not just a “smell test” and that the court could not recharacterize the Summa transactions because they “violate[d] neither the letter nor the spirit of the relevant statutory provisions.” 887 F.3d at 523. The Second Circuit stated that “[l]ike the Sixth Circuit, and for much the same reasons, we conclude that Summa’s payment of deductible DISC commissions was grounded in economic reality and not distortive of the tax code provisions establishing the DISC program.” 910 F.3d at 700.

Thus, the appeal in Mazzei comes to the Ninth Circuit in a posture where it will be difficult for the court to affirm the Tax Court without creating considerable tension or outright disagreement with its sister circuits. The Tax Court distinguished the Sixth Circuit’s Summa II opinion on two grounds. One of those has now essentially been rejected by two other courts of appeals. And even the government did not agree that the second ground was a material distinction.

The taxpayers’ opening brief is due on January 25, 2019.

Mazzei – Tax Court opinion

Sixth Circuit opinion in Summa Holdings

First Circuit opinion in Benenson

Second Circuit opinion in Benenson