Government Brief Filed in Mazzei

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April 9, 2019

The government has filed its response brief in Mazzei urging the Ninth Circuit to accept the Tax Court’s recharacterization of the taxpayer’s transaction using the substance-over-form doctrine.  See our prior reports here.  The government’s brief starts by highlighting the IRS’s issuance of Notice 2004-8, which related to certain “abusive Roth IRA transactions” between: (1) a taxpayer’s pre-existing business, (2) the taxpayer’s Roth IRA, and (3) “a corporation (the Roth IRA Corporation), substantially all the shares of which are owned or acquired by the Roth IRA.”  Notice 2004-8 identified potentially abusive situations where the Roth IRA’s acquisition of shares, the overall transactions, or “both are not fairly valued and thus have the effect of shifting value into the Roth IRA.”  A few years later, the Joint Committee on Taxation referenced Notice 2004-8 in discussing “abusive Roth transactions.”  The government cites Notice 2004-8 to attack the taxpayers’ argument that the transaction complied with Congressional intent.  But the Notice was issued years after the taxpayers in Mazzei entered into the transactions at issue, and the examples of “abusive transactions” referenced in the notice did not involve Foreign Sales Corporations (“FSCs”), which were used in Mazzei, or Domestic International Sales Corporations (“DISCs”), which were used in Summa Holdings.

The government also takes on the taxpayer’s reliance on the Summa Holdings cases by asserting that the courts in those cases did not address the “same issue.”  In particular, the government argues that the Tax Court’s decision in Summa Holdings v. Commissioner, did not reach the issue presented in Mazzei.  In that case, the Tax Court used the substance-over-form doctrine to recharacterize the entire transaction between the taxpayers, the operating business, the DISC, and the Roth IRAs.  The government points out that the Tax Court did not address the argument presented in Mazzei that the formal issuance of stock to Roth IRAs violated the substance-over-form doctrine.  Because the Tax Court did not address the stock issuance the First, Second, and Sixth Circuits were not presented with that issue on appeal.  Thus, the government argues that in Mazzei it is not asking the Ninth Circuit to “disagree with three other Circuits . . . but to consider a distinct issue that the other circuits did not consider.”

The government also argues that the Tax Court’s analysis of the Roth IRAs’ ownership of the FSC stock was appropriate because FSCs are “not immune from the operation of fundamental tax principles” (that is, substance-over-form). The focus of this argument is on the discrepancy in value between what the FSC could be expected to earn in commissions from the operating company and what the Roth IRAs paid for the stock in the FSC.  The government acknowledges that FSCs were created to produce a tax benefit but asserts that the rules providing for FSC tax benefits “do not extend to the purchase of FSC stock.”  Rather, the tax benefit provided by FSCs applies “only to transactions between FSCs and their related supplier regarding qualifying export sales.”  After acknowledging that regulations allow entities related to the owners of an operating company to own FSC stock and that an FSC does not require an economic purpose, the government contends that those facts do not support the conclusion “that dividends paid to that entity will automatically be respected for tax purposes as earnings from a genuine investment.”

Finally, the government argues that the Tax Court’s determination that the Roth IRAs did not own the FSC stock was supported by the record and that the taxpayers did not identify any error in the Tax Court’s factual analysis that would support reversal.  The Tax Court determined that the taxpayers (not the Roth IRAs) owned the FSC stock because the Roth IRAs paid very little for the FSC stock, the Roth IRAs put nothing at risk, and at the time the Roth IRAs entered into the transaction they could not have expected to receive any economic benefits (because the taxpayers retained complete control over the payment of commissions).  But those facts are likely applicable to most FSCs.  Disregarding a transaction because the owner of an FSC’s stock paid very little, put nothing at risk, and could not have expected to receive economic benefits (due to the FSC structure) appears to be at odds with the Congressional intent that FSCs would be valid entities that could be used by taxpayers to reduce their tax liability.  Under the government’s theory, it would be very difficult for anyone to be the “real” owner of an FSC, even though Congress sanctioned the use of these entities despite their lack of economic purpose.

The reply brief is due on April 26, 2019.

Mazzei – Government Answering Brief