No. 18-72451
United States Court of Appeals for the Ninth Circuit
June 2, 2021
Tax Ct. Nos. 16702-09, 16779-09
Appeal from a Decision of the United States Tax Court
Argued and Submitted February 14, 2020 Pasadena, California
Filed June 2, 2021
Before: Jay S. Bybee and Daniel P. Collins, Circuit Judges, and Barry Ted Moskowitz,* District Judge.
Opinion by Judge Collins
SUMMARY**
Tax
The panel reversed a decision by the full Tax Court in favor of the Commissioner on a petition for redetermination of federal excise tax deficiency, in a case involving the use of a Foreign Sales Corporation to reduce the tax paid on income that was then distributed as dividends to Roth Individual Retirement Accounts.
Appellants established a FSC under since-repealed provisions of
Appellants made their Roth IRAs formal shareholders of their FSC. Appellants’ export corporation paid commissions into the FSC, and the FSC‘s after-tax income was returned as dividends and distributed to appellants’ IRAs rather than to their export corporation. As а result, no tax was paid when the money was received into the Roth IRAs, and no tax would be paid on qualified withdrawals from the Roth IRAs.
The Commissioner challenged this scheme, asking the Tax Court to recharacterize the entire scheme under the doctrine of substance over form. The Tax Court held that, under substance-over-form principles, appellants-not the Roth IRAs-were the real owners of the FSC. This meant that appellants should be deemed to have received the dividends, their contributions to the Roth IRAs exceeded the statutory limits for such contributions, and appellants were consequently liable for excise taxes on the excess contributions.
The panel concluded that, due to the unusual statutory provisions at issue here, the Tax Court erred by invoking substance-over-form principles to effectively reverse congressional judgment and to disallow what the statute plainly allowed. The panel joined three other circuits that have similarly disallowed the invocation of substance-over-form principles to undo the congressionally authorized separation of substance and form that is involved in an entity similar to the FSC at issue here.
COUNSEL
Judith A. Hagley (argued), Gilbert S. Rothenberg, and Teresa E. McLaughlin, Attorneys, Tax Division; Richаrd E. Zuckerman, Principal Deputy Assistant Attorney General; United States Department of Justice, Washington, D.C.; for Respondent-Appellee.
OPINION
COLLINS, Circuit Judge:
Angelo, Mary, and Celia Mazzei appeal the Tax Court‘s ruling that they are liable for excise taxes for having made excess contributions to their Roth Individual Retirement Accounts (“IRAs“). Invoking substance-over-form principles, the Commissioner insists that the dividends that the Mazzeis’ Roth IRAs received from a specific corporation were actually contributions from the Mazzeis, because the Commissioner deemed the Mazzeis, rather than the IRAs, to be the real owners of that corporation. Over the vigorous dissent of four judges, the full Tax Court sided with the Commissioner. Because we conclude that the unusual statutory provisions at issue here expressly elevated form over substance in the relevant respects, the Tax Court erred by invoking substance-over-form principles to effectively reverse that congressional judgment and to disallow what the statute plainly allowed.
The underlying dispute arises from the Mazzeis’ establishment of a Foreign Sales Corporation (“FSC“) under the since-repealed provisions of
The Mazzeis (and many others) took this one step further by having their Roth IRAs be the formal shareholders of the FSC. This meant that, when the FSC‘s after-tax income was being returned as dividends, it was distributed to the IRAs rather than to the export corporаtion that had paid the commissions into the FSC. As a result, no tax was paid when the money was received into the Roth IRAs, no tax would be paid on the growth of those funds over time, and no tax would be paid if and when the Mazzeis made qualified withdrawals
Three circuits have addressed comparable questions in the context of a similar type of corporation allowed by the Internal Revenue Code, namely, a Domestic International Sales Corporation (“DISC“). All three courts reversed the Tax Court and disallowed the invocation of substance-over-form principles to undo the congressionally authorized separation of substance and form that is involved in a DISC. We reach a similar conclusion as to FSCs here, and we therefore reverse the judgment of the Tax Court.
I
This is a case in which the details matter a great deal, and so we first set forth the complex legal backdrop and then explain the specific facts of this case.
A
The legal context for this dispute involves three different entities that are (or were) specially authorized by the Internal Revenue Code, namely, Roth IRAs, FSCs, and DISCs. Although the Mazzeis did not use a DISC, the FSC regime was expressly modeled after the DISC system, and so an understanding of the latter will help to elucidate the distinctive features of the former. Moreover, the only circuit decisions addressing comparable issues arose in the DISC context, thereby underscoring the importance of understanding both types of corporations. Accordingly, we briefly review the key features of the Roth IRA, DISC, and FSC.
1
Congress first authorized tax-advantaged IRAs in 1974, initially as a means of providing retirement assistance to those who lacked coverage under a pension plan. See Employee Retirement Income Security Act of 1974, Pub. L. 93-406, § 2002, 88 Stat. 829, 958-64. Cоngress has substantially expanded the availability of IRAs since then, and it has made numerous changes to the tax treatment of such accounts. In particular, Congress in 1997 authorized a new alternative type of IRA called a “Roth IRA.” See Taxpayer Relief Act of 1997, Pub. L. No. 105-34, § 302(a), 111 Stat. 788, 825.
The tax treatment of earnings in a Roth IRA are generally the same as for a traditional IRA: earnings grow tax-free, except that they remain “subject to the taxes imposed by section 511” concerning unrelated business income.
Given the significant tax advantages of a Roth IRA, in which funds grow tax free and then remain free from taxation upon authorized distribution, Congress has established a statutory formula that strictly limits contributions to Roth IRAs. See
2
To promote exports of domestic goods, Congress in 1971 authorized the creation of DISCs, which are governed by special rules that allow companies to reduce the taxes they pay on export income. See Revenue Act of 1971, Pub. L. No. 92-178, §§ 501-507, 85 Stat. 497, 535-53. The DISC system has been amended over the intervening years, and we briefly sketch its key features in their present form.
The central feature of the DISC system is a special statutory exception for DISCs from the normal rules that govern allocation of income between “two or more organizations, trades, or businesses ... owned or controlled directly or indirectly by the same interests.”
Although the statute itself articulates these special rules only in the context of the “sale of export property to a DISC” by a commonly controlled entity,
As a result of these unique rules, neither the export corporation nor the DISC pays any income tax on the applicable income that is attributable to the corporation‘s qualified export receipts but that was effectively allocated to the DISC by way of (as the case may be) the hypothetically priced sale or the artificially determined “commissions.” Income tax is generally only paid when the DISC distributes its received commissions as dividends to the DISC‘s shareholders, either because the DISC actually pays out the dividends, see
The “net effect” of these complex rules is thus to allow an export company to ultimately transfer a portion of its export revenue to the DISC‘s shareholders (who are often either the export company or its shareholders) in the form of dividends, without having it ever being taxed “as corporate income.” Summa Holdings, Inc. v. Commissioner, 848 F.3d 779, 782 (6th Cir. 2017).
Thе Internal Revenue Code explicitly contemplates that tax-exempt entities-a category that now includes Roth IRAs-may own shares of a DISC. It does so by establishing a special rule that applies when the “shareholder in a DISC” is an “organization ... subject to tax under section 511.” See
all withdrawals from [a] traditional IRA, are subject to personal income tax when taken out.” Id. (emphasis added) (citing Summa Holdings, 848 F.3d at 783). That makes a traditional IRA a singularly unattractive vehicle for holding DISC shares. Id. And that is no accident-Congress еnacted the special taxation rule in § 995(g) in 1989 precisely because, under the prior rule in which “tax-exempt entities like IRAs paid nothing on DISC dividends,” export companies were “shield[ing] active business income from taxation by assigning DISC stock to controlled tax-exempt entities like pension and profit-sharing plans.” Summa Holdings, 848 F.3d at 782.
But the situation with a Roth IRA is somewhat different. To be sure, a Roth IRA, like a traditional IRA, generally must still pay unrelated-business-income tax on dividends received from a DISC.
3
“Soon after its enactment, the DISC statute became ‘the subject of an ongoing dispute between the United States and certain other signatories of the General Agreement on Tariffs and Trade (GATT)’ regarding whether the DISC provisions were impermissible subsidies that violated our treaty obligations.” Boeing Co., 537 U.S. at 442 (citation omitted). As a result, Congress in 1984 authorized a distinct but similar entity known as a “Foreign Sales Corporation” or “FSC.” See Deficit Reduction Act of 1984, Pub. L. No. 98-369, §§ 801-805, 98 Stat. 494, 985-1003. The hope was that the FSC system, which would serve as an alternative to a modified DISC scheme, would ameliorate such international controversy. Boeing Co., 537 U.S. at 442. That hope proved illusory, and the FSC regime itself was determined by the World Trade Organization in March 2000 to be “an impermissible subsidy.” Ford Motor Co. v. United States, 908 F.3d 805, 808 (Fed. Cir. 2018). Congress promptly repealed the FSC provisions in November 2000, but the repeal statute contained transition provisions that allowed for certain existing FSCs to continue for a specified time. See FSC Repeal and Extraterritorial Income Exclusion Act of 2000, Pub. L. No. 106-519, 114 Stat. 2423.3 Throughout all of this,
The statutory provisions governing FSCs were set forth in former
contrast to DISCs, which are domestic corporations, a FSC5 generally must be organized under the laws of certain foreign countries or under the laws applicable to a U.S. possession.
“does not depend on the extent to which the FSC performs substantial economic functions beyond those required by section 925(c)“).
In contrast to a DISC, whose income is generally exempt from tax, see
The taxation of a FSC‘s dividend payments differs in some respects from those of a DISC. Dividends that are distributed by a FSC to a domestic parent corporation out of the earnings and profits attributable to the FSC‘s foreign trade income are generally not subject to corporate income tax.
If the FSC paid dividends to individual shareholders, then those dividends would generally be subject to taxation under the default rule that dividends are treated as income. See
B
With this complex statutory background in place, we can now turn to the facts of this case. We first describe the Mazzeis’ relevant transactions and then recount the proceedings below.
1
In 1977, Angelo Mazzei filed a patent application for an “injector” that added fertilizers to the water used in agricultural irrigation systems. The following year, recognizing the business potential in his invention, Angelo and his wife Mary Mazzei formed the Mazzei Injector Corp. (“Injector
thereafter actively ran the business, although Mary later reduced her role. Once their daughter, Celia, graduated from college, she became more active in the company and served as its vice president of research and development. During the time period at issue in this case, Angelo and Mary each owned 45 percent of Injector Corp. while Celia owned the remaining 10 percent. Through the Mazzeis’ efforts, Injector Corp. grew rapidly, and by 1984, the business began exporting its products through foreign distributors. By the late 1990s, export sales provided a steady stream of revenue to Injector Corp.
The Mazzeis also owned a 20-acre farm, and as a result they were long-time members of the Western Growers Association (“WGA“), a trade association representing farmers. In the 1990s, WGA developed a program for its members that would facilitate their use of FSCs, and in 1998 the Mazzeis decided to participate in that program. In connection with doing so, the Mazzeis took steps to set up Roth IRAs. The amount that may be contributed to a Roth IRA is determined according to a statutory formula, see
Meanwhile, the newly formed entity, Injector Co., applied to join WGA‘s FSC program. Once WGA approved Injector Co.‘s application, the Mazzeis took steps to establish a FSC under WGA‘s auspices. The WGA FSC program took advantage of the statute‘s allowance of a “shared FSC,” under which an entity (such as WGA) could arrange for a FSC to maintain “separate account[s]” that each would then generally “be treated as a separate corporation for purposes” of the FSC statute.
WGA also provided Injector Co. with drafts of the various agreements that would be needed to ensure that its FSC-which was ultimately a separate account in the “Western Growers Shared Foreign Sales Corporation IV Ltd.” (“WG FSC
intended, and Injector Co. executed these agreements in early 1998. These various agreements underscore what the statutory framework expressly contemplates, which is that the FSC would be paid commissions that were set according to regulatory formulas and that did not reflect any actual services provided by the FSC.
First, Injector Co. and WG FSC IV executed a “Foreign Trade Commission, Sale, License, Lease and Services Agreement” (“Commission Agreement“), under which WG FSC IV agreed to perform certain activities and services for Injector Co. “but only to the extent it can delegate such activities and services” back to Injector Co. “and is not required to use its own assets and/or personnel to perform such activities and services” (emphasis added). Thus, for example, WG FSC IV agreed to “promote the license, lease and sale” of Injector Co.‘s products, but it also stated that none of these activities “shall be of the type which involve the use of the FSC‘s own assets or personnel to perform such activities.” The Commission Agreement also specified that if a particular sale, license, or lease was “considered as solicited or promoted” by WG FSC IV, then the FSC would receive a commission, but that Injector Co. would have the “final decision” as to whether the FSC was to be “considered as having solicited or promoted a transaction” (emphasis added). If a commission was to be paid, then it would be determined by mutual agreement in accordance with the formulas in the applicable federal FSC regulations “so as to provide the maximum federal income tax benefits” to Injector Co. Likewise, the Commission Agreement specified that if Injector Co. “performs any service for a
customer that would constitute” a relevant service “if performed by [WG FSC IV] for a customer considered as solicited or promoted” by the FSC, then Injector Co. would pay a “commission” to the FSC. Once again, Injector Co. had the “final decision” as to whether WG FSC IV would be “considered” to have solicited or promoted a transaction, and any commission paid would be determined by mutual agreement in accordance with the relevant regulatory formulas.
Second, consistent with what was expressly contemplated in the Commission Agreement, the “Export Related Services Agreement” (“Services Agreement“) formally delegated back to Injector Co. the relevant activities and services that WG FSC IV was to perform in connection with “earning foreign trade income.” WG FSC IV agreed to pay Injector Co. a “service fee” for performing these services, but any such fee could not exceed the commissions that the FSC received and was to be “immediately offset against the discretionary commissions which [Injector Co.] would otherwise pay to [the FSC].” The agreement further provided that services would be deemed to have been performed by Injector Co. for WG FSA IV only to the extent required to “maxim[ize] federal income tax benefits.”
Third, under the “Management Contract,” WG FSC IV agreed to pay “administrative fees” to Quail Street Management (“Quail Street“), the Bermuda-based management company that administered WGA‘s FSC program. The fee was set at 0.1 percent of the FSC‘s foreign gross trading receipts as defined in
Fourth, under the “Shareholders’ Agreement,” each IRA shareholder owned one-third of their FSC‘s 100 shares, which could not be sold without the approval of the FSC‘s directors. The agreement confirmed the $500 purchase price for the 100 shares and specified that this amount consisted of $1 of “paid-in capital” and $499 of “paid-in surplus.” The agreement further stated that, in the event that the FSC exercised its right to purchase the FSC stock from the shareholders, the purchase price would be the paid-in-capital amount ($1). However, the agreement specified that this right of purchase did not apply in the case of an “IRA Shareholder” and that any such sale by an IRA Shareholder to the FSC was prohibited.
With these agreements in place, Injector Co. thereafter reported its foreign sales to Quail Street each quarter. Based on these numbers, Quail Street computed the maximum commission that Injector Co. was allowed to pay to the FSC in accordance with the federal FSC regulatory formulas. Quail Street then reported that amount in letters to the Mazzeis that identified (1) the amount of the FSC tax that had been paid (and that had to be reimbursed);9 and (2) the remainder amount that could be distributed to the IRA shareholders. In accordance with these instructions, Injector Co. paid a total of $558,555 in commissions and taxes to WG FSC IV between 1998 and March 2002. In turn, the FSC paid $533,057 in dividends to the Mazzeis’ Roth IRAs over that same time period.
Through these various steps, the Mazzeis took full advantage of the tax benefits described earlier. See supra at 17. The corporations that generated the foreign sales ultimately benefitted from a tax deduction for the “commissions” paid to the FSC. WG FSC IV paid a modest amount of tax on the income attributable to its commissions. The Roth IRAs paid no tax on the substantial dividends they received from the FSC because (unlike
2
Unsurprisingly, the Commissioner did not like this arrangement. On April 6, 2009, the Commissioner served notices of deficiency against each of the Mazzeis. The Commissioner asserted that the $533,057 that had been paid by WG FSC IV into their respective Roth IRAs should be deemed, in substance, to be contributions to their Roth IRAs that exceeded their statutory contribution limits. For tax years 2002 through 2007, the Commissioner asserted excise tax deficiencies against Angelo and Mary (who filed joint returns) in the amount of $67,590, as well as penalties totaling $19,215.10 For tax years 2002 through 2007, the Commissioner asserted against Celia excise tax deficiencies of $40,692 and penalties totaling $11,912. All three petitioned the Tax Court for a redetermination
The consolidated case was tried on November 20, 2014 before Judge Mark Holmes. After Judge Holmes circulated his proposed opinion within the Tax Court, the full Tax Court determined to decide the matter. See
The dissenters disagreed, asserting that the majority had overlooked the import of the special rules that governed FSCs, which expressly allowed transactions between commonly held entities that lacked economic substance. In particular, the dissenters questioned the majority‘s conclusion that, because the Roth IRAs had “paid so little” for their FSC stock and had put nothing at risk, they could not be the true owners of the FSC. 150 T.C. at 192-93 (Holmes, J., dissenting). As the dissent explained, “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.” Id. at 193. Indeed, the dissenters argued that, under a consistent application of the majority‘s reasoning, “no one could ever own an FSC because FSCs never put capital at risk.” Id.
The Mazzeis filed a motion for reconsideration and a motion to vacate, which the Tax Court denied. The Mazzeis timely appealed to this court.
II
In addressing the parties’ contentions on appeal, we begin by identifying several points that are not in dispute. In particular, the Commissioner does not contend that the Mazzeis failed to follow any of the formalities required by the Internal Revenue Code concerning the FSC or their Roth IRAs. On the contrary, the Commissioner stipulated at trial that WG FSC IV met all of the requirements for a small FSC; that the Mazzeis’ Roth IRAs were properly established under the Code; that there had not been a prohibited transaction involving the Roth IRAs within the meaning of
Rather than contest whether the Mazzeis followed the letter of the Code, the Commissioner instead asked the Tax Court to “‘recharacterize [the Mazzeis‘] entire scheme‘” under the “doctrine of substance over form.” See 150 T.C. at 150. The Tax Court, however, expressly rejected the Commissioner‘s “request for a complete recharacterization of all [of the Mazzeis‘] transactions,” id. at 151, and the Commissioner has not challenged that ruling in this court. Instead, the Tax Court recharacterized only one of the transactions at issue, viz., the purchase of the FSC‘s stock by the Roth IRAs. Id. Accordingly, the only issue before us is whether the Tax Court properly concluded that, under the substance-over-form doctrine, the Mazzeis, rather than their Roth IRAs, were the owners of the FSC for federal tax purposes.
We review the Tax Court‘s decision “in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury.”
A
It is a “black-letter principle” that, in construing and applying the tax laws, courts generally “follow substance over form.” PPL Corp. v. Commissioner, 569 U.S. 329, 340 (2013); see also United States v. Eurodif S.A., 555 U.S. 305, 317-18 (2009) (“[I]t is well settled that in reading regulatory and taxation statutes, ‘form should be disregarded for substance and the emphasis should be on economic reality.‘” (citation omitted)). Indeed, quoting Professor Boris Bittker, we have described this “substance-over-form doctrine” and other related doctrines as resembling, in combination, a sort of “‘preamble to the Code, describing the framework within which all statutory provisions are to function.‘” Stewart v. Commissioner, 714 F.2d 977, 987-88 (9th Cir. 1983) (quoting Boris I. Bittker, Pervasive Judicial Doctrines in the Construction of the Internal Revenue Code, 21 How. L.J. 693, 695 (1978)). Under these settled background principles, this would be an easy case if it involved ordinary business entities, as opposed to the distinctive vehicle of a FSC. The taxpayers used what is essentially a shell corporation to engage in arbitrarily priced, self-dealing transactions that lacked economic substance and then funneled those proceeds as “dividends” to a tax-free Roth IRA. This would appear to present a paradigmatic case to apply such doctrines. Cf., e.g., Repetto v. Commissioner, 103 T.C.M. (CCH) 1895, 2012 WL 2160440, at *9-12 (2012) (invoking substance-over-form doctrine where two Roth IRAs respectively received dividends from commonly controlled C corporations that received “service” payments without themselves actually performing any business sеrvices).
But like any background maxim that informs the construction and application of a statute, the doctrine of substance over form can be negated by Congress in express statutory language. See Chickasaw Nation v. United States, 534 U.S. 84, 94 (2001) (interpretive “canons are not mandatory
The question in this case, then, is whether the Tax Court applied the substance-over-form doctrine in a manner that properly takes account of Congress‘s limited abrogation of that doctrine here. The Tax Court construed that abrogation very narrowly, saying that Congress endorsed form over substance only with respect to the “specific transactions” in which the export company pays commissions based on statutory formulas that lack any economic reality, and then ”only for the purpose of computing the income taxеs of the FSC and its related supplier.” See Mazzei, 150 T.C. at 159 (emphasis added). Beyond that, the Tax Court concluded, the FSC statute left the substance-over-form doctrine intact. As that court stated, “[n]o 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 tools of statutory interpretation.” Id. at 160 (simplified). The Tax Court therefore held that the FSC statute‘s partial abrogation of substance-over-form principles did not apply “in deciding who actually owned the FSC stock” and that that question was therefore governed by “normal substance principles.” Id. at 154. While we share the Tax Court‘s concern that exemptions from normal substance-over-form rules should not be read overly broadly, we cannot agree with that court‘s extremely restrictive view of the exemption reflected in the FSC statute. In our view, the Tax Court‘s invocation of the substance-over-form doctrine in this case rests on subsidiary premises that cannot be reconciled with what Congress has decreed with respect to FSCs.
1
In applying normal substance-over-form principles to the issue of the ownership of WG FSC IV, the Tax Court considered whether the stockholders—i.e., the Roth IRAs—had “the benefits and risks of ownership,” or whether some other entity possessed them. 150 T.C. at 163. The court noted that the Roth IRAs had put essentially nothing at risk because the $500 “prearranged” price they paid for the FSC stock bore no “relationship to the actual value” of that stock. Id. at 165. The court concluded that the $500 the Roth IRAs paid thus “represented at most a de minimis risk which was insufficient to give substance to the Roth IRAs’ purported ownership of the FSC stock.”12 Id. at 164. The Tax Court also addressed “what benefits an independent holder of the FSC stock could realistically have expected on the basis of the ‘objective nature’ of the FSC stock,” and the court concluded that there were none: because “Injector Co. retained complete control over whether any of its export receipts would flow to the FSC in any year,” it followed that “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.” Id. at 166-67. Because the Roth IRAs thus lacked the risks and benefits of ownership, the court “disregard[ed]” their purchase of the FSC stock. Id. at 168. Instead, the court concluded, the Mazzeis (through Injector Co.) were the truе owners of the FSC. Id. And that meant that, under Commissioner v. Banks, 543 U.S. 426 (2005),
Banks, 543 U.S. 426 (2005), the income of the FSC that was paid out as dividends was, in the view of the Tax Court, received by the Mazzeis for tax purposes. Mazzei, 150 T.C. at 160-61 (“‘In an ordinary case attribution of income is resolved by asking whether a taxpayer exercises complete dominion over the income in question.‘” (quoting Banks, 543 U.S. at 434)).
The problem with this analysis is that its underlying premises are directly contrary to what is expressly contemplated by the FSC statute. It makes no sense to ask whether the formal owner of the FSC stock would, by virtue of that purchase, be exposed to any risk as a result of that ownership because the statute allows FSCs to be set up so as to eliminate any risk from owning the FSC stock. Specifically, the statute explicitly authorizes the establishment of a FSC that will not conduct any operations itself, and in such cases the FSC will effectively be a shell corporation that generates value only by virtue of the reduced rate of taxation that is paid on moneys that are funneled through it in accordance with strict statutory formulas. See supra at 13-17, 27-28. Such a shell corporation presents little, if any, risk at all to its owner because it
The Tax Court discounted this point, noting that “nothing in the Code prevents an FSC shareholder from capitalizing its FSC,” and such capital could be at risk. Mazzei, 150 T.C. at 164 n.36 (emphasis added). This is an ironic comment to make in an analysis that is supposedly focused on economic realities. The reality is that, for a FSC to function as the statute contemplates, there must be related parties on both sides of the FSC, because the whole point of the FSC vehicle is to cycle money through it so that it is taxed at the FSC‘s lower rate. The statute clearly envisions that the parties who pay money into the FSC and the parties who receive dividends out of it will be related.13 Given that reality, it would not make much economic sense to “capitalize” the FSC with more than a nominal amount of capital. As the dissenters noted, taking the Tax Court‘s analysis seriously would lead to the illogical conclusion that “no one could ever own an FSC” because no owner would ever “put capital at risk” in the FSC. Id. at 193 (Holmes, J., dissenting). The Tax Court also claimed that the Mazzeis (unlike the Roth IRAs) did have risk because they were “exposed at all times” to the risk “that their investment in their export business would decline.” Id. at 165 n.37 (majority opinion). But this is the risk that the Mazzeis faced as the owners of Injector Co.; it is not a risk that they would face as the owners of the FSC.
Moreover, it makes even less sense to ask, as the Tax Court did, “what benefits an independent holder of the FSC stock could realistically have expected.” 150 T.C. at 166 (emphasis added). By statutory design, a FSC typically will not be owned by an “independent” entity; it will be owned by “a person described in section 482,”
an FSC because a foreign exporter would have no practical incentive to choose to pour money into such a FSC.14
For similar reasons, the Tax Court‘s reliance on the “anticipatory assignment doctrine” discussed in Banks, 543 U.S. at 434, is also flawed. That doctrine states that, as a general matter, “gains should be taxed ‘to those who earned them,‘” so that a “taxpayer cannot exclude an economic gain from gross income by assigning the gain in advance to another party.” Id. at 433 (citation omitted). The FSC regime explicitly departs from that principle as well because the key feature of the FSC mechanism is that the relevant income earned by the export company is instead funneled to the FSC—which did not earn it—and it is then taxed at the FSC level
characterizing the FSC as the generator of the income, see Mazzei, 150 T.C. at 161, but of course the FSC did pay tax on its income. The court purported to treat the dividends as the relevant income, see id., but that approach—which asks who controls the assignment of the FSC‘s dividends—simply begs the earlier-addressed question of who owns the FSC.
Accordingly, the Tax Court‘s application of substance-over-form principles in determining who owned the FSC in this case rested critically on subsidiary premises that directly conflict with the very features of the FSC regime that explicitly depart from such principles. The court therefore erred in invoking such principles to set aside the Roth IRAs’ formal ownership of the FSC‘s shares.
2
This conclusion is reinforced by two further textual clues in the language of the FSC statute.
First, as noted earlier, the special hypothetical valuation formulas contained in the FSC statute are an express exception to the allocation rules that would otherwise govern under
Second, Congress is obviously aware that tax-free entities, including IRAs, can own a FSC because the FSC was modeled on the DISC and Congress added a provision to specifically address that scenario only in the DISC context. The DISC and FSC statutes use identical language in waiving the normal allocation rules that would apply to the DISC or FSC in a transaction with “a person described in section 482,” and both statutes therefore contemplate that a variety of related entities might be the holder of the DISC or FSC stock, including tax-exempt entities like IRAs. Compare
3
Finally, our conclusion is supported by the decisions of the First, Second, and Sixth Circuits in three appeals arising from a single Tax Court proceeding involving a Roth IRA that indirectly owned shares in a DISC.
In Summa Holdings, Inc. v. Commissioner, 109 T.C.M. (CCH) 1612, 2015 WL 3943219 (2015), James Benenson, Jr. (“James Jr.“) and Sharen Benenson were the trustees of a trust (the “Benenson Trust“) for which their two sons (“James III” and Clement) were the beneficiaries. 2015 WL 3943219, at *1. The Benenson Trust, together with James Jr., owned most of the shares of Summa Holdings, a company whose subsidiaries had significant export sales. Id. at *1-2. James III and Clement established Roth IRAs, which ultimately became equal shareholders in JC Holding, a C corporation, which in turn owned JC Export, a DISC. Id. Through a series of agreements with Summa subsidiaries, JC Export received commissions from those subsidiaries in accordance with the statutory formulas applicable to DISCs. Id. at *2. JC Export then paid out the sums it received as dividends to JC Holding, and that company, as a C corporation, paid corporate tax on those sums. Id. After withholding that estimated tax, JC Holding then distributed the remainder equally as a dividend to James III‘s and Clement‘s Roth IRAs. Id. The Commissioner issued deficiency notices to several of the taxpayers involved, and the Tax Court ultimately relied on substance-over-form principles in concluding that the payments made by the Summa subsidiaries to JC Export “were not DISC commissions but deemed dividends to Summa‘s shareholders followed by contributions to the Benenson Roth IRAs.” Id. at *8. As a result, Summa‘s deduction of those commissions was disallowed; James Jr. and the Benenson Trust were found to have failed to report these “deemed” dividends as income; and James III and Clement owed excise taxes on the excess contributions to their Roth IRAs. Id. at *4, *9. These taxpayers each appealed to their respective circuit courts—Summa to the Sixth Circuit; James Jr. and Sharen (the trustees of the Benenson Trust) to the Second Circuit; and James III and Clement to the First Circuit. All three circuits ruled against the Commissioner.
None of these decisions addressed the exact question presented here, but the First Circuit‘s decision comes closest. That court addressed the Commissioner‘s claim that the dividends received by the Benenson sons’ Roth IRAs should be characterized as contributions in excess of the applicable limits. Benenson v. Commissioner, 887 F.3d 511, 516-22 (1st Cir. 2018). The First Circuit distinguished the Tax Court‘s decision in the Mazzeis’ case on the grounds that, in the Benenson case, the Commissioner had “never challenged the valuation of the shares the Roth IRAs purchased.” Id. at 522; see also id. at 522 n.10. But in rejecting the Commissioner‘s
Moreover, the First Circuit held that it did not matter that the dividends ultimately received by the Roth IRAs greatly exceeded any risk to the direct and indirect shareholders of the DISC. As the court explained, the Code provisions governing IRAs plainly allow the funds in an IRA “to grow through investment in qualified privately held companies, even during periods where the taxpayers are no longer allowed to сontribute, and even if such growth occurs at a swift rate.” Benenson, 887 F.3d at 520 (emphasis added). And in response to the Commissioner‘s complaint that this enormous return was for an investment in the DISC that involved “no risk” to the Roth IRAs, the First Circuit noted that this was “due to the unique, congressionally designed DISC corporate form.” Id. at 522. The same reasoning supports our earlier conclusion that, because a similar lack of risk is inherent in the “unique, congressionally designed [FSC] corporate form,” the Commissioner may not invoke that congressionally sanctioned feature as a basis for attacking the ownership structure of the FSC. See supra at 29.
Although less directly relevant, the decisions of the Sixth and Second Circuits in the Benensons’ case are also consistent with our holding. The appeals in these two circuits involved different taxpayers (Summa in the Sixth Circuit and James Jr. and Sharen in the Second Circuit), but the underlying issue in both cases was the same—viz., whether the commissions paid by the Summa subsidiaries to the DISC were properly recharacterized, under the substance-over-form doctrine, as dividends to Summa‘s shareholders. Both courts answered that question in the negative. Underscoring the core point we have made here, the Second Circuit held that the Commissioner‘s effort to invoke the substance-over-form doctrine to recharacterize the commissions to the DISC ignored the fact that “Congress has itself elevated form over substance insofar as DISC commissions are concerned by affording exporters ‘commission’ deductions for payments that lack the economic substance generally associated with commissions.” Benenson, 910 F.3d at 700. And the Sixth Circuit likewise noted that the Commissioner‘s reliance on the doctrine could not be reconciled with the fact that the “Code authorizes companies to create DISCs as shell corporations that can receive commissions and pay dividends that have no economic substance at all.” Summa Holdings, 848 F.3d at 786; see also id. (“By congressional design, DISCs are all form and no substance . . . .“).
We join our sister circuits in concluding that, when Congress expressly departs from substance-over-form principles, the Commissioner may not invoke those principles in a way that would directly reverse that congressional judgment.
III
As the First Circuit noted in the Benenson case, some might think that what the Mazzeis did here was too “clever,” if not “unseemly.” 887 F.3d at 523. But as that court noted, the substance-over-form doctrine “is not a smell test,” it is “a tool of statutory interpretation.” Id. It may have
REVERSED.
Notes
P Corporation forms S Corporation as a wholly-owned subsidiary. S qualifies as a DISC for its taxable year. S has no employees on its payroll. S is granted a sales franchise with respect to specified exports of P and will receive commissions with respect to such exports. Such exports are of a type which will produce gross receipts for S which are qualified export receipts as defined in paragraph (b) of this section. P‘s sales force will solicit orders in the name of P. Billings and collections are handled directly by P. Under these facts, the commissions paid to S for such taxable year with respect to the specified exports shall be treated for Federal income tax purposes as the income of S, and the amount of income allocable to S is determined under sectiоn 994 of the Code.