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.
UNITED STATES TAX COURT
Filed March 5, 2018.
150 T.C. No. 7
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
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
Held, further, R’s imposition of additions to tax under
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
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
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
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
| 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) |
1Amounts 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):
| 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) |
1Amounts to be determined.
While residing in California, petitioners timely petitioned this Court with respect to both notices of defiсiency. 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
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.
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
II. Petitioners’ Contribution Limits
Contributions to a Roth IRA are limited according to a statutory formula. See
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
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
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
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.
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
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., $1.
F. Compliance Guide
The compliance guide advised Injector Co. on how to report its activities in its accounting records and on its tax returns.
In the aggregate, the agreements described above did not require the FSC to perform any export-related activities for Injector Co., and any payments to the FSC were optional (excepting a few management and operational fees paid to
IV. Operations of the FSC/IRA Program
Every quarter, Quail Street asked Injector Co. for a report of its foreign sales for the period. This request included a template worksheet for reporting sales. Injector Co. bookkeepers were to complete the report and return it to Quail Street. Quail Street would then compute the maximum commission payment allowed under section 925(b) and associated temporary regulations, see infra pp. 29-34, and send a letter inviting petitioners to fund their IRAs. In relevant part, the letter said:
Based on the recent export sales and cost information that you reported, we calculate the amount of [$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:
| Export year | Payments to FSC | Tax paid by the FSC | Amount deposited 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
| 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
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.
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
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
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
Respondent contends that the payments to the Roth IRAs were contributions within the meaning of sections
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.
Reference tо 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.
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
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
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
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
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
An understanding of the actual, limited scope of the FSC provisions, and how they applied tо 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.
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
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
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).
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).
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
| Year | (1) Combined income | (2) Income assigned to FSC | (3) FSC taxable income | (4) FSC tax | (5) 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.
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. United States, 844 F.3d at 21. Therefore, the normal substance doctrines apply in these cases, at least for the purpose of determining
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,
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
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:
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
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,
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
Petitioners also suggest that their transactions have substance because the Roth IRAs were eventually exposed to risk with respect to investments purchased
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]
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
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
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
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 (6th Cir. 2017)--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
In Summa Holdings I a domestic international sales cоrporation (DISC) was used generally in the same way the FSC was used in these cases.41 Individual
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
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
Petitioners attempt to analogize their cases to the DISC situation, arguing that because Congress acknowledged ownership of DISCs by IRAs when it added
In any event, although
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.
In Swanson, 106 T.C. at 86-92, the Court rejected the Commissioner‘s arguments that
In Hellweg and Ohsman the Court rejected the Commissioner‘s attempt to recharacterize the taxpayers’ transactions for the purposes of the
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
Finally, petitioners argue that any recharacterization of their transactions is prohibited by
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
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
It is true that
There is no dispute that the requirements for applying the
In short, the dissent leaps from an unsupported belief that the purpose of
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
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
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:
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
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
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.
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
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
X. Additions to Tax
Respondent asserts that petitioners are liable for additions to tax under
Petitioners can avoid these additions to tax by showing that their nonfiling and nonpayment were due to reasonable cause and not willful neglect. See
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
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
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 tо 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.
Accordingly, petitioners are not liable for
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.
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
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
For these reasons we agree with the opinion of the Court.
THORNTON, GOEKE, and LAUBER, JJ., agree with this concurring opinion.
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
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.
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
FSCs were very similar--barely-there entities through which businesses could funnel “foreign trading gross receipts” to largely escape corporate-level tax. See
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
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 & 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
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. 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,
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.
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
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
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 anticiрatory assignments of
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
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.
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-priсing rules but on a statutory formula unrelated to economic
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
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.
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.)
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.
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 аnd 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
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:
[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)).
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
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
We ourselves applied similar reasoning in Austin v. Commissioner, T.C. Memo. 2017-69, at *31-*35, where we refused to sаy 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
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
FOLEY and BUCH (join only Parts I through IV) and MORRISON (joins only Parts I through III), JJ., agree with this dissent.
Notes
Sacks, 69 F.3d at 992 (internal citations omitted).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.
(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 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.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.]