Originally published on Forbes.com.
Judge Jeffrey Sutton is confirming his status as “the intellectual engine behind a conservative movement of the jurisprudence of the Sixth Circuit” in Summa Holdings vs CIR. The opinion limits the use by the IRS of the “substance over form doctrine” as writing for a three-judge panel he overturns the decision of Tax Court Judge Kathleen Kerrigan, who was appointed by President Obama. Judge Sutton, appointed by George W Bush, clerked for the late Justice Scalia and it appears the apple did not fall far from the tree. In 2014 Judge Sutton wrote the Sixth Circuit opinion that upheld bans on same-sex marriage.
Clever Maybe Too Clever
The Benenson family had used a clever technique to shelter a large amount of capital from future taxation by combining two disparate tax-saving provisions. DISCs allow corporations to avoid corporate income tax on income attributable to export earnings by distributing the earnings to shareholders (That is an extreme oversimplification). The earnings of Roth IRAs are never subject to tax even when they are distributed to the account holders. Unlike regular IRAs there is no deduction on contribution. There are pretty tight limits on how much can go into a Roth IRA.
Congress noted that the DISC deal was a little too rich when the shareholder is exempt, so DISC dividends are subject to the tax on unrelated business taxable income, which really takes most of the fun out of them for regular IRAs. There is the same drawback for Roth’s, but DISC dividends allow a lot of money to flow into a Roth and the earnings on that money will never be subject to tax. And the clever combination of the two techniques allowed two Berenson Roth accounts to accumulate millions of dollars. The dollars going in were post-tax dollars, but future earnings will never be taxed. Very clever.
Too clever by a half as far as the IRS was concerned. The IRS held that the substance of the transaction was dividends to the Roth beneficiaries who then contributed the money to the Roths. Of course, those contributions were far beyond the Roth limits making them subject to excise tax. There were other adjustments. When a plan like this is held invalid, it is like unscrambling an egg.
The taxpayers went to Tax Court where Judge Kerrigan, as noted, ruled in favor of the IRS.
Section 995(g) was enacted in 1988, almost 10 years before the enactment of the Roth IRA provisions, which were enacted as part of the Taxpayer Relief Act of 1997, sec. 302. They became effective for tax years beginning after December 31, 1997. Id. sec. 302(f), 111 Stat. at 829. Congress could not have been aware of the type of abusive transaction involving Roth IRAs at issue here at the time of enactment of section 995(g).
It Is What It Is
Judge Sutton, however, thinks that the IRS has exceeded its authority.
In today’s case, however, the Commissioner of the Internal Revenue Service denied relief to a set of taxpayers who complied in full with the printed and accessible words of the tax laws.The Benenson family, to its good fortune, had the time and patience (and money) to understand how a complex set of tax provisions could lower its taxes. Tax attorneys advised the family to use a congressionally innovated corporation—a “domestic international sales corporation” (DISC) to be exact—to transfer money from their family-owned company to their sons’ Roth Individual Retirement Accounts. When the family did just that, the Commissioner balked. He acknowledged that the family had complied with the relevant provisions. And he acknowledged that the purpose of the relevant provisions was to lower taxes. But he reasoned that the effect of these transactions was to evade the contribution limits on Roth IRAs and applied the “substance-over-form doctrine,” …..
Each word of the “substance-over-form doctrine,” at least as the Commissioner has used it here, should give pause. If the government can undo transactions that the terms of the Code expressly authorize, it’s fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is. “Form” is “substance” when it comes to law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence—to allow him to determine the substance of a law and to make it govern “over” the written form of the law—and to call it a “doctrine” no less.
As it turns out, the Commissioner does not have such sweeping authority. And neither do we ……
It’s one thing to permit the Commissioner to recharacterize the economic substance of a transaction—to honor the fiscal realities of what taxpayers have done over the form in which they have done it. But it’s quite another to permit the Commissioner to recharacterize the meaning of statutes—to ignore their form, their words, in favor of his perception of their substance.
Judge Sutton does not really seem to care whether Congress intended taxpayers to be able to use DISCs to skirt limits on Roth funding.
If Congress sees DISC–Roth IRA transactions of this sort as unwise or as creating an improper loophole, it should fix the problem. Until then, the DISC will continue to provide tax savings to the owners of U.S. export companies, just as Congress intended—even if subsequent changes to the Code have increased the scale of the savings beyond Congress’s original estimation. The last thing the federal courts should be doing is rewarding Congress’s creation of an intricate and complicated Internal Revenue Code by closing gaps in taxation whenever that complexity creates them.
The Problem
Wholesale rejection of the substance over form doctrine can end up disproportionately favoring those that have the “time and patience (and money)” to construct hyper-technical arguments that arguably follow the Code – maybe. This could be a set up for another raid on the Treasury like the one that was engineered by law firms and the Big 4 in the nineties and around the turn of the millennium. See Confidence Games by Tanina Rostain and Milton Regan.
Classical Reference
The first paragraph of the decision made it irresistible to me. As part of making the point that the law is what it is (See Reilly’s First Law of Tax Planning) relates an anecdote about a Roman emperor.
Caligula posted the tax laws in such fine print and so high that his subjects could not read them. Suetonius, The Twelve Caesars, bk. 4, para. 41 (Robert Graves, trans., 1957). That’s not a good idea, we can all agree. How can citizens comply with what they can’t see? And how can anyone assess the tax collector’s exercise of power in that setting? The Internal Revenue Code improves matters in one sense, as it is accessible to everyone with the time and patience to pore over its provisions.
Caligula, who reigned for four years gets a pretty bad rap for “cruelty, sadism, extravagance, and sexual perversity”, but maybe he was just trying to make Rome great again and didn’t want people wasting time reading tax laws. He could just tell them what they owed and that was it. Simple.
As it happens, this is the only time that Caligula is mentioned in all the body of tax authority available to me (which is pretty extensive). You will find references to Caligula XXI, but that was a topless club, that seems to have had more than its share of tax troubles.
Other Coverage
Ed Zollars has a good summary in Current Federal Tax Developments. Lorraine Bailey has a piece titled Sixth Circuit Upholds Tax Loophole for the Rich in the Courthouse New Service.
Law 36o interviewed with Neal Block of Baker McKenzie LLP, which represented the taxpayers.
“Important to this case is the fact that the Code, regulations, prior case law and now this case emphasize that commissions to DISCs owned by IRAs, paid under the code’s safe harbor rules, and the subsequent dividends from the DISCs are immune from disqualified transactions and substance over form recharacterization,” Block said while adding that the IRS has historically used “baseless” threats of litigating DISCs that include an IRA, to discourage taxpayers from using them.
I’m expecting that there might be more commentary on this case and I may revisit it.