Sixth Circuit Limits Scope of Substance Over Form Doctrine

The U.S. Court of Appeals for the Sixth Circuit recently dealt a significant taxpayer victory in Summa Holdings, Inc. v. Commissioner, No. 16-1712 (Decided February 16, 2017), and limited the government's ability to assert the substance over form doctrine to dismantle the taxpayer's combination plan of providing estate planning wealth shifting benefits to younger generation family members using a domestic international sales corporation (DISC) shelter in tandem with Roth IRA's.

In Summa, the taxpayer father operated an exporting business, and his two sons established their own Roth IRA's, with initial contributions of $3,500 each.  Shortly thereafter, the Roth IRAs as sole shareholders invested $1,500 of capital each in newly formed JC Export, which was established as DISC.  Under the tax law, DISCs can receive up to 10% of an affiliated company's export sales revenue as "sales commissions" as so designated by Congress, which commissions are deductible by the affiliated export company and tax exempt to the DISC.  However, DISC dividends to shareholders are subject to up to 33% income taxes to the DISC as unrelated business taxable income, which was paid by JC Export.  However then the DISC paid the remaining funds to the son's Roth IRA accounts. Over a period of years and by 2008, each Roth IRA had accumulated over $3 million under this plan.

The IRS argued that in substance, Summa Holdings paid a non-deductible dividend to it's shareholders, who were Mr. Benenson and a trust for the benefit of his sons.  The U.S. Tax Court agreed and decided the case in favor of the IRS.

On appeal, the 6th Circuit reversed the Tax Court and held that the substance over form doctrine did not and could not apply to circumstances where the substance of a tax statute enacted by Congress was defined by the IRS through re-characterizing transactions which adhered to the form prescribed by Congress.  The 6th Circuit reasoned that while the substance over form doctrine could be used to prevent a taxpayer from distorting a transaction's true substance by adopting a masquerading transactional form inconsistent with economic reality, here Congress expressly sanctioned using a shell DISC and/or a Roth IRA in form only to achieve an artificial but Congressional permitted tax benefit, as a matter of "congressional design."

The 6th Circuit referred to this type of transaction as "Code compliant" form of tax advantaged transaction that did not follow a devious path in its form but straightforward steps as authorized by Congress.  And quoting Judge Hand in Helverling v. Gregory, 69 F. 2d 809 (2d Cir. 1934), the 6th Circuit reiterated that "Any 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, " and added that if Congress by design and through the Code authorizes a set of "formal" transactions the taxpayer entered into, "it is of no consequence that it  was all an elaborate scheme to get rid of income taxes."  Consequently, the 6th Circuit refused to adopt the alternative two step narrative of the Commissioner re-characterizing the DISC commissions as constructive dividends follow by excessive Roth IRA contribution.

Our Firm predicts that a huge amount of discussion and debate in the tax scholarship and in the tax press will ensue from this decision.  Stay tuned.