In Summa Holdings, Inc. v. Commissioner, (“Summa”) the IRS takes issue with two taxpayers who used the combination of a DISC and Roth IRAs to avoid taxation of income. The taxpayers set up two Roth IRAs. One Roth IRA for each taxpayer. They immediately made a contribution, within prescribed limits, and used the funds contributed to purchase shares of a DISC. A holding company was then formed which purchased the DISC shares back from the Roth IRAs, but the holding company itself was also owned by the Roth IRAs, 50 percent each. By funneling income through this structure into the Roth IRAs, each of the two Roth IRAs accumulated more than three million dollars, achieving major tax savings. The Roth IRAs grew by a combined 1.4 million dollars in one year alone.
The IRS, as you can imagine, did not like this tax savings scheme.
The IRS sought to recast the funds funneled into the Roth IRAs through this structure as dividends to the individual shareholders of Summa Holdings. The result of the IRS’s proposed recast would have been a large amount of tax, an excise tax penalty, accuracy related penalty, and interest on the tax and penalties. The IRS presented its argument based on the doctrine of substance over form. In simple terms, under this doctrine, the form of a transaction is ignored for the true substance of the transaction. The economic reality of a transaction is analyzed to determine whether or not the transaction meets legal requirements imposed by the Tax Code. The idea is to achieve a clear reflection of income on a tax return, or set of tax returns, by setting aside transactions that have no economic purpose other than tax avoidance. The concept of substance over form is captured exceptionally well by Judge Sterrett in the Tax Court case John D. Gray, 56 T.C. 1032 in which he writes “Once the fog of [a transaction] is blown away by the fresh air of economic reality the substance of the transactions is clearly visible.” Although the case was decided in 1972, it is still relevant.
The IRS’s point in Summa was that the structure the taxpayers set-up had no economic substance, except to avoid tax. On that point the IRS is correct. The Tax Court initially went along with the IRS’s argument and application of substance over form. There is no doubt substance over form has its place in tax law. Congress believes it does as well since the judicially created doctrine has been adopted in the Internal Revenue Code, but in this case the Court of Appeals for the Sixth Circuit said not so fast:
How can citizens comply with what they cannot 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 pour over its provisions. 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 Court of Appeals flatly rejects the IRS’s argument and reversed the Tax Court. It holds that the law allows the taxpayers to do exactly what they did and scolds the IRS:
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.
The Court goes on to state:
Each word of the 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 the 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.
These are strong words used by the Court. Because the taxpayers used a legislatively approved mechanism to legally reduce tax, there is no basis for the Commissioner to change the application of the law, by arguing in esoteric terms, that what is plainly allowed under the law is somehow forbidden. While not expressly stated, the Court of Appeal seems to be reminding the IRS of a basic tenet of the U.S. Constitution, separation of powers. The IRS cannot legislate through the courts by arguing substance over form because it doesn’t like the result of proper application of the law. I guess the IRS forgot about that.
There is no question the substance over form doctrine has its place in tax jurisprudence. I, for one, think the IRS’s use of the doctrine is at times an overreach. The irony… Unfortunately, the courts tend to go along. It’s refreshing to see the IRS pushed back in persuasive terms in the Summa case. I wonder if it will mark a scaling back of the IRS’s use substance over form doctrine as a sword. Or, will the IRS in its arrogance persist? Probably the latter.