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Tax Court Erred by Invoking Substance-Over-Form to Reverse Congressional Judgment

(Parker Tax Publishing June 2021)

A panel of the Ninth Circuit reversed a decision by the full Tax Court involving the use of a foreign sales corporation owned by individuals to reduce the tax paid on income that was then distributed as dividends to the shareholders' Roth individual retirement accounts (Roth IRAs). The panel concluded that, due to the unusual statutory provisions at issue in the case, the Tax Court erred by invoking substance-over-form principles to effectively reverse congressional judgment and to disallow what the statute plainly allowed. Mazzei v. Comm'r, 2021 PTC 153 (9th Cir. 2021).


Angelo Mazzei and his wife, Mary, established a foreign sales corporation (FSC) under since-repealed Code Sec. 921 through Code Sec. 927 (the FSC statute). Under the FSC statute, a corporation with foreign trade income could establish a related FSC as a shell corporation and then effectively cycle a portion of that income through the FSC where it would be taxed at lower rates. As a result, the FSC's taxable income was generated through related-party transactions that lacked meaningful economic substance. The FSC taxation rules thus reflected a departure from the normal principle that taxation is based on economic substance rather than on legal form.

The Mazzeis had their Roth IRAs purchase the FSC shares. An export corporation the Mazzeis established paid commissions into the FSC, and the FSC's after-tax income was returned as dividends and distributed to the Mazzeis' Roth IRAs rather than to their export corporation. As a result, no tax was paid when the money was received into the Roth IRAs, and no tax would be paid on qualified withdrawals from the Roth IRAs. The IRS challenged this arrangement, asking the Tax Court to recharacterize the entire scheme under the doctrine of substance over form. The Mazzeis argued that the reasoning of the Sixth Circuit in Summa Holdings, Inc. v. Comm'r, 2017 PTC 58 (6th Cir. 2017), rev'g T.C. Memo. 2015-119, should apply. In that case, the Sixth Circuit held that, because a corporation used a domestic international sales corporation (DISC) and Roth IRAs for their congressionally sanctioned purposes (i.e., tax avoidance), the IRS had no basis for recharacterizing transactions involving the transfer of funds from the DISC to the Roth IRA accounts. Nor, the Sixth Circuit said, did the Tax Court have any basis for recharacterizing the law's application to the transactions at issue.

The Tax Court, in Mazzei v. Comm'r, 150 T.C. No. 7 (2018), rejected the Mazzeis' argument and upheld the IRS's assessment of excise taxes against the couple by a vote of 12 to 4. Invoking the doctrine of substance over form, the Tax Court concluded that the Roth IRAs' purchase of the FSC stock did not reflect the underlying reality because 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 ownership. The court therefore disregarded the Roth IRAs purchase of the FSC stock and treated the Mazzeis as the owners of the stock for federal tax purposes. Thus, the court recharacterized the payments from the FSC as dividends to the Mazzeis. And that meant that the payments into the Roth IRAs were made by the Mazzeis and were, therefore, excess contributions to the Roth IRAs by the Mazzeis. The Mazzeis appealed to the Ninth Circuit.

Observation: The Tax Court dissenters asserted that the majority had overlooked the import of the special rules that governed FSCs, which expressly allowed transactions between commonly held entities that lacked economic substance. The dissenters questioned the majority's conclusion that because the Roth IRAs had paid so little for their FSC stock and had put nothing at risk, they could not be the true owners of the FSC. As the dissent explained, the Mazzeis also put nothing at risk to get the FSC stock, so by the majority's reasoning they couldn't have owned the FSC either. The dissenters argued that, under a consistent application of the majority's reasoning, no one could ever own an FSC because FSCs never put capital at risk.


A panel of the Ninth Circuit reversed the Tax Court and concluded that, due to the unusual statutory provisions at issue, the Tax Court erred by invoking substance-over-form principles to effectively reverse congressional judgment and to disallow what the statute plainly allowed. In doing so, the Ninth Circuit panel joined three other circuits that had reversed the Tax Court's decision in Summa Holdings, Inc. (i.e., Summa Holdings, Inc. v. Comm'r, 2017 PTC 58 (6th Cir. 2017); Benenson v. Comm'r, 2018 PTC 98 (1st Cir. 2018); and Benenson v. Comm'r, 2018 PTC 431 (2d Cir. 2018)) that have similarly disallowed the invocation of substance-over-form principles to undo the congressionally authorized separation of substance and form that is involved in an entity similar to the FSC at issue in the Mazzeis' situation.

The court noted that the centerpiece of the FSC system was similar to that of the DISC system, viz., an explicit statutory exception from the ordinary rules that govern allocation of income between "two or more organizations, trades, or businesses . . . owned or controlled directly or indirectly by the same interests." Specifically, the Ninth Circuit said, the shareholders of an export corporation could create a commonly controlled FSC and then make sales of export property to the FSC at hypothetical transfer prices that were fixed by a complex statutory formula regardless of the sales price actually charged. According to the court, what matters is the fact that the formulas allowed the FSC's commissions and income to be set at artificial levels that did not necessarily correspond to the actual value of any services provided by the FSC. The court noted that the IRS had estimated that the bottom-line result of these complex rules was to allow a U.S. manufacturer to reduce its corporate income tax on export sales by approximately 15 percent.

With respect to the Tax Court's reliance on the substance-over-form doctrine, the Ninth Circuit explained that this doctrine can be negated by Congress in express statutory language. As a result, there are some circumstances when form - and form alone - determines the tax consequences of a transaction, such as when statutory provisions deliberately elevate, or have been construed to elevate, form above substance. The instant case, the Ninth Circuit concluded, is such a case.

For a discussion of what does and does not constitute abusive Roth IRA transactions, see Parker Tax ¶135,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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