Analysis of and reflections on recent cases and rulings.

• Author: Beavers, James A.
• Position: TAX TRENDS

Employee Benefits & Pensions

Court says statutory language precludes substance-over-form analysis

The Ninth Circuit, reversing the Tax Court, held that foreign sales corporation (FSC) shares owned by a Roth IRA should not be recharacterized as shares owned by the beneficiaries of the Roth IRAs. The court found that the Tax Court had improperly invoked the substance-over-form doctrine to reverse congressional judgment and disallow Roth IRA ownership of FSC shares, which was plainly allowed by the FSC statutes.

Background

Angelo, Mary, and Celia Mazzei jointly owned Injector Corp., which had export sales that generated considerable amounts of foreign trade income. In 1998, the Mazzeis entered a prepackaged tax shelter program under which they bought accounts in a foreign sales corporation (FSC). These accounts were treated as a separate corporation.

Congress authorized FSCs with the intent of promoting exports, under the since-repealed Sees. 921-927 (the FSC statutes). Under the FSC statutes, a corporation with foreign trade income from export sales could establish a related FSC as a shell corporation and the export corporation could pay tax-deductible "commissions" to the FSC that were determined according to complex statutory formulas, which did not correspond to any actual services provided by the FSC. The FSC would pay a small tax on the commission income, and the FSC would then return the remaining income to the export corporation (or a related entity) as dividends, usually tax-free. As a result, the FSC's taxable income was largely generated through related-party transactions that lacked meaningful economic substance, a departure from the normal principle that taxation is based on economic substance rather than on legal form.

Under the program, the Mazzeis sold their shares in the FSC to their Roth IRAs. Injector Corp. paid the FSC commissions, and the FSC returned its aftertax income as dividends to the Mazzeis' Roth IRAs rather than to Injector Corp. The result of this arrangement was that no tax was paid on the dividends because they were paid to Roth IRAs, and the Mazzeis paid no tax when they took qualified withdrawals of the dividend money from the Roth IRAs.

The IRS, arguing substance over form, asserted that despite the actual transfer of the FSC shares to their Roth IRAs, the Mazzeis, in substance, remained the owners of the FSC. As a result, the dividend payments from the FSC to the Mazzeis' Roth IRAs were income to the Mazzeis that they contributed to the Roth IRAs. Because the dividend payments exceeded the Mazzeis' contribution limits for their Roth IRAs, the IRS found that the Mazzeis were liable for excise taxes under Sec. 4973 on the excess contributions.

The IRS issued notices of deficiency based on its theory for the years in question, assessing tax, interest, and penalties against the Mazzeis. The Mazzeis challenged the IRS's determination in Tax Court. The Tax Court upheld the tax assessments but not the penalties. While the IRS had asked the court to recharacterize the entire scheme under the substance-over-form doctrine, the court declined to do so. It instead only recharacterized one part of the scheme, the purchase of the FSC shares by the Roth IRAs.

The Mazzeis appealed the Tax Court's decision to the Ninth Circuit. The Ninth Circuit found because the Tax Court had only recharacterized the purchases of the Roth IRA stock, the only issue for the court to decide was whether the Mazzeis, rather than their Roth IRAs, were the true owners of the FSC.

The Ninth Circuit's decision

The Ninth Circuit reversed the Tax Court and held that the Roth IRAs, and not the Mazzeis, were the real owners of the FSC. It concluded that Congress, in the FSC rules, had authorized a separation of substance and form for FSCs, and the Tax Court had erred in invoking the substance-over-form doctrine "to effectively reverse congressional judgment and to disallow what the statute plainly allowed."

The Ninth Circuit explained that it was black letter law that in construing and applying the tax laws, courts should generally follow the substance-over-form doctrine; however, in specific situations, Congress could...