Appeals court limits application of substance-over-form doctrine

In Summa Holdings Inc. v. Commissioner, No. 16-1712 (6th Cir. 2017), the U.S. Court of Appeals for the Sixth Circuit reversed the Tax Court and held that the IRS could not apply the substance-over-form doctrine to recharacterize commission payments made to a domestic international sales corporation (DISC) that was owned, indirectly, by a Roth Individual Retirement Account (Roth IRA).

The DISC is a congressionally created structure designed to incentivize export activity. Generally, an exporter is permitted to pay certain amounts of its export income as “commissions” to a DISC. The exporter can deduct the commission and the DISC is not taxed on that income. Tax-exempt entities like IRAs are permitted to own DISCs but are required to pay an unrelated business income tax on dividends received from them.

In Summa Holdings, two individual shareholders of an exporting corporation established Roth IRAs. The Roth IRAs each purchased half the shares of a DISC and then transferred the DISC shares to a holding company. The shareholders caused the export company to pay commissions to the DISC, which resulted in paid dividends to the holding company. The holding company paid income tax on the dividends and then distributed the remainder to the Roth IRAs. In this way, each Roth IRA was able to accumulate over $3,000,000 between 2002 and 2008, an amount that far exceeds the statutory limit on individual contributions over that period.

The IRS applied the substance-over-form doctrine to recast the taxpayer’s chosen steps. The IRS argued that the taxpayer’s steps should be recast as if the exporting corporation paid dividends to its individual shareholders, who then made impermissible contributions to their respective Roth IRAs.

The Sixth Circuit acknowledged the usefulness of the substance-over-form doctrine when transactions employ a “labeling-game sham” and the economic substance doctrine transactions defy economic reality. The court drew the line, however, at allowing the IRS to “recharacterize the meaning of statutes – to ignore their form, their words, in favor of [the Commissioner’s] perception of their substance.” The court pointed out that the DISC and the Roth IRA are both creations of Congress designed for use by taxpayers to lower their tax burdens and that, in this case, both were used in a manner that complied in full with the Internal Revenue Code.

The Sixth Circuit noted the IRS concern that combining the two structures may cause consequences unintended by Congress and may be a bad tax policy. In spite of this concern, however, the Sixth Circuit stated that “the substance-over-form doctrine does not give the Commissioner a warrant to search through the Internal Revenue Code and correct whatever oversights Congress happens to make or redo any policy missteps the legislature happens to take.”

Because of its refutation of the IRS attempt to apply substance-over-form doctrine, Summa Holdings may have application outside of the narrow area of DISC-Roth IRA structures. It is likely to be cited widely for the proposition that judicially created doctrines cannot be used to change the plain meaning of the Internal Revenue Code.

Andy Cordonnier
Partner, Washington National Tax Office
+1 202 521 1502

Jeff Borghino
Partner, Washington National Tax Office
+1 202 521 1532

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.