Tax Strategy: Is a more restrained use of substance-over-form now a trend?

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The substance-over-form doctrine has been the undoing of many otherwise “legitimate” tax strategies over the years. This doctrine looks to what a particular transaction or series of transactions accomplishes, rather than what the Internal Revenue Service has argued is often a myopic reading of any particular provision of the Tax Code.

A recent Sixth Circuit appellate court case, Summa Holdings (Feb. 16, 2017), however, may signal a significant push back against the broad use of this doctrine. The taxpayer win here was itself preceded by several other judicial holdings that may help shore up the future use of the Summa Holdings decision, signaling the development of a judicial trend, rather than a one-off victory against the IRS. As a result, tax strategies that follow the letter of the Tax Code may now be less susceptible to deconstruction by the IRS.

Summa Holdings involved the confluence of two perfectly valid tax benefits, permitted by two separate code provisions that the taxpayer had the creativity to pair together. When one of them was used to maximize the benefit of the other, however, the IRS balked. The benefits conferred by each of these code sections were strung together in a way not contemplated by Congress. Yet they fell within the confines of the text of each code provision and the separate benefits they each intended to encourage. What’s more, the taxpayer did not disguise the transaction to be other than what it was.


The intended tax benefit from using a domestic international sales corporation is to defer tax on a U.S. exporter’s income by paying the DISC “commissions” of up to 50 percent of qualified net export income, which commissions sit in the DISC until paid out to DISC shareholders as dividends at a qualified dividend rate as unrelated business income tax under Code Sec. 995. If the export company and the DISC are owned by the same persons, the net result is export profits that avoid immediate corporate income tax rates and are taxed to DISC shareholders when distributed as qualified dividends.

The intended tax benefit from using a Roth IRA is to allow assets to accumulate and grow, to be eventually paid out tax-free to the account holder. The trade-off is that contributions to the Roth IRA are not deductible, unlike traditional IRAs. To limit its benefit to higher-income taxpayers, however, contributions to a Roth IRA must not exceed $5,500 annually (inflation-adjusted) and must not be made by those whose modified adjusted gross income exceed certain amounts (for joint filers, between $186,000 and $196,000 MAGI in 2017).

The taxpayer in Summa Holdings figured out that dividends from a DISC could avoid the contribution limit for Roth IRAs by being considered gains on investments net of the Code Sec. 995 tax (i.e., on DISC shares owned by the Roth IRA, purchased with assets acquired within the annual $5,500 contribution limitation).

In addition, those larger amounts could then grow tax-free within the Roth IRA, thus enhancing that benefit. Finally, to add to the benefit, the initial DISC contributions can effectively transfer assets from a family corporation to the Roth IRAs owned by family members. Voila! In the case of the family corporation in Summa Holdings, involving a business that had some exports, the result was that each Roth IRA accumulated over $3 million for each family member over the course of only six years. And any later distributions from the Roth IRA to its owners would be tax-free.


The IRS assessed a deficiency under the rationale that the initial commissions to the DISC should be treated as dividends, making the payments from the DISC to the Roth IRAs to be considered Roth IRA contributions in violation of the annual limitations on Roth IRA contributions.

The Tax Court agreed with the IRS, finding that the transactions were without economic substance or a non-tax business purpose. As a result, payments made by the DISC to another entity were not to be considered DISC commission payments, but rather dividends paid to the DISC’s shareholders followed by contributions (exceeding statutory contribution limits) to the Roth IRAs, resulting in an excise tax deficiency.


The Sixth Circuit, in reversing the Tax Court, viewed the transactions from an entirely differently perspective. In response to the IRS’s argument that the substance-over-form doctrine allowed it to recharacterize the transaction because its purpose was to sidestep the contribution limits on Roth IRAs and lower the tax obligations of the children, the Sixth Circuit replied:

“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 Sixth Circuit reasoned that the substance-over-form doctrine has viability when taxpayers place labels on a transaction that are not true to what they represent. That interpretation, it added, reaches the same end under the “sham” transaction doctrine, which also looks at economic realities.

In Summa Holdings, however, the Sixth Circuit found that none of the transactions were “a labeling-game sham or defied economic reality.”

In other words, the Sixth Circuit held that the substance-over-form doctrine should only apply when the taxpayer’s formal characterization of a transaction fails to capture economic reality and would distort the meaning of the Tax Code in the process. Here, the court reasoned that the form of the transaction was expressly authorized by the code and that no further inquiry was needed.

While Congress’ decision to permit Roth IRAs to own DISCs might have been an oversight, it was the law. The substance-over-form doctrine did not authorize the IRS to undo a transaction just because taxpayers undertook it to reduce their tax bills.

“If Congress sees DISC–Roth IRA transactions of this sort as unwise or as creating an improper loophole, it should fix the problem.” The Sixth Circuit reasoned that it was not its job to do so.


Taxpayers and their advisors will continue to find “loopholes” in the tax law. Some of those loopholes will be adjudicated as ineffective promptly by either the IRS or the courts. Others are sufficiently enmeshed within a facts-and-circumstances analysis that they are suspect but not under any blanket rule. Among this group are those on the IRS list of transactions that must be disclosed on Form 8886.

Still other loopholes are recognized as perhaps in need of closing by Congress to end them definitively. For example, 10 “loophole-closing” provisions within last year’s budget “Greenbook” included tax benefits that the Obama administration believed could not be closed without legislation, among them, carried interest.

Summa Holdings is not the only decision in support of a restricted use of the substance-over-form doctrine. Wright (January 2016), also decided by the Sixth Circuit, concluded that a foreign currency option involving a major currency (e.g., euros) qualified as a foreign currency contract under a strict, textual reading of Code Sec. 1256.

There, the Sixth Circuit, which reversed the Tax Court, noted that the Tax Court’s reasoning may have been supported by sound tax policy but conflicted with the statute’s plain language. It concluded that concern for tax policy did not justify reforming the statutory language. A year earlier, the Fifth Circuit also followed similar reasoning in Pilgrim’s Pride (February 2015), reading Code Sec. 1234A on its face, and observing that Congress could have phrased the statute differently if its intent was to treat the abandonment of a capital asset as a capital loss.

Other parties to the DISC–Roth IRA transaction examined by the Sixth Circuit have cases pending in First and Second Circuits, so the IRS may get another bite at the apple to put the brakes on the Sixth Circuit. Also to be considered is the enactment of Code Sec. 7701(o) on codification of the economic substance doctrine after the transaction in Summa Holdings arose and therefore not relevant to those litigants.

Finally to be considered, a more conservative-leaning future U.S. Supreme Court might itself amend the substance-over-form doctrine in favor of fewer restrictions on similar transactions in general.

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