United States: Ninth Circuit reverses Tax Court’s use of substance-over-form doctrine in Mazzei

In brief

Following similar precedents from the First, Second, and Sixth Circuits, the Ninth Circuit Court of Appeals reversed a Tax Court opinion and held that the substance-over-form doctrine did not apply to make individual taxpayers, rather than those taxpayers’ Roth IRAs, the owners of a Foreign Sales Corporation (FSC). As such, the funds received by the Roth IRAs were not excess contributions from the taxpayers subject to excise taxes.

The dispute centered around the taxpayers, members of the Mazzei family, and their company, Mazzei Injector Corp. Mazzei Injector Corp. actively exported product that added fertilizers to the water used in agricultural irrigation systems. The Mazzeis were also farmers and members of a trade association who represented farmers, the Western Growers Association (WGA). WGA promoted the use of FSCs by its members.

Congress created FSCs in 1984 as an alternative to the Domestic International Sales Corporation (DISC). DISCs were created by Congress for the express purpose of incentivizing American export companies. In preceding years, DISCs had become the subject of trade disputes, and Congress created FSCs to ameliorate international controversy. Eventually, FSCs themselves were found by the World Trade Organization to be impermissible subsidies, and Congress repealed FSC provisions in November 2000. But the repeal statute contained transition provisions that allowed existing FSCs to continue for a specified time. The statutory provisions governing FSCs had been set forth in former Code Sections 921-927.

The central premise of an FSC was that a company engaged in exporting goods could take a portion of the proceeds from export sales and contribute those proceeds to the FSC. A portion of the FSC’s income attributable to those commissions was declared to be “exempt foreign trade income.” That portion was treated as not effectively connected with the conduct of a trade or business in the United States, exempting that portion from taxation. The remaining income was subject to the corporate income tax rate without paying corporate income tax on the amount of the DISC commission. The export corporation was allowed to allocate a portion of its export sales income to the FSC by paying the FSC artificially determined commissions. The export company deducted the commissions as an expense, and paid no income tax on the commissions. The FSC paid income tax only on the non-exempt portion of its income attributable to the commissions.

Any entity may own shares in a FSC, and thus receive commissions from the FSC. Shares of a FSC may also be owned through traditional IRAs and Roth IRAs. Generally, unless otherwise specified in the Code, Roth IRAs are treated exactly the same as traditional IRAs. The most important distinction between the two types of IRAs is how contributions and distributions are treated. The Code sections that apply to traditional IRAs allow taxpayers to deduct their contributions, but taxpayers must pay tax on distributions from those accounts. In contrast, the taxpayers do not receive a deduction for contributions to Roth IRAs, but distributions from a Roth IRA are tax-free. Thus, a Roth IRA allows for the tax-free growth of their retirement account. In exchange for that benefit, Roth IRAs have a yearly contribution limit, and that limit phases out to zero based on the annual income of the Roth IRA owner.

The Mazzeis worked with WGA to set up their FSC, including entering into a commission agreement between the FSC and the Mazzeis’ export company. The Mazzeis also each set up their own Roth IRA accounts. Each of the three Roth IRA accounts became a one-third shareholder of the FSC. Once this structure was in place, the FSC paid USD 533,057 in dividends to the Mazzeis’ Roth IRAs between 1998 and March 2002. While the FSC paid some tax on the income attributable to its commissions, the Roth IRAs paid no tax on the dividends received from the FSC.

In 2009, the IRS issued notices of deficiency against each of the Mazzeis. The IRS asserted that the dividends paid by the FSC to the Roth IRA accounts were actually contributions from the Mazzeis to their Roth IRA accounts. The IRS assessed excise tax deficiencies totaling USD 108,282 against the three Mazzeis collectively, along with USD 31,127 in penalties. The three Mazzeis petitioned to the Tax Court.

The full Tax Court reviewed the case and upheld the excise tax assessment by a vote of 12-4, while unanimously setting aside the penalties. The Tax Court reasoned that the Roth IRAs’ purchases of FSC stock did not reflect economic 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 owning the FSC stock. For that reason, the Tax Court treated the Mazzeis as the owners of the FSC stock and its dividends. Accordingly, the court determined that the contributions to the Roth IRAs came from the Mazzeis. Any contributions over the Roth IRA contribution limit in the relevant year were treated by the Tax Court as excess contributions subject to excise tax. The Mazzeis timely appealed to the Ninth Circuit.

On appeal, the Ninth Circuit reversed the Tax Court’s decision, finding that the substance-over-form doctrine utilized by the Tax Court did not apply to the structure used by the Mazzeis. In some cases, “form — and form alone — determines the tax consequences of a transaction.” The Ninth Circuit found that was the case with FSCs, which Congress expressly decreed can engage in transactions that lack economic substance.

In so finding, the Ninth Circuit relied heavily on three cases decided in the time frame between shortly before the Tax Court’s decision in Mazzei and the Ninth Circuit’s reversal. In these cases, the First, Second, and Sixth Circuits each reversed the Tax Court’s decision in Summa Holdings, Inc. v. Commissioner, TC Memo 2015-119, 109 T.C.M. (CCH) 1612, 2015 Tax Ct. Memo LEXIS 125 (29 June 2015). There, the Tax Court had utilized the substance-over-form doctrine to uphold excise tax assessments for shares of a DISC owned by Roth IRAs. In three separate appeals, the First, Second, and Sixth Circuits addressed separate parts of the same transaction with regard to different taxpayers, finding that Congress’s intent in establishing both the DISC and Roth IRA regimes was to allow for the reduction of relevant taxes.

In joining the First, Second, and Sixth Circuits, the Ninth Circuit concluded that, “when Congress expressly departs from substance-over-form principles, the Commissioner may not invoke those principles in a way that would directly reverse that congressional judgment.” “It is not our role to save the Commissioner from the inescapable logical consequence of what Congress has plainly authorized.” As such, the Ninth Circuit reversed.