Last week the Sixth Circuit Court of Appeals took the IRS to task for overreaching its authority. Summa Holding, Inc. v. Commissioner, No. 16-1712 (Feb. 16, 2017), (reversing T. C. Memo 2015-119). The taxpayers had combined two tax strategies, each created and intended by Congress to allow avoidance of taxes (a Domestic International Sales Corporation (“DISC”) owned by a Roth IRA). The Sixth Circuit reversed the Tax Court and the IRS determination, finding that because Summa had “used the DISC and Roth IRAs for their congressionally sanctioned purposes—tax avoidance—the Commissioner had no basis for recharacterizing the transactions and no basis for recharacterizing the law's application to them.”
The IRS decided the two strategies should not be combined to avoid more tax than either strategy would save separately. The IRS acknowledged that the taxpayers had complied with the letter of the law in setting up the legal structure of a Roth IRA — owned DISC and that the purpose of these structures was to lower taxes. But this seemed “too good to be true” to the IRS, which recharacterized the transaction as an attempt to evade contribution limits on Roth IRAs. The IRS said the “substance-over-form doctrine” prohibited the combination of the two otherwise legal tax avoidance structures.
In declaring a “fall” against the IRS in a unanimous decision, the Sixth Circuit approved of the use of a DISC to transfer money from a family-owned business to Roth IRAs established by the owner's sons. But the Sixth Circuit complained about the government's use of substance-over-form as a “gotcha” when the IRS just didn't like the result. In the words of the Court: “If the government can undo transactions that the terms of the Code expressly authorize, it's fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collectors is. “Form” is “substance” when it comes to the law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence—to allow him to determine the substance of the law and make it govern “over” the written form of the law—and to call it “doctrine” no less.”
One need not delve into the inner workings of DISCs or Roth IRAs (though one can by reading the Court's opinion) to appreciate the Sixth Circuit's view that the “substance-over-form doctrine does not authorize the Commissioner to undo a transaction just because the taxpayers undertook it to reduce their tax bills.” The Sixth Circuit noted that the point of these entities (DISCs and Roth IRAs) is tax avoidance and the Court will not allow the Commissioner to “place ad hoc limits on them by invoking a statutory purpose (maximizing revenue) that has little relevance to the text-driven function of these portions of the Code (minimizing revenue).”
If the IRS attacks tax structures clearly intended to allow taxpayers to minimize their tax burden, based on substance-over-form or other tax doctrines, we may see the IRS thwarted by the language found in Summa. At least for now, the Sixth Circuit's view of substance-over-form may put a chill on how the IRS attacks congressionally mandated tax structures in the future, at least in the Sixth Circuit and maybe in others. We will see how the broad language of this case is used by taxpayers who are defending the use of transaction structures that Congress has mandated to provide a tax savings incentive to encourage certain types of activities.