The judicial substance-over-form doctrine provides the IRS with the ability to set aside carefully orchestrated tax planning arrangements to treat a transaction consistent with its substance. However, the doctrine does not give the Service carte blanche to deny tax benefits. In Summa Holdings, Inc. v. Commissioner, No. 16-1712 (available here), the Sixth Circuit overturned the Tax Court and declined to apply the substance-over-form doctrine when faced with taxpayers who, “to [their] good fortune, had the time and patience (and money) to understand how a complex set of tax provisions could lower [their] taxes” and “complied in full with the printed and accessible words of the tax laws.”
Summa Holdings involved a closely held corporation (Summa Holdings, Inc.) that supercharged the tax benefits provided by paying commissions to an interest charge domestic international sales corporation (IC-DISC) by having the IC-DISC owned by two Roth IRAs. While the dividends paid by the IC-DISC were taxable upon receipt, the dividend amounts (totaling $6 million over 7 years) were vastly larger than the annual contribution limits placed on Roth IRAs. For unfathomable reasons, the IRS did not challenge the $3,000 price that the Roth IRAs paid for the IC-DISC stock. Instead, the IRS asserted that that the substance of the arrangement was that the corporation paid dividends to its shareholders and the shareholders made excess contributions to the Roth IRAs.
In overturning the Tax Court, the Sixth Circuit limited the applicability of the substance-over-form doctrine to situations in which “the taxpayer’s formal characterization of a transaction fails to capture economic reality and would distort the meaning of the Code in the process.” The Sixth Circuit refused to apply the doctrine just because the transactions lacked a valid business purpose and conferred tax benefits that might not have been predicted by Congress (“[Statutory] purpose must be grounded in text. It cannot be invoked to save the statute from itself.”). Of particular import in Summa Holdings was the taxpayer favorable nature of both the IC-DISC and the Roth IRA rules. The Sixth Circuit stated:
The point of [both sets of rules] is tax avoidance. The Commissioner cannot 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).
Practice Point: The opinion in Summa Holdings makes for a refreshing modern take on the Learned Hand maxim that, “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury.” However, two caveats are worth noting. First, the shareholders in this case have related appeals pending before the First and Second Circuits; so the story is not over. Second, the year at issue in Summa Holdings was before the enactment of Code section 7701(o), the codified economic substance doctrine. Under section 7701(o), to the extent it is “relevant” (a concept that is still in a state of flux), the lack of a valid business purpose is enough, by itself, for the IRS to deny the tax benefits of a transaction.