Posted by: Robert Horwitz | March 14, 2017


An opinion that begins “Caligula posted the tax laws in such fine print and so high that his subjects could not read them” has to end well for the taxpayer. In Summa Holdings, Inc. v. Commissioner, No. 16-1712 (6th Cir. Feb. 16, 2017), the appellate court reversed the Tax Court and rejected the IRS’s invocation of a “substance over form” argument that sought to disregard a transaction set up in compliance with two Internal Revenue Code provisions that were designed to reduce taxes.

As the Sixth Circuit noted, it takes time, patience and money to learn how complex provisions of the Internal Revenue Code work. The Benenson family, with the assistance of its tax attorneys, used the “domestic international sales corporation” (“DISC”) and the Roth IRA provisions of the Code to avoid tax.

DISCs are an innovation of the Code designed to incentivize domestic corporations to export goods by allowing them to lower tax on export income. A corporation sets up a DISC to which it pays a commission of up to 4% of gross receipts or 50% of net income from qualified exports.  The DISC pays no corporate income tax on its commission income and can pay dividends to shareholders, who are often shareholders of the export corporation.  If the shareholder is a non-taxable entity or a corporation, it pays tax on the dividends at a 33% rate.

A taxpayer who sets up a Roth IRA pays tax on contributions but not on withdrawals, including accrued gains. A taxpayer cannot make contributions to an IRS if his income exceeds a certain level.

Summa Holdings is a manufacturing corporation. James Benenson, Jr., and trusts he formed for his two sons owned over 99% of the corporation’s stock.  In 2001, each of his sons set up a Roth IRA.  Each son contributed $3,500 to his Roth IRA.  Summa Holdings formed JC Export.  Each Roth IRA purchased 50% of the stock of JC Export for $1,500.  The Roth IRAs were the sole shareholders of JC Holdings, to which they transferred the JC Export stock.

JC Export acted as the DISC for Summa Holdings, which paid it commissions. JC Export distributed the commissions as dividends to JC Holdings, which paid tax on the dividends at a 33% rate.  The net dividend income was distributed to the two Roth IRAs as dividends.  Between 2002 and 2008 (the year in issue) JC Holdings distributed over $5.1 million to the Roth IRAs, each of which had accumulated over $3 million.

The IRS issued notices of deficiency. Determining that the substance of the transaction was to distribute Summa Holdings income to the sons without paying tax at the individual level, the IRS invoked the substance over form doctrine.  It disallowed the deductions taken by Summa Holdings as commissions and determined that the commissions were dividends to its shareholders.  It therefore asserted deficiencies against the corporation, Mr. Benenson and his two sons.  It gave a credit to JC Holdings for the 33% tax it paid.  Because each of the Benenson sons earned more than the allowable amount for making contributions to a Roth IRA, the IRS imposed a 6% excise tax on the contributions.  It also imposed accuracy penalties.  The Tax Court upheld the deficiencies but not the penalties and the taxpayers appealed.

The Sixth Circuit reversed. The crux of the Court’s decision was that since Roth IRAs and DISCs were designed by statute to reduce tax, there was nothing improper about a taxpayer using them to do just that.  The Court noted that under any other title of the United States Code this would end the matter:

But when it comes to the Internal Revenue Code, the Commissioner claims a right to reclassify Code-compliant transactions under the “substance-over-form doctrine” in order to respect “overarching . . . principles of federal taxation.” Appellee’s Br. 39, 41. Overarching indeed. As he sees it, the doctrine allows him to nullify the DISC commissions and dividends to the Roth IRAs on the ground that the purpose of the transactions was to sidestep the contribution limits on Roth IRAs and lower the tax obligations of the Benenson sons in the process. That is a step too far. 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.

As originally conceived and as traditionally used, the substance-over-form doctrine has something to it. In writing the tax laws, Congress uses many general terms—“income,” “indebtedness,” “corporate reorganization”—that refer to real-world economic activities, and it assigns tax consequences to those activities. When the courts decide how to classify a transaction, they focus, quite appropriately, on the transaction’s workaday realities, not the labels used by the taxpayers. Take “income.” If a taxpayer receives something of value, 26 U.S.C. § 61(a), he can call it whatever he wants—this, that, or something else. What the taxpayer cannot do is claim that the label he affixes on the transaction precludes it from being “income” under the Code or prevents the courts from treating it as “income” under the Code. Slip op. at 6-7.

As the Court noted, the sham transaction doctrine also disregards labels put on a transaction in order to look at economic reality. But the substance over form and the sham transaction doctrines do not “give the Commissioner purchasing power here.”  Both DISC and Roth IRAs are creatures of Congress designed to help taxpayers reduce taxes.  The Court therefore found it odd for the IRS to reject the transactions at issue “in the service of general concerns about tax avoidance.  It chided the IRS Commissioner for using these doctrines to “avoid tax consequences he doesn’t like”:

The substance-over-form doctrine, it seems to us, makes sense only when it holds true to its roots—when the taxpayer’s formal characterization of a transaction fails to capture economic reality and would distort the meaning of the Code in the process. But who is to say that a low- tax means of achieving a legitimate business end is any less “substantive” than the higher-taxed alternative? There is no “patriotic duty to increase one’s taxes,” as Judge Learned Hand memorably told us in the case that gave rise to the economic-substance doctrine.Slip op. at 10.

This decision will hearten taxpayers who try to utilize the Code in order to minimize their tax in ways that Congress mandated. It will also undoubtedly be used to justify abusive transactions.

ROBERT S. HORWITZ – For more information please contact Robert S. Horwitz – or 310.281.3200   Mr. Horwitz is a principal at Hochman, Salkin, Rettig, Toscher & Perez, P.C., a former Assistant United States Attorney of the Tax Division of the Office of the U.S. Attorney (C.D. Cal) and represents clients throughout the United States and elsewhere involving federal and state, administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at

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