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Limiting the Substance Over Form Doctrine

At the end of 2018, to the dismay of the IRS and the Tax Court, the Second Circuit joined the First and Sixth in reversing the Tax Court’s decision in the Summa Holdings “substance over form” matter.  In these three related appellate cases, the IRS sought to recharacterize millions of dollars that had been paid as commissions into a domestic international sales corporation (DISC) and then shielded from income tax when the DISC contributed the funds to a Roth IRA.

Why the IRS Claimed Substance Over Form

The Benenson family owned a group of companies that fell under a holding company called Summa Holdings, which was in Ohio. The father and mother lived in New York and their two sons lived in Massachusetts. The two Benenson sons each set up a Roth IRA and made a small contribution to it. They used the Roth IRAs to buy stock in a DISC which the family held through Summa Holdings. The controversy began when the family used a DISC to transfer money from their business to the Roth IRAs owned by the sons. Summa Holdings paid commissions to the DISC, which then contributed to the Roth IRAs. Eventually, contributions to the two Roths were over $6 million.

The IRS cried “Foul!” and claimed that under the substance over form doctrine, the payments should be considered dividends from Summa Holdings to its shareholders rather than commission to the DISC. The result of recharacterizing the payments as dividends would be the holding company would pay income tax on the DISC commissions it had deducted. The holding company would then get a refund on the income tax it had paid on the dividend from the DISC.

However, if the sons tried to contribute the money directly to the Roth IRA rather than through a DISC, they would have been slapped with a 6% excise tax. In other words, the family used the DISC to get around the Roth IRA contribution limits, and the IRS said that was not allowed under the substance over form doctrine. To add insult to injury, the IRS wanted to penalize the taxpayers for even trying this.

How DISCS Work

To make sense of the appellate courts’ decisions to reverse the Tax Court ,let’s first take a step back and consider the nature and purpose of DISCs. Congress established DISCs in order to give export companies a tax break by deferring and lowering taxes on their income from exports. The purpose is to give incentive to companies to export goods in return for deferring taxes and lowering them.

The exporting company pays a commission to the DISC. In the Summa cases, the IRS wanted to recharacterize the commission payments as dividends to stockholders. A DISC does not pay tax on commission income up to $10 million. IF the DISC distributes money to shareholders, then it is subject to corporate tax. However, it if distributes money to a Roth IRA shareholder, the Roth IRA may invest it tax-free as it can with any other funds. Also, there is no tax when the funds are distributed to the account holder when they reach retirement age.

Sixth Circuit: Summa Holdings v. Commissioner, February 16, 2017

The first case to be decided came before the Sixth Circuit in Summa Holdings, Inc. v. Comm’r, 848 F.3d 779 (2017). The case came before the Sixth Circuit because Summa Holding Company was in Ohio. In the Tax Court case, the Tax Court agreed with the IRS that the payments should be reclassified under the substance over form doctrine, but it threw out the IRS’s request for a penalty against the taxpayer. Summa Holdings appealed to the Sixth Circuit which reversed the Tax Court’s decision.

The Sixth Circuit in Summa Holdings, Inc. v. Commissioner, 848 F.3d 779 (2017), put it this way,

“ 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 collector is. “Form” is “substance” when it comes to 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 a law and to make it govern “over” the written form of the law—and to call it a “doctrine” no less.

“…Because Summa Holdings 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.”

What we take away from the court’s decision is that

  • Congress created DISCs for the purpose of allowing exporters to defer corporate income tax.
  • DISCs by their nature are all form and no substance.
  • Congress created Roth IRAs to enable taxpayers to reduce taxes.
  • Roths are legally allowed to own DISC shares according to statute.
  • Since the very purpose of DISCs and IRAs is to reduce taxes, the IRS cannot successfully claim that Summa Holdings followed a “devious path” in order to avoid taxes.
  • The IRS cannot change laws after the fact that Congress put in place for tax deferment just to suit IRS purposes.

The First Circuit: Benenson v. Commissioner, April 6, 2018

While Summa Holdings based in Ohio took its case to the Sixth Circuit, the Benenson sons based in Massachusetts appealed to the First Circuit in Benenson v. Commissioner, 887 F.3d 511 (2018). The First Circuit’s decision was consistent with that of the Sixth Circuit in Summa, but the First Circuit distinguished its findings in Benenson from a split decision from the Tax Court after Summa called Mazzei v. Commissioner.

In Mazzei, the Tax Court again applied substance over form in a Roth IRA case. This case involved a foreign sales corporation (FSC) making payments to a Roth IRA. But unlike the DISC program, Congress repealed the FSC statutes in 2000. The decision in Mazzei was narrow. The Tax Court viewed the Roth IRAs’ purchase of the FSC shares as without substance and found that “the payments from the FSC were income to petitioners rather than to their Roth IRAs.” The only question was who owned the FSC, the taxpayers or their Roth IRAs. Because the Roth IRAs bought the FSC stock for only $1, and because of some issues concerning the contracts, the purchase was considered to be without substance. Therefore, the payments were recharacterized as dividends and subject to the 6% excise penalty. In the Summa cases, valuation of the shares the Roth IRAs purchased were not a question, so the two outcomes are not inconsistent.

As for the Benenson case, the First Circuit Court of Appeals stated,

“Some may call the Benensons’ transaction clever. Others may call it unseemly. The sole question presented to us is whether the Commissioner has the power to call it a violation of the Tax Code. We hold that he does not. The substance over form doctrine is not a smell test. It is, in this circuit, a tool of statutory interpretation.”

Second Circuit: Benenson v. Commissioner, December 14, 2018

At the end of 2018, the Second Circuit handed down a decision in Benenson v. Commissioner that was brought by the Benenson father and mother who lived in New York. Consistent with the First and Sixth Circuits, the Second Circuit Court of Appeals also reversed the decision of the Tax Court which employed the substance over form doctrine. This reversed the Tax Court judgment that the petitioners must pay $77,850 in income taxes.


The substance over form doctrine has been around for a very long time, and these decisions have not done away with it. However, three circuits have made clear that the Tax Commissioner may not overrule the Code as established by Congress just because it does not feel right. Taxpayers have a right to minimize their taxes under the law. Roth IRAs and DISCs are two of the tools Congress has given them to do just that, and only Congress can change the laws they have passed.

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