Court says statutory language precludes substance-over-form analysis

By James A. Beavers, CPA, CGMA, J.D., LL.M.

The Ninth Circuit, reversing the Tax Court, held that foreign sales corporation (FSC) shares owned by a Roth IRA should not be recharacterized as shares owned by the beneficiaries of the Roth IRAs. The court found that the Tax Court had improperly invoked the substance-over-form doctrine to reverse congressional judgment and disallow Roth IRA ownership of FSC shares, which was plainly allowed by the FSC statutes.


Angelo, Mary, and Celia Mazzei jointly owned Injector Corp., which had export sales that generated considerable amounts of foreign trade income. In 1998, the Mazzeis entered a prepackaged tax shelter program under which they bought accounts in a foreign sales corporation (FSC). These accounts were treated as a separate corporation.

Congress authorized FSCs with the intent of promoting exports, under the since-repealed Secs. 921-927 (the FSC statutes). Under the FSC statutes, a corporation with foreign trade income from export sales could establish a related FSC as a shell corporation and the export corporation could pay tax-deductible "commissions" to the FSC that were determined according to complex statutory formulas, which did not correspond to any actual services provided by the FSC. The FSC would pay a small tax on the commission income, and the FSC would then return the remaining income to the export corporation (or a related entity) as dividends, usually tax-free. As a result, the FSC's taxable income was largely generated through related-party transactions that lacked meaningful economic substance, a departure from the normal principle that taxation is based on economic substance rather than on legal form.

Under the program, the Mazzeis sold their shares in the FSC to their Roth IRAs. Injector Corp. paid the FSC commissions, and the FSC returned its after-tax income as dividends to the Mazzeis' Roth IRAs rather than to Injector Corp. The result of this arrangement was that no tax was paid on the dividends because they were paid to Roth IRAs, and the Mazzeis paid no tax when they took qualified withdrawals of the dividend money from the Roth IRAs.

The IRS, arguing substance over form, asserted that despite the actual transfer of the FSC shares to their Roth IRAs, the Mazzeis, in substance, remained the owners of the FSC. As a result, the dividend payments from the FSC to the Mazzeis' Roth IRAs were income to the Mazzeis that they contributed to the Roth IRAs. Because the dividend payments exceeded the Mazzeis' contribution limits for their Roth IRAs, the IRS found that the Mazzeis were liable for excise taxes under Sec. 4973 on the excess contributions.

The IRS issued notices of deficiency based on its theory for the years in question, assessing tax, interest, and penalties against the Mazzeis. The Mazzeis challenged the IRS's determination in Tax Court. The Tax Court upheld the tax assessments but not the penalties. While the IRS had asked the court to recharacterize the entire scheme under the substance-over-form doctrine, the court declined to do so. It instead only recharacterized one part of the scheme, the purchase of the FSC shares by the Roth IRAs.

The Mazzeis appealed the Tax Court's decision to the Ninth Circuit. The Ninth Circuit found because the Tax Court had only recharacterized the purchases of the Roth IRA stock, the only issue for the court to decide was whether the Mazzeis, rather than their Roth IRAs, were the true owners of the FSC.

The Ninth Circuit's decision

The Ninth Circuit reversed the Tax Court and held that the Roth IRAs, and not the Mazzeis, were the real owners of the FSC. It concluded that Congress, in the FSC rules, had authorized a separation of substance and form for FSCs, and the Tax Court had erred in invoking the substance-over-form doctrine "to effectively reverse congressional judgment and to disallow what the statute plainly allowed."

The Ninth Circuit explained that it was black letter law that in construing and applying the tax laws, courts should generally follow the substance-over-form doctrine; however, in specific situations, Congress could negate the doctrine in express statutory language. The court found that Congress had done so with the FSC statute, so the tax rules of the FSC scheme in some respects followed the form of a transaction rather than its substance.

The Tax Court had also found that Congress had negated the application of the substance-over-form doctrine with respect to the FSC statute but construed Congress's limitation of the doctrine very narrowly. It determined that Congress intended that form over substance only applied with respect to the "specific transactions" in which the export company pays commissions based on statutory formulas that lack any economic reality, and then "only for the purpose of computing the income taxes of the FSC and its related supplier." Beyond that, the Tax Court found the substance-over-form doctrine still applied, so it was relevant in determining who owned the stock of an FSC.

The Tax Court, in applying the doctrine to the Roth IRAs' purchase of the FSC shares, considered whether the Roth IRAs had obtained the benefits and risks of ownership of the FSC through the purchase. With regard to the risks, the Tax Court found they did not, primarily because the Roth IRAs had purchased the stock for a de minimis amount, and therefore their amount at risk was insufficient to give substance to their ownership of the FSC. Consequently, their purchase of the FSC stock should be disregarded.

The Ninth Circuit stated that the problem with the Tax Court's analysis was:

that its underlying premises are directly contrary to what is expressly contemplated by the FSC statute. It makes no sense to ask whether the formal owner of the FSC stock would, by virtue of that purchase, be exposed to any risk as a result of that ownership because the statute allows FSCs to be set up so as to eliminate any risk from owning the FSC stock. [slip op. at 31]

With respect to the benefits of ownership, the Tax Court analyzed whether the Roth IRAs had any benefits of ownership of the FSC by considering what benefits an independent holder of the FSC stock could realistically have expected. Because, by statutory design, an FSC will always be owned by a related entity, the Ninth Circuit concluded this inquiry made no sense. According to the court, no independent person would realistically be expected to obtain value from owning an FSC because a foreign exporter would have no practical incentive to choose to put money into an FSC owned by an independent person.

The court noted that its conclusion was supported by two textual clues in the FSC statute. First, the FSC statute expressly contemplated that an FSC will ordinarily receive its funds from an entity owned or controlled by the same interests and applied its special rules regardless of which related entity owns the FSC. Second, Congress enacted a special provision in 1988 that if a tax-exempt entity (such as an IRA) owns shares in a domestic international sales corporation (DISC), dividends distributed to the IRA are subject to tax under Sec. 511, but Congress did not add a similar provision to the FSC statute.

The Ninth Circuit also claimed support for its conclusion from decisions of the First, Second, and Sixth Circuits in three appeals arising from a single Tax Court proceeding involving a Roth IRA that indirectly owned shares in a DISC. According to the court, the courts in all those cases found that "when Congress expressly departs from substance-over-form principles, the [IRS] may not invoke those principles in a way that would directly reverse that congressional judgment."


Although it is highly unlikely that Congress intended to create a system where taxpayers like the Mazzeis could avoid almost all tax on foreign trade income from export businesses they owned, the applicable statutes as written literally allow them to do so. Furthermore, as the Ninth Circuit pointed out, the abuse the IRS claimed the Mazzeis (and other taxpayers engaging in similar activity) perpetrated could have been prevented if Congress had enacted a provision prohibiting ownership of FSCs by IRAs or Roth IRAs, or one like Sec. 995(g), under which dividends paid by a DISC to an IRA or Roth IRA were subject to the Sec. 511 tax on unrelated business income. Since Congress had not enacted any such provision, the Ninth Circuit, citing Russello, 464 U.S. 16, 23 (1983), stated that it "must be deemed to have chosen not to do so."

Mazzei, No. 18-72451 (9th Cir. 6/2/21)

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