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Ninth Circuit Reverses Tax Court in Roth-Related Decision

This article applies to taxpayers that have made contributions to a Roth IRA from a foreign sales corporation (FSC).

Abstract: In Mazzei v. Commissioner, the U.S. Court of Appeals for the Ninth Circuit reversed the U.S. Tax Court in a case involving Roth IRAs. At issue was whether the IRS can assert the “substance over form” doctrine to prevent a taxpayer from using a foreign sales corporation to make contributions beyond the stated limit for Roth IRAs. This article explores the details.

Mazzei v. Commissioner, No. 18-72451, June 2, 2021 (U.S. Ninth Circuit)

Ninth Circuit Reverses Tax Court in Roth-Related Decision

In the recent case of Mazzei v. Commissioner, the U.S. Court of Appeals for the Ninth Circuit reversed the U.S. Tax Court in a case involving Roth IRAs. The appellate court held that the IRS cannot assert the “substance over form” doctrine to prevent a taxpayer from using a transaction involving a foreign sales corporation (FSC) to contribute more to a Roth IRA than the stated contribution limit. Let’s take a closer look at the pertinent details of this important decision.

The Case Arises

Two members of a family established an FSC. They then each established a Roth IRA and named their Roth IRAs as shareholders of the FSC. The family’s corporation with foreign trade income (otherwise known as an “export corporation”) paid commissions into the FSC. In turn, the FSC distributed its after-tax income (which was greater than the Roth IRA contribution limit) as dividends to its shareholders (the Roth IRAs) rather than to their export corporation.

The IRS challenged the scheme of having the Roth IRAs as shareholders rather than the family members themselves, saying that it lacked any economic substance. The IRS asked the Tax Court to recharacterize the entire scheme under the substance over form doctrine — that is, the agency believed a court should look at the economic realities of a transaction, not legal abstractions.

The Tax Court held that, under substance over form principles, the family members — not the Roth IRAs — were the real owners of the FSC. This meant that they should be deemed to have received the dividends, and their contributions to the Roth IRAs exceeded the limits for such contributions. Therefore, according to the Tax Court, the family members were liable for excise taxes on the excess contributions.

Appellate Decision

As mentioned, the Ninth Circuit reversed this decision. It found that having Roth IRAs as FSC shareholders — effectively allowing contributions to the Roth accounts exceeding the contribution limit — didn’t violate the FSC rules or the Roth IRA contribution rules.

The court stated that, “It is a ‘black-letter principle’ that, in construing and applying the tax laws, courts generally ‘follow substance over form.’” But, it continued, “Like any background maxim that informs the construction and application of a statute, the doctrine of substance over form can be negated by Congress in express statutory language.” The court said that, “This is such a case.”

Under since-repealed provisions of the Internal Revenue Code, otherwise known as the “FSC statute,” an export corporation could establish a related FSC as a shell corporation and then effectively cycle a portion of that income through the FSC where it would be taxed at lower rates.

As a result, the Ninth Circuit found that the FSC’s taxable income was generated through related-party transactions that lacked meaningful economic substance. The FSC taxation rules, however, reflected a departure from the normal principle that taxation is based on economic substance rather than on legal form.

The court’s basic argument why was that repealed Section 925(a) of the tax code provided that:

… the taxable income of [an] FSC and [a commonly controlled entity] shall be based upon a transfer price which would allow such FSC to derive taxable income attributable to such sale (regardless of the sales price actually charged) in an amount which does not exceed [a statutory provided formula].

The Ninth Circuit said the parenthetical phrase “regardless of the sales price actually charged” showed that Congress had expressly decreed that FSCs can engage in transactions with commonly controlled entities that lack any economic substance. And, stated the court, these transactions can be assigned hypothetical values determined according to statutory formulas that bear no relationship to any underlying real-world valuation.

Because the family members otherwise complied with the FSC rules when they named their Roth IRAs as shareholders of the FSC, and because the FSC rules expressly allow for transactions that lack economic substance, the IRS couldn’t invoke the substance over form doctrine to say that the Roth IRA contributions were really dividends to the family members.

Joining in

In making its decision in Mazzei, the Ninth Circuit said it was joining with the First, Second and Sixth Circuits in concluding 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. For further questions about this case, contact your CPA.

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