Is That a Change in the Wind? The 6th Circuit Rules Against the IRS on the Application of the Substance-Over-Form Doctrine

On February 16th, the Federal Court of Appeals for the Sixth Circuit issued a very entertaining and interesting opinion in Summa Holdings Inc. v. Commissioner, (HERE) holding that the taxpayers’ use of a Domestic International Sales Corporation (DISC) and two Roth IRAs for their congressionally sanctioned purposes - tax avoidance - was permissible. The 6th Circuit opinion reversed a Tax Court decision that upheld an IRS determination that the substance-over-form doctrine allowed the transactions to be re-characterized as dividends to the taxpayers followed by excess Roth IRA contributions. The IRS had argued that the transactions should be re-characterized although it agreed that the taxpayers had complied with the relevant Tax Code provisions and that the purpose of the provisions was to lower taxes.

In ruling for the taxpayers, the 6th Circuit had a number of highly quotable statements that will likely be used by taxpayers in future disputes with the IRS, such as:

        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.

        How odd, then, to permit the tax collector to reverse the sequence – to allow him to
        determine the substance of the law and to make it govern “over” the written form of the law
        – and to call it a “doctrine” no less.

In addressing the application of the substance-over-form doctrine the 6th Circuit said:

        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 the statutes – to ignore their form, their words, in favor of
        his perception of their substance.

        But it’s odd to reject a Code-compliant transaction in the service of general concerns
        about tax avoidance. Before long, allegations of tax avoidance begin to look like efforts at
        text avoidance. What started as a tool to prevent taxpayers from placing labels on
        transactions to avoid tax consequences they don’t like runs the risk of becoming a tool that
        allows the Commissioner to place labels on transactions to avoid textual consequences he
        doesn’t  like.

Because there are taxpayer appeals on this same transaction pending in other circuits, it is likely we have not seen the end of this issue. If a different circuit court issues a contrary opinion, an appeal to the U.S. Supreme Court is likely. In the meantime, I don’t expect the IRS to discontinue its use of the substance-over-form doctrine or other soft doctrines in attacking these and other transactions which the IRS dislikes. However, the Summa Holdings opinion should hearten taxpayers and cause the IRS to pause.

For any questions on this or any other tax-related matter, please feel free to contact me at (214) 749-2456 or jcrouch@meadowscollier.com.