Understanding the Substance Over Form Doctrine

Substance over form. For tax practitioners this can be a big issue. Is that a real business loss your client has or is it just a hobby? Do you get to deduct all of your expenses related to the Becker Annual Tax Conference or is that merely a disguised gambling trip to Las Vegas? Two recent court cases shed some light on this matter.

In 2017, the sixth circuit examined a case (Summa Holdings, 2/6/17) where the IRS applied the “Substance Over Form” doctrine. The case involved a Domestic International Sales Corporation (DISC) and Roth IRA’s.

Congress designed DISC’s to incentivize corporations to export their goods by lowering their taxes on export income. The exporter avoids corporate income tax by paying the DISC “commissions.” The DISC pays no income tax on commissions of up to $10,000,000 per year. The shareholder would pay tax on dividends received from the DISC.

Roth IRA’s are great for avoiding tax. If an individual has reached 59½ and has had the Roth for at least five years all of the distributions are tax free. The code does impose annual contribution limits ($5,000 at the time) and restricts contributions to those with AGI below certain thresholds.

Two of the shareholders in Summa Holdings created Roth IRA’s that ended up owning shares in a newly created DISC. Over a period of seven years, $5,182,314 was channeled from Summa Holdings through the DISC and eventually to the two IRAs. These amounts are way over the $5,000 allowed each year plus the AGI of the shareholders was also over the threshold allowing contributions.

The IRS acknowledged that the relevant provisions of the law had been complied with. The service argued the effect of these transactions was to evade the Roth contribution limits and applied the “substance-over-form doctrine”. The IRS said the “critical point” is that the tax benefits Summa Holdings had enjoyed were “unintended by both the DISC and Roth provisions.”

In the opinion Judge Sutton wrote, “The substance–over-form doctrine…makes sense only…when the taxpayer’s formal characterization… fails to capture economic reality and would distort the meaning of the code.” In this case there was no distortion of the code or failure to capture economic reality… a Roth owned a DISC.

The problem for the IRS is that they saw this kind of arrangement as creating unintended tax consequences. To that the judge wrote, “If congress sees DISC-Roth transactions as unwise…it should fix the problem.” “The substance–over-form doctrine does not give the Commissioner a warrant to search through the code and correct whatever oversights Congress happens to make…”

In Hawk (Sixth Circuit 5/15/2019) the same court was again faced with a substance-over-form argument. This case involved Holiday Bowl, a C corporation that sold its bowling alleys. The sale left Holiday Bowl with $4.2 million in cash and left the company owing about $1 million in federal income taxes and about $200,000 in state income taxes.

The shareholders wanted to minimize the tax effect. Their broker referred them to a scheme involving a company called MidCoast that had tremendous loss carryforwards. Somehow they thought these losses could be used to offset the$4.2 million gain. At the end of the day the shareholders would enjoy the best attributes of an asset sale (the higher sales price) and a stock-sale (no corporate-level tax). The broker said in closing his recommendation, “If it seems too good to be true, it probably is. But maybe this is the exception.” Sadly, for the owners it was not exception.

In upholding the Tax Court’s ruling against the taxpayer, the court said the transaction lacked economic substance. “It was nothing but misleading labels and distracting forms.” It is clear that the code and courts prohibit trafficking in net operating losses.

In clarifying the substance-over-form doctrine, Judge Sutton wrote that in Summa Holdings the IRS ignored what the Internal Revenue Code allowed. Summa Holdings was a case in which the taxpayers forced the IRS to respect the form and substance of the Code. The Hawk case was different. In Hawk,the government was not seeking to ignore the code. It was enforcing the statute as written.

These two cases do harmonize. When considering tax situations our clients get into, we need to examine both the written code and the economic realities. This same standard applies to the IRS.

Join tax expert John Stevko at the Becker National Tax Conference in Las Vegas, where he’ll share practical insights into a number of important tax areas including recent developments, legislative agendas and tax proposals.

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John M. Stevko, CPA, has over 40 years of professional experience as a tax practitioner, national seminar instructor, writer, and business owner. John began his career with what is now a “Big 4” public accounting firm before founding a local CPA firm in Beaverton, Oregon. At that same time, John began speaking for Gear Up Tax seminars and eventually becoming a managing partner of the business. John has lectured on tax law and healthcare reform throughout the country at national conferences and in-house for top 100 CPA firms and the large banking industry. He has also appeared on television and radio programs seeking his expertise on tax and healthcare legislation.