Court of Appeals rejects IRS' substance over form argument

Jun 07, 2021
Jun 07, 2021
0 min. read

Introduction – substance over form

Article I of the Constitution gives Congress the authority to lay and collect taxes. This concept seems simple, but may be complicated by courts’ interpretations of the laws Congress has enacted. The judicially-created substance over form doctrine is an excellent example of this type of complication. 

If a transaction’s substance varies from its form, the substance over form doctrine may deny tax benefits that would otherwise be allowed based on the transaction’s form. The June 2021 Ninth Circuit Court of Appeals decision explains a key limitation of the substance over form doctrine. Mazzei v. Commissioner, No. 18-72451 (9th Cir. 2021). 

Congress may provide tax rules expressly based on form 

The substance over form doctrine is a well settled principle that federal courts apply when interpreting tax rules, as the Court of Appeals acknowledged in Mazzei. However, Congress may authorize or prohibit attaining tax benefits based on the form of a transaction without regard to the transaction’s substance. The Ninth Circuit denied the IRS’ assertion of substance over form in Mazzei, holding 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.

Congress expressly based FSC tax benefits on form

The Tax Code’s foreign sales corporation (FSC) rules formerly provided a U.S. federal tax benefit to taxpayers exporting goods from the U.S.1 The taxpayers in Mazzei owned stock of a FSC through their Roth IRAs (individual retirement accounts). The FSC's after-tax income was returned to the Mazzeis as dividends distributed to the taxpayers’ Roth IRAs. The IRS did not think it was appropriate that the Roth IRAs would pay no tax on the receipt of these dividends, with the Mazzeis later paying no tax upon receipt of qualified withdrawals from the Roth IRAs. 

The Ninth Circuit observed that the case would be an easy one to apply substance over form principles to if it involved ordinary business entities. The court pointed out that “[t]he taxpayers used what is essentially a shell corporation to engage in arbitrarily priced, self-dealing transactions that lacked economic substance and then funneled those proceeds as “dividends” to a tax-free Roth IRA.” It then considered the extent to which the FSC provisions should override substance over form principles. 

While the IRS had argued at the Tax Court that the taxpayers’ entire FSC arrangement should be essentially disregarded under the substance over form doctrine and treated as a device for making Roth IRA contributions. The Tax Court did not go that far, but held that the Roth IRAs purchase of the FSC stock for nominal consideration should be disregarded under substance over form principles. In the Tax Court’s view, the FSC would be respected, but the Roth IRAs ownership of the FSC would not. Under the Tax Court’s approach, export activity-based benefits would still be allowed, but the FSCs’ dividends would be taxable to the Mazzeis.  

On appeal, the Ninth Circuit held that the Tax Court erred by invoking substance-over-form doctrine to forbid what the Tax Court plainly allowed. The Tax Court had emphasized that the Roth IRAs were not exposed to any significant risk with respect to their FSC ownership. The Court of Appeals noted that the Tax Code itself eliminated business risk from the FSC by “explicitly authoriz[ing] the establishment of a FSC that will not conduct any operations itself, and… generates value only by virtue of the reduced rate of taxation that is paid on moneys that are funneled through it in accordance with strict statutory formulas.”


Even though the FSC provisions were repealed over 20 years ago, the principle the Ninth Circuit adhered to in Mazzei remains valid. If Congress has plainly authorized a transaction, it is not up to the courts to save the IRS from the resulting consequences, even if it perceives authorization of the tax result as unwise. While this principle provides an important limitation to the substance over form doctrine’s scope, that doctrine remains broadly applicable. Taxpayer considering transactions that have forms that could be viewed as inconsistent with their substance should consult their tax advisors.


1Congress repealed the FSC rules in 2000, after the WTO (World Trade Organization) found that the FSC regime was an impermissible subsidy. 

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