The recent unanimous opinion from the United States Court of Appeals for the 6th Circuit by Judge Sutton, on a technical international corporate tax issue, while not terribly important from a tax law perspective, is a brilliant example of exemplary legal writing in the modern 21st century style.
On the merits the court upheld an innovative combination of a special kind of tax advantaged export company called a DISC with a Roth IRA against a substance over form challenge from the IRS which the Tax Court had upheld. The IRS argued essentially that while Congress had contemplated and addressed the combination of a DISC with a traditional IRA that it had not contemplated the particular advantage available when a DISC was joined to a Roth IRA applying the logic of the plain language of the pertinent Internal Revenue Code sections.
Here is an excerpt in which I have put in italic type some of the most distinctive modern aspects of the writing style used which focuses on "tricks" to make the material more readable that ordinary traditional legal prose:
SUTTON, Circuit Judge. Caligula posted the tax laws in such fine print and so high that his subjects could not read them. Suetonius, The Twelve Caesars, bk. 4, para. 41 (Robert Graves, trans., 1957). That’s not a good idea, we can all agree. How can citizens comply with what they can’t see? And how can anyone assess the tax collector’s exercise of power in that setting? The Internal Revenue Code improves matters in one sense, as it is accessible to everyone with the time and patience to pore over its provisions.
In today’s case, however, the Commissioner of the Internal Revenue Service denied relief to a set of taxpayers who complied in full with the printed and accessible words of the tax laws. The Benenson family, to its good fortune, had the time and patience (and money) to understand how a complex set of tax provisions could lower its taxes. Tax attorneys advised the family to use a congressionally innovated corporation—a “domestic international sales corporation” (DISC) to be exact—to transfer money from their family-owned company to their sons’ Roth Individual Retirement Accounts. When the family did just that, the Commissioner balked. He acknowledged that the family had complied with the relevant provisions. And he acknowledged that the purpose of the relevant provisions was to lower taxes. But he reasoned that the effect of these transactions was to evade the contribution limits on Roth IRAs and applied the “substance-over-form doctrine,” Appellee’s Br. 41, to recharacterize the transactions as dividends from Summa Holdings to the Benensons followed by excess Roth IRA contributions. The Tax Court upheld the Commissioner’s determination.
Each word of the “substance-over-form doctrine,” at least as the Commissioner has used it here, should give pause. 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. “Form” is “substance” when it comes to law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence—to allow him to determine the substance of a law and to make it govern “over” the written form of the law—and to call it a “doctrine” no less.
As it turns out, the Commissioner does not have such sweeping authority. And neither do we. Because Summa Holdings used the DISC and Roth IRAs for their congressionally sanctioned purposes—tax avoidance—the Commissioner had no basis for recharacterizing the transactions and no basis for recharacterizing the law’s application to them. We reverse.
A few definitions are in order, as are a few explanations about how the tax laws in this area work.
Congress designed DISCs to incentivize companies to export their goods by deferring and lowering their taxes on export income. Here’s how the tax incentives work. The exporter avoids corporate income tax by paying the DISC “commissions” of up to 4% of gross receipts or 50% of net income from qualified exports. The DISC pays no tax on its commission income (up to $10,000,000), 26 U.S.C. §§ 991, 995(b)(1)(E), and may hold onto the money indefinitely, though the DISC shareholders must pay annual interest on their shares of the deferred tax liability, id. § 995(f). Once the DISC has assets at its disposal, it can invest them, including through low-interest loans to the export company. See 26 C.F.R. § 1.993-4. Money and other assets in the DISC may exit the company as dividends to shareholders. The Code taxes dividends paid to individuals at the qualified dividend rate, see 26 U.S.C. § 1(h)(1)(D), 1(h)(3), 1(h)(11)(B), which (since 2003) is lower than the corporate income rate that otherwise would apply to the company’s export revenue, id. § 11(a), (b). A DISC’s shareholders often will be the same individuals who own the export company. In those cases, the net effect of the DISC is to transfer export revenue to the export company’s shareholders as a dividend without taxing it first as corporate income.
Congress has made clear that corporations and other entities, including IRAs, may own shares in DISCs. 26 U.S.C. §§ 246(d), 995(g). A corporation that owns DISC shares still has to pay the full corporate income tax on any dividends, which cancels out any tax savings. See id. § 246(d). For a time, tax-exempt entities like IRAs paid nothing on DISC dividends, which enabled export companies to shield active business income from taxation by assigning DISC stock to controlled tax-exempt entities like pension and profit-sharing plans. But Congress closed this gap in 1989 and required tax-exempt entities to pay an unrelated business income tax, set at the same rate as the corporate income tax, on DISC dividends. Id. §§ 511, 995(g).
With § 995(g), Congress made it less attractive for a traditional IRA to own shares in a DISC. Investment earnings (including dividends) generally accumulate tax-free in IRAs. Id. § 408(e)(1). But DISC dividends are subject to the high unrelated business income tax when they go into an IRA and, like all withdrawals from a traditional IRA, are subject to personal income tax when they come out. Id. § 408(d)(1).
The same considerations do not apply to the Roth IRA, which Congress created in 1997. With traditional IRAs, savers deduct contributions and pay income tax on withdrawals, including accrued gains in their accounts. Roth IRAs work in the other direction: Savers do not deduct their contributions from pre-tax income, but they take withdrawals, including accrued gains, tax free. Id. § 408A(c)(1), (d)(1).
The Code imposes contribution limits on traditional and Roth IRAs. In 2008, the maximum annual contribution to each was $5,000. Id. §§ 219(b)(5)(A), 408A(c)(2) (2008). The maximum annual contribution to a Roth IRA decreases as an individual’s income increases. In 2008, single filers who made over $116,000 could not make any contributions to a Roth IRA. See id. § 408A(c)(3) (2008); Internal Revenue Serv., Publication 590, Individual Retirement Arrangements (IRAs), at 2 (2008).
At this point, one can begin to see why the owner of a Roth IRA might add shares of a DISC to his account. The owner of a closely held export company could transfer money from the company to the DISC, as the statute encourages, and pay some (or all) of that money as a dividend to its shareholders, allowing the money to enter the Roth IRA and grow there. The IRA account holder, it is true, would have to pay the high unrelated business income tax—here roughly 33%—when the DISC dividends go into the IRA. But once the Roth IRA receives the money, the account holder could invest it freely without having to pay capital gains taxes on increases in the value of each share or incomes taxes on the dividends received—just like other Roth IRA owners who buy shares of stock in companies that generate considerable dividends and rapid growth in share value. As with all Roth IRAs, the owner would not have to pay any individual income or capital gains taxes when the assets leave the account after he hits the requisite retirement age. That’s how the tax laws worked at the time of the relevant transactions.
Here’s how the Benenson family and the relevant companies put them to use.
The case is Summa Holdings v. Comm’r of Internal Revenue, No. 16-1712, Slip Op. at 1-5 (6th Cir. February 16, 2017).
It takes real artistry to explain such a technical tax transaction so fluidly and plainly. The overall rhetorical style of fancifully and engagingly explaining the fundamental legal concept driving the court's decision, and then laying out the history and structure of how this kind of transaction is intended to work in general, before applying it to the facts, is also a powerful one.