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IRA Tax Ruling Favors Captive Insurance

Gavel and Dollars-SF
June 26, 2017

Management Services International (MSI) recently analyzed Summa Holdings, Inc. v. Comm'r, 848 F.3d 779, which was decided and filed in February. In its analysis, MSI asks us to consider if the Summa Holdings individual retirement account (IRA) tax ruling has favorable implications for the captive insurance industry and moves to the conclusion that the answer is affirmative.

What Is Substance-over-Form?

Earlier this year, in Summa Holdings, Inc. v. Comm'r, the United States Court of Appeals for the Sixth Circuit aroused the tax world with an opinion restricting the Internal Revenue Service's use of the "substance-over-form doctrine." Under the "substance-over-form doctrine," technical compliance with the tax law "on paper" may be inadequate. As such, judgment should also be used to determine the true nature of a transaction. While the legal aspects or recording (the form) of a transaction or an arrangement are vital to its understanding, these aspects may have to be disregarded at times in favor of understanding the true nature or underlying transaction (the substance) of the situation. 

MSI's Case Summary

In Summa Holdings, Inc. v. Comm'r, the Sixth Circuit Court of Appeals tethered the IRS commissioner's argument that a transaction, if done solely for income tax purposes, may be set aside, on substance-over-form arguments, even if the transaction clearly follows the Tax Code. While the Sixth Circuit does not sweep away this broad IRS tool for recharacterizing an arrangement just because a business chose the lowest tax method to structure the transaction, it does allow such a structure, if it is a path that Congress intended. 

The original case stipulated that the petitioners' sole reason for entering into the transaction was to transfer money into Roth IRAs so that income on assets could accumulate and be distributed tax-free without a nontax business purpose for the transactions.

The commissioner argued that the substance of the transaction and not the form must determine its tax consequence. He cited the preeminent case of Gregory v. Helvering, 293 U.S. 465, 55 S. Ct. 266, 79 L. Ed. 596 (1935). Where a series of transactions, taken as a whole, shows either that the transactions themselves are shams or that the transactions have no "purpose, substance, or utility apart from their anticipated tax consequences," the transactions are not recognized for federal tax purposes. See also Commissioner v. Court Holding Co., 324 U.S. 331, 65 S. Ct. 707, 89 L. Ed. 981, 1945 C.B. 58 (1945).

The Supreme Court has "looked to the objective economic realities of a transaction rather than to the particular form the parties employed." Frank Lyon Co. v. United States, 435 U.S. 561, 98 S. Ct. 1291, 55 L. Ed. 2d 550 (1978). "The substance over form doctrine applies when the transaction on its face lies outside the plain intent of the statute and respecting the transaction would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose." Gregory v. Helvering, 293 U.S. at 470.

The Sixth Circuit began its analysis with quotes from various cases and treatises that do not support the theory that one must maximize his or her own taxation.

There is no "patriotic duty to increase one's taxes," as Judge Learned Hand memorably told us in the case that gave rise to the economic-substance doctrine, Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934). "Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury." Id. If the Code authorizes the "formal" transactions the taxpayer entered into, then "it is of no consequence that it was all an elaborate scheme to get rid of income taxes." Id; see also David P. Hariton, Sorting Out the Tangle of Economic Substance, 52 Tax Law. 235, 236–41 (1999).

The court further addressed the complexity of the Tax Code and that the substance-over-form doctrine does not authorize the commissioner to undo a transaction just because taxpayers undertook it to reduce their tax bills.

The court added that many provisions of the Code owe their existence solely to tax-reducing purposes, to lower current taxes, or to shelter income from taxes over time. Many areas the IRS is attacking currently, particularly listed transactions or reportable transactions, may, in theory, be perfectly allowable transactions. As such, as long as each component of the transaction is compliant with the expressed language in the Code and properly characterized, income tax can be reduced without regard to questions concerning the "substance" of the resultant structure. 

The commissioner further argued that the income tax results in the instant case were "unintended by both the Roth IRA and DISC [domestic international sales corporation] provisions." The commissioner was most likely correct, but the court noted "the substance-over-form doctrine does not give the Commissioner a warrant to search through the Internal Revenue Code and correct whatever oversights Congress happens to make or redo any policy missteps the legislature happens to take." So, tax benefits when correctly following the Code, even if the consequences may have been unintended, do not by themselves allow the imposition of the substance-over-form doctrine.

Concerning the Internal Revenue Code’s complexity and intricate structure, the court noted, "The last thing the federal courts should be doing is rewarding Congress's creation of an intricate and complicated Internal Revenue Code by closing gaps in taxation whenever that complexity creates them." 

As stated by the court, "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."

Therefore, if the actual language or text of the Code allows it, it is allowed.

View "Great Court Ruling That Can Favor the Captive Industry," the full article and analysis of how this IRA ruling favors captive insurance, available in the Thought Leadership section of MSI's sponsor profile.

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