16‐2953‐ag
Benenson v. Comm’r
In the
United States Court of Appeals
for the Second Circuit
AUGUST TERM 2017
No. 16‐2953‐ag
JAMES BENENSON, JR. AND SHAREN BENENSON,
Petitioners‐Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent‐Appellee.
On Appeal from the United States Tax Court
ARGUED: APRIL 10, 2018
DECIDED: DECEMBER 14, 2018
Before: PARKER, RAGGI, LIVINGSTON, Circuit Judges.
________________
Petitioners appeal from a decision of the United States Tax
Court (Kerrigan, J.), upholding 2008 tax deficiencies identified by
respondent Commissioner upon application of the substance‐over‐
form doctrine to recharacterize various lawful tax‐avoiding
transactions as tax‐generating events for petitioners, their adult sons,
a family trust, and a family‐controlled corporation. The First and
Sixth Circuits have already reversed judgments against petitioners’
sons and the corporation. See Benenson v. Comm’r, 887 F.3d 511 (1st
Cir. 2018); Summa Holdings, Inc. v. Comm’r, 848 F.3d 779 (6th Cir. 2017).
We here review the judgment against petitioners, focusing
particularly on the Commissioner’s recharacterization of the
corporation’s tax‐deductible “DISC” commission payments as non‐
deductible constructive dividends to the corporation’s shareholders,
including petitioner James Benenson, Jr., thereby triggering personal
income tax liability for him and his wife.
REVERSED AND REMANDED.
NEAL J. BLOCK (Robert S. Walton, on the
brief), Baker & McKenzie LLP, Chicago,
Illinois, for Petitioners‐Appellants.
ELLEN PAGE DELSOLE, Attorney, Tax
Division (Gilbert S. Rothenberg, Teresa E.
McLaughlin, Attorneys, Tax Division, on the
brief), for Richard E. Zuckerman, Deputy
Assistant Attorney General, Washington
D.C., for Respondent‐Appellee.
2
REENA RAGGI, Circuit Judge:
At issue on this appeal is a decision of the United States Tax
Court (Kathleen Kerrigan, Judge), upholding tax deficiencies noticed
by respondent Commissioner for tax year 2008 against (1) petitioners,
James Benenson, Jr. (“Benenson, Jr.”) and his wife Sharen Benenson;
(2) petitioners’ adult sons, James Benenson III and Clement Benenson
(“Benenson sons” or “sons”); and (3) Summa Holdings, Inc.
(“Summa”), a C corporation founded and, in 2008, still controlled by
Benenson, Jr. See Summa Holdings, Inc. v. Comm’r, 109 T.C.M. (CCH)
1612 (2015). The Commissioner identified these deficiencies by
applying the substance‐over‐form doctrine to recharacterize a series
of concededly lawful tax‐avoiding transactions as tax‐generating
events.
These transactions included (1) Summa’s payments, totaling
$2.2 million, in genuine export income as tax‐deductible commissions
to a qualified domestic international sales corporation (“DISC”); (2)
the DISC’s payment of $2.2 million in taxable dividends to its sole
shareholder, a holding company owned by the Benenson sons’
individual retirement accounts (“IRA”); (3) the holding company’s
after‐tax payment of $1.477 million in non‐taxable dividends to the
Benenson sons’ IRAs. There is no question that the “sole reason” for
the taxpayers to enter into these aforementioned transactions “was to
transfer money into the [sons’] IRAs so that income on assets in the
Roth IRAs could accumulate and be distributed on a tax‐free basis.”
App’x 102. They stipulated as much in the Tax Court. The
Commissioner concedes that, in form, the money transfers present as
lawful, non‐taxable returns on IRA investments. Nevertheless, he
maintains that, in substance, the transfers effect excess IRA
contributions subject to excise taxes. Accordingly, he noticed
3
deficiencies against the sons for such taxes. Further, concluding that
the excess contributions derived from the $2.2 million that Summa
had treated as deductible DISC commissions, the Commissioner
recharacterized those commissions as non‐deductible constructive
dividends to Summa shareholders, specifically, Benenson, Jr. and a
Benenson family trust, thereby triggering income tax deficiencies for
Summa, petitioners, and the trust.1
Consistent with their diverse residences in Massachusetts
(Benenson sons), New York (petitioners), and Ohio (Summa), the
taxpayers appealed the Tax Court’s judgment to the First, Second, and
Sixth Circuits respectively. See 26 U.S.C. § 7482(b) (establishing
taxpayer residence as appropriate venue for appeals from Tax Court).
The First and Sixth Circuits have now reversed the judgment as it
pertains to the Benenson sons and Summa, concluding that the
substance‐over‐form doctrine does not support the Commissioner’s
recharacterization either of Summa’s deductible DISC commission
payments as non‐deductible constructive dividends to its
shareholders, see Summa Holdings, Inc. v. Comm’r (“Summa v.
Comm’r”), 848 F.3d 779 (6th Cir. 2017); or of the holding company’s
dividend payments to the sons’ IRAs as excess contributions, see
Benenson v. Comm’r, 887 F.3d 511 (1st Cir. 2018). On this appeal, we
consider petitioners’ challenge to the same Tax Court decision as it
pertains to them and also reverse.
1 Before the Tax Court, the Commissioner belatedly determined that the tax deficiency
attributed to the trust should have been attributed to the trust’s beneficiaries, i.e., the
Benenson sons, but by that time it was too late to pursue the sons for that obligation.
Accordingly, the Tax Court entered no judgment against the trust or the sons for any tax
deficiency attributable to constructive dividends from Summa.
4
BACKGROUND
We assume readers’ familiarity with the First and Sixth
Circuits’ opinions, particularly their detailed discussions of the
transactions at issue and the tax code provisions relevant to those
transactions. We, therefore, only briefly summarize these matters as
pertinent to petitioners’ appeal.
I. DISCs and IRAs
The transactions at issue sought to take advantage of the tax‐
minimizing features of two creatures of federal law, DISCs and IRAs.
Congress created DISCs to provide domestic companies with
tax incentives to increase exports. See LeCroy Research Sys. Corp. v.
Comm’r, 751 F.2d 123, 124 (2d Cir. 1984); see also Benenson v. Comm’r,
887 F.3d at 514; Summa v. Comm’r, 848 F.3d at 782. Toward that end,
the tax code allows companies to avoid corporate tax on export
income up to 4% of gross export receipts (or 50% of net export
income), by paying that amount as tax‐deductible “commissions” to
a DISC. See 26 U.S.C. §§ 993(a)(1), (f); 994(a). The DISC itself pays no
tax on the commission income. See id. § 991. Rather, tax obligations
arise only for DISC shareholders when the DISC distributes
dividends to them. See id. § 995(a), (b)(1)(E). Thus, tax liability on
export income, when channeled through a DISC, can not only be
deferred until such distribution, but also can be reduced by
application of the dividend tax rate rather than the higher corporate
rate that would otherwise apply to export revenues. See Summa v.
Comm’r, 848 F.3d at 782 (citing relevant statutory provisions in
observing that “net effect” of DISC is “to transfer export revenue to
the export company’s shareholders as a dividend without taxing it
first as corporate income”). These benefits obtain even if, as is
5
frequently the case, the exporter and the DISC are related entities and
commission transactions between them are not conducted at arms‐
length. See 26 C.F.R. § 1.994–1(a)(1). They obtain even if the DISC is
a mere shell entity, as is likely because a DISC “need not have
employees or perform any specific function” for its commissions to be
immunized from challenge by the Commissioner for tax purposes. Id.
§ 1.993–1(l); see id. example 2; id. § 1.994–1(a)(2) (providing that DISC
tax benefits do “not depend on the extent to which the DISC performs
substantial economic functions”). Indeed, as the Commissioner
himself acknowledges, as long as a company complies with DISC
statutory requirements, its commission payments to a DISC cannot be
challenged. See id. § 1.992–1(a) (noting that regulations governing
DISCs “constitute a relaxation of the general rules of corporate
substance otherwise applicable under the Code”).
As for IRAs, the law provides for two types: traditional and
Roth. Traditional IRAs encourage retirement savings by allowing
taxpayers to make tax‐deductible contributions to such accounts up
to specified limits ($5,000 in 2008). See 26 U.S.C. § 219(b)(5) (2008).
Contributions to a traditional IRA, as well as earnings on such
contributions, are taxed only upon withdrawal. See id. § 408(d)(1).
Roth IRAs offer inverse tax incentives. While contributions to
such accounts (also limited to $5,000 in 2008) are not deductible from
current income, withdrawals from Roth IRAs are not taxed. See id.
§ 408A(c)(2)–(3), (d)(1)–(2). Thus, contributions to Roth IRAs grow
tax‐free. Income limits restrict participation in Roth IRAs. In 2008, a
person filing singly with income over $116,000, or jointly with income
over $169,000, could not contribute to a Roth IRA. See id. § 408A(c)(3).
6
Excess contributions to either traditional or Roth IRAs are subject to
an annual six‐percent excise tax until eliminated. See id. § 4973(a), (f).
The tax code permits both traditional and Roth IRAs to invest
in various legal entities, including, as relevant here, C corporations
and DISCs. See Benenson v. Comm’r, 887 F.3d at 520 (discussing how
various code provisions, read together, lead to that conclusion);
Summa v. Comm’r, 848 F.3d at 784 (same). But whereas an individual
DISC owner is taxed at the dividend rate on DISC dividends, a
corporate owner is taxed at the higher corporate rate, and an IRA
owner is taxed at the unrelated business income rate, which is equal
to the corporate rate. See 26 U.S.C. §§ 246(d), 511, 995(g). This makes
DISC ownership less attractive for traditional IRAs. See Summa v.
Comm’r, 848 F.3d at 783 (explaining that DISC dividends are subject
to high unrelated business income tax when they go into traditional
IRA and, like all withdrawals from traditional IRA, are subject to
personal income tax when taken out). Not so for Roth IRAs. While a
Roth IRA must also pay unrelated business income tax on any DISC
dividends that it receives, ensuing investment gains on those
dividends are tax‐free because, as with all Roth IRA assets, DISC
dividends and gains thereon are not subject to individual income or
capital gains taxes when withdrawn. See id. (summarizing
advantageous interaction between Roth IRAs and DISCs and noting
that “one can begin to see why the owner of a Roth IRA might add
shares of a DISC to his account”).
II. The Transactions at Issue
Summa is the parent company of several industrial
manufacturing subsidiaries with significant export income. During
the 2008 tax year, Summa was 99% owned by its founder, Benenson,
Jr. (23.18%), and a family trust benefitting the Benenson sons for
7
which petitioners served as trustees (76.05%). Benenson, Jr. then
controlled Summa through his majority ownership of the company’s
voting shares.
From 2002 through 2008, Benenson, Jr., his sons, and Summa
engaged in various transactions that they acknowledge had as their
sole purpose the transfer of money into the sons’ Roth IRAs “so that
income on assets in the Roth IRAs could accumulate and be
distributed on a tax‐free basis.” App’x 102. Each Benenson son had
established a Roth IRA in 2001, contributing $3,500. Neither made
any further contributions to these accounts and, indeed, by 2008, each
son’s income was too high to allow him to do so. Nevertheless, by
2008, each son’s Roth IRA held $3.1 million in assets. How was this
achieved?
On January 31, 2002, the sons’ Roth IRAs each paid $1,500 to
acquire 1,500 shares (a 50% interest each) of a newly formed,
Benenson‐family controlled DISC, JC Export, Inc. (“JC Export”). That
same day, the Benensons also formed a new C corporation, JC Export
Holding, Inc. (“JC Holding”), which promptly purchased all JC
Export shares from the sons’ Roth IRAs in return for an equal number
of shares in JC Holding.2 From January 31, 2002, through December
31, 2008, each of the Roth IRAs continued to own 50% of JC Holding,
which remained the sole shareholder of JC Export. By thus owning
2 Questions might be raised about whether the Benenson sons’ IRAs paid fair value for
their interests in JC Export and JC Holding. See Benenson v. Comm’r, 887 F.3d at 524 (Lynch,
J., dissenting) (stating that “DISC shares were not purchased at market prices”). But, as
both the First and Sixth Circuits have observed, the Commissioner has raised no such
challenge. See id. at 522 (“[T]he Commissioner has never challenged the valuation of the
shares the Roth IRAs purchased in either JC Export or JC Holding.”); Summa v. Comm’r,
848 F.3d at 783 (“The Commissioner did not challenge the valuation of these shares then
and has not challenged them since.”).
8
JC Export indirectly through JC Holding, the sons’ Roth IRAs avoided
tax‐reporting and shareholder obligations for the DISC.
From 2002 to 2008, Summa—presumably with the consent, and
possibly at the direction of, its controlling shareholder, Benenson,
Jr.—paid millions of dollars of its export income to JC Export as tax‐
deductible DISC commissions. JC Export promptly distributed those
funds as dividends to JC Holding, which paid the required 33%
corporate income tax on DISC dividends. JC Holding then
distributed the balance as its own dividends to its shareholders, the
sons’ Roth IRAs. These dividends—totaling over $5 million from
2002 to 2008, with $1.477 million in 2008—entered the sons’ IRAs as
tax‐free returns on their investment in JC Holding. With those returns
growing tax‐free in the sons’ IRAs, by 2008, each IRA had a fair
market value of $3.1 million.
III. Recharacterization of the Transactions
The Commissioner concedes that the above‐described
transactions were all lawful in form. Nevertheless, in 2012, he
determined that, in substance, the transactions amounted to excess
contributions to the sons’ IRAs. Accordingly, for the 2008 tax year, he
issued tax deficiency notices not only to the Benenson sons, but also
to Summa, Benenson, Jr. and his wife, 3 and the family trust. 4 The
Commissioner determined that what Summa had treated as tax‐
deductible DISC commissions was properly recharacterized as non‐
deductible dividends from Summa to its shareholders. With the DISC
transaction thus recharacterized, the Commissioner concluded that
3 Mrs. Benenson was named in the deficiency notice because she and her husband filed a
joint 2008 tax return.
4 The Commissioner did not notice tax deficiencies for any other years in which the
described transfers were made to the sons’ IRAs.
9
Summa owed corporate tax on the DISC commissions that it had
deducted from income. Meanwhile, Benenson, Jr., his wife, and the
family trust all owed income tax on unreported constructive
dividends received from Summa. On such recharacterization, the
Commissioner further deemed JC Export not to have received actual
DISC commissions and, thus, not to have paid actual DISC dividends
to JC Holding, which, therefore, could claim a refund of the corporate
taxes it had paid on such dividends. Meanwhile, the Commissioner
recharacterized the more than $1.477 million in JC Holding dividends
paid to the Benenson sons’ IRAs in 2008 as excess contributions on
which the sons owed excise tax.5
IV. Tax Court Proceedings
On January 7, 2013, petitioners initiated this proceeding in the
Tax Court to challenge the noticed deficiency in their 2008 income
taxes. The action was consolidated with similar challenges by
Summa, the Benenson sons, and the family trust. The parties cross‐
moved for summary judgment on a stipulated factual record.
In an opinion dated June 29, 2015, the Tax Court granted
summary judgment to the Commissioner and denied it to the
taxpayers. Like the Commissioner, the Tax Court did not identify any
of the tax‐avoiding transactions at issue as unlawful in form.
Nevertheless, it determined that they had been employed to
circumvent annual Roth IRA contribution limits and had no non‐tax
business purpose. In these circumstances, the Tax Court held that the
Commissioner had appropriately recharacterized the transactions’
form to comport with their substance. On May 20, 2016, the Tax Court
5 Notably, the Commissioner has never maintained that the transactions conceal the
economic reality of untaxed gifts from Benenson, Jr. to his sons. Specifically, he has noticed
no gift tax deficiency.
10
entered judgment holding that petitioners owed an income tax
deficiency of $77,850.
On August 11, 2016, petitioners timely appealed the judgment
to this court. Meanwhile, Summa appealed to the Sixth Circuit, which
reversed in a unanimous opinion dated February 16, 2017. See Summa
v. Comm’r, 848 F.3d 779. The Benenson sons appealed to the First
Circuit, which also reversed by majority opinion dated April 6, 2018.
See Benenson v. Comm’r, 887 F.3d 511.
DISCUSSION
On this appeal, petitioners challenge the Tax Court’s decision
to uphold a tax deficiency against them based on the Commissioner’s
recharacterization of Summa’s tax‐deductible commission payments
to a DISC as taxable dividends to Summa shareholders. Petitioners
contend that because that recharacterization was expressly rejected
by the Sixth Circuit in reversing the related deficiency judgment
against Summa, see Summa v. Comm’r, 848 F.3d 779, the Commissioner
is precluded from relitigating the issue here. 6 In any event,
petitioners urge this court to conclude for itself that the substance‐
over‐form doctrine does not support the challenged
recharacterization. The Commissioner disputes preclusion and
defends the Tax Court’s judgment on the merits. For the reasons
stated herein, we conclude that the Commissioner is not here
precluded from defending the challenged recharacterization.
Nevertheless, we hold that the substance‐over‐form doctrine does not
support recharacterization of Summa’s DISC commission payments
as constructive dividends to its shareholders. Accordingly, we
While petitioners do not urge preclusion based on the First Circuit’s rejection of the
6
Commissioner’s transaction recharacterizations, see Benenson v. Comm’r, 887 F.3d 511, they
maintain that the decision’s reasoning also supports reversal.
11
reverse that portion of the Tax Court judgment holding petitioners
liable for $77,850 in 2008 income taxes.
I. Standard of Review
The proper characterization of a transaction for tax purposes is
a legal question that we review de novo. See Frank Lyon Co. v. United
States, 435 U.S. 561, 581 n.16 (1978); Bank of N.Y. Mellon v. Comm’r, 801
F.3d 104, 112 (2d Cir. 2015). While we normally review the Tax
Court’s findings of fact for clear error, see Bank of N.Y. Mellon v.
Comm’r, 801 F.3d at 112, that principle is not relevant here because the
case was submitted to the Tax Court on a stipulated record.
II. The Commissioner Is Not Precluded from Defending the
Challenged Recharacterization
Petitioners argue that, in defending the deficiency judgment
against them, the Commissioner cannot rely on his recharacterization
of Summa commissions as shareholder dividends because the Sixth
Circuit rejected that recharacterization when the Commissioner relied
on it to defend the related deficiency judgment against Summa. In
general, nonmutual offensive collateral estoppel is not allowed
against the government. See United States v. Mendoza, 464 U.S. 154,
159–60 (1984); accord United States v. Certified Envtl. Servs., Inc., 753
F.3d 72, 100 (2d Cir. 2014). Nevertheless, the Supreme Court has
permitted government preclusion where, inter alia, parties opposing
the government in the two lawsuits are the same. See United States v.
Stauffer Chem. Co., 464 U.S. 165, 171–73 (1984). This mutuality
requirement can be satisfied by privity, which can be established by
showing that the litigant urging preclusion in the subsequent action
12
“totally controlled and financed” a litigant in the prior action. United
States v. Mendoza, 464 U.S. at 164 n.9.
Petitioners fail to make such a showing here. It is not enough
for them to show that Benenson, Jr. controlled Summa at the time of
the transactions at issue, a point that appears undisputed. See Summa
Holdings, Inc. v. Comm’r, 109 T.C.M. (CCH) 1612, 2015 WL 3943219, at
*2 (“From 2001 to 2008 [Benenson, Jr.] had the power to direct
Summa’s operations, including the transfer of its funds.”); Resp’t Br.
at 4 (“Benenson controlled Summa and its subsidiaries.”). What
petitioners must establish is that Benenson, Jr. controlled Summa’s
conduct in the litigation before the Sixth Circuit. See United States v.
Mendoza, 464 U.S. at 164 n.9. According to petitioners themselves,
however, the Benenson sons became Summa’s controlling
shareholders in 2012, see Pet’rs. Br. at 23; Pet’rs. Reply Br. at 7 n.5, well
before the filing of the Sixth Circuit appeal. In the face of such an
adverse admission, petitioners cannot show the mutuality necessary
to support offensive collateral estoppel against the government.7
In urging otherwise, petitioners rely on Taylor v. Sturgell, 553
U.S. 880 (2008), to argue that mutuality is satisfactorily established by
their profession, in advance of the Sixth Circuit decision, to be bound
by that court’s ruling as to the recharacterization of Summa’s
commission payments as shareholder dividends. While Taylor
references such concessions in identifying circumstances where a
nonparty to an earlier action might be estopped from relitigating the
7 The First Circuit, in rejecting the Benenson sons’ preclusion claim against the
Commissioner, declined to consider evidence of a controlling‐share transfer to the sons
that had not been presented to the Tax Court. See Benenson v. Comm’r, 887 F.3d at 516.
Here, we deal not with a party’s reliance on extra‐record evidence to support a preclusion
claim; rather, we deal with a party’s adverse admission that necessarily defeats that claim.
13
question in a subsequent action, see id. at 893–95, it does so in the
context of private‐party litigation, nowhere suggesting any expansion
of the use of nonmutual offensive collateral estoppel against the
government. In any event, to the extent Taylor recognizes that “a
person who agrees to be bound by the determination of issues in an
action between others is bound in accordance with the terms of his
agreement,” id. at 893 (brackets and internal quotation marks
omitted), that example might support collateral estoppel against
petitioners based on their agreement to be bound, but it warrants no
such conclusion against the Commissioner. As Taylor observed, “if
separate actions involving the same transaction are brought by
different plaintiffs against the same defendant, all the parties to all the
actions may agree that the question of the defendant’s liability will be
definitely determined, one way or the other, in a ‘test case.’” Id.
(emphasis added) (internal quotation marks omitted). Here, the
Commissioner never so agreed.
In sum, we reject petitioners’ preclusion claim and proceed to
the merits. In doing so, we are respectful of, but not bound by, the
First and Sixth Circuit decisions identifying error in the
Commissioner’s recharacterization of the tax‐avoiding transactions
common to all three appeals.
III. The Substance‐Over‐Form Doctrine Does Not Support the
Commissioner’s Recharacterization of Summa’s DISC
Commission Payments as Dividends to its Shareholders
Federal tax obligations are established entirely by statute. See
Benenson v. Comm’r, 887 F.3d at 517. Thus, as has long been
recognized, a taxpayer may “arrange his affairs” to take advantage of
those tax code provisions that allow him to minimize his taxes.
Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934) (L. Hand, J.)
14
(observing that taxpayer “is not bound to choose that pattern which
will best pay the Treasury”; there is no “patriotic duty to increase
one’s taxes”), aff’d, 293 U.S. 465 (1935). At the same time, however,
transactions whose “true nature” triggers statutory tax obligations
cannot be “disguised by mere formalisms,” “solely to alter tax
liabilities.” Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945);
accord Frank Lyon Co. v. United States, 435 U.S. at 573 (observing that
in field of taxation, “administrators of the laws and the courts are
concerned with substance and realities”). Thus, “[i]n tax law, . . .
substance rather than form determines tax consequences.” Raymond
v. United States, 355 F.3d 107, 108 (2d Cir. 2004) (alteration in original)
(internal quotation marks omitted). Put another way, the “objective
economic realities of a transaction,” rather than “the particular form
the parties employed,” will determine tax consequences. Frank Lyon
Co. v. United States, 435 U.S. at 573.
So understood, the substance‐over‐form doctrine is a tool of
statutory interpretation that serves to ensure that the tax code’s
“‘technical language conform[s] more precisely with Congressional
intent.’” Benenson v. Comm’r, 887 F.3d at 517 (quoting Dewees v.
Comm’r, 870 F.2d 21, 35 (1st Cir. 1989) (Breyer, J.)). The doctrine
guards against “labeling‐game sham[s]” by “attend[ing] to economic
realities” in deciding, for example, whether words used in the tax
code, such as “‘income,’ ‘reorganization,’ and ‘debt,’. . .‘contribution’
or ‘dividend,’” cover particular transactions. Summa v. Comm’r, 848
F.3d at 786–87. Such a tool was particularly useful when the tax code
was simpler, and when “finite language” had to “account for infinite
tax transactions,” as well as “an endless supply of tax‐reducing
ingenuity.” Id. at 789. The doctrine is appropriately applied more
cautiously to the now “highly reticulated Internal Revenue Code,
which uses language, lots of language, with nearly mathematic
15
precision . . . to pursue a wide range of policy goals through a
complicated set of tax credits, deductions and savings accounts.” Id.
Specifically, the doctrine is not an invitation for the Commissioner to
recharacterize transactions that, in fact, comport with the economic
reality of their authorizing code provisions, as higher‐tax‐yielding
transactions “in the service of general concerns about tax avoidance.”
Id. at 787. In short, substance‐over‐form is a tool to prevent taxpayers
from mislabeling transactions “to avoid tax consequences they don’t
like”; it is not an authorization for the Commissioner to relabel
transactions “to avoid textual consequences he doesn’t like.” Id.
Thus, “when the taxpayer’s formal characterization of a transaction
fails to capture economic reality and would distort the meaning of the
Code in the process,” form properly gives way to substance. Id. But
if the economic reality of what was done “was the thing which the
statute intended,” it is of no matter that its purpose was tax
avoidance. Altria Grp., Inc. v. United States, 658 F.3d 276, 284 (2d Cir.
2011) (internal quotation marks omitted); see Helvering v. Gregory, 69
F.2d at 810.8
With these principles in mind, we here consider the
Commissioner’s invocation of the substance‐over‐form doctrine to
recharacterize a series of transactions that he maintains had, as their
8 The substance‐over‐form doctrine is related to, but distinct from, the “economic
substance” doctrine, sometimes known as the “sham transaction doctrine.” See 2
Ginsburg, Levin & Rocap, MERGERS, ACQUISITIONS, AND BUYOUTS ¶ 608.1 (Apr. 2018 ed.)
(observing that economic‐substance doctrine grew out of substance‐over‐form doctrine);
Altria Grp., Inc. v. United States, 658 F.3d at 291 (recognizing doctrines as distinct). But see
Summa v. Comm’r, 848 F.3d at 785 (equating doctrines). The economic‐substance doctrine
“allows courts to question the validity of a transaction and deny taxpayers benefits to
which they are technically entitled under the Code if the transaction at issue lacks
economic substance.” Bank of N.Y. Mellon Corp. v. Comm’r, 801 F.3d at 113 (internal
quotation marks omitted). The Commissioner concedes that the transactions here are not
lacking in economic substance, and, thus, we do not consider that doctrine further. We
consider only whether the form of the transactions at issue reflects the economic reality,
i.e., substance, intended by Congress in authorizing legislation.
16
economic reality, the circumvention of tax code limitations on Roth
IRA contributions. Two circuit courts have held application of the
doctrine unwarranted here, concluding that the recharacterized
transactions have the economic substance identified in the code
provisions authorizing their tax‐minimizing form.
Thus, as to Summa’s payment of a portion of its export income
as tax‐deductible commissions to a DISC, the Sixth Circuit observed
that the payment comported with the economic reality of the DISC
program, which is “to enable exporters to defer corporate income tax”
by “creat[ing] DISCs as shell corporations that can receive
commissions and pay dividends that have no economic substance at
all.” Summa v. Comm’r, 848 F.3d at 786 (observing that economic
reality of DISCs is that they “are all form and no substance”); accord
Benenson v. Comm’r, 887 F.3d at 517–18.
As for JC Holding’s payment of $1.477 million in dividends to
the Benenson sons’ Roth IRAs, the First Circuit majority held that this
comported with economic reality because provisions of the tax code
expressly allow taxpayer contributions to Roth IRAs to grow tax‐free
through investment in qualified entities, including DISCs, “even
during periods where the taxpayers are no longer allowed to
contribute, and even if such growth occurs at a swift rate.” Benenson
v. Comm’r, 887 F.3d at 519–20. Although the Commissioner argued
that the IRAs had assumed no investment risk in acquiring JC
Holding, the majority concluded that, “at least initially,” the degree
to which the Roth IRAs would benefit from owning JC Holding
depended on the success of Summa’s export subsidiaries. See id. at
522. As to whether the IRAs had given fair value for their interests in
JC Holding, the majority observed that the Commissioner had never
urged otherwise. See supra at 8 n.2.
17
Like the Sixth Circuit, and for much the same reasons, we
conclude that Summa’s payment of deductible DISC commissions
was grounded in economic reality and not distortive of the tax code
provisions establishing the DISC program. As this court has
recognized, Congress created the DISC program specifically to
provide a tax incentive for domestic companies in order to “‘increase
our exports and improve an unfavorable balance of payments.’”
LeCroy Research Sys. Corp. v. Comm’r, 751 F.2d at 124 (quoting S. Rep.
No. 92‐437, at 1 (1971), reprinted in 1971 U.S.C.C.A.N. 1918). Thus, the
tax code permits domestic companies to avoid taxes on a percentage
of their export income by paying that amount as tax‐deductible
“commissions” to DISCs. The DISCs themselves need do nothing to
earn such commissions. In fact, they are usually shell corporations
created only to receive the commissions and, eventually, to distribute
them as dividends to DISC owners. At that point tax obligations do
arise for DISC shareholders, who must pay dividend, corporate, or
unrelated business taxes on the DISC distribution, depending on their
respective status as individuals, C corporations, or IRAs. See 26 U.S.C.
§§ 1(h), 246(d), 511, 991, 995(b), (f), (g); 26 C.F.R. § 1.884–1(a). It is in
this sense that the economic reality of a commission payment to a
DISC might be deemed “all form and no substance.” Summa v.
Comm’r, 848 F.3d at 786. Put another way, Congress has itself elevated
form over substance insofar as DISC commissions are concerned by
affording exporters “commission” deductions for payments that lack
the economic substance generally associated with commissions, i.e.,
some services rendered by the payees. But as long as (1) DISC
commissions are a function of genuine export income, and (2) taxes
are paid by the recipients of DISC dividends, a domestic company is
entitled to a virtually unchallengeable tax deduction for its DISC
commissions, with no tax consequences for its shareholders.
18
Both circumstances are satisfied here. Indeed, there is no
question that (1) the commissions Summa paid to JC Export
represented a percentage of genuine export income; and (2) when JC
Export distributed those commissions as dividends to its sole
shareholder, JC Holding, that shareholder paid corporate tax on the
distribution. Thus, the commission payments were real DISC
transactions, not sham transfers lacking the economic reality
envisioned by Congress when it made such commissions tax‐
deductible. By thus legislatively characterizing payments of export
income to a DISC as deductible commissions, Congress left no room
for the Commissioner to recharacterize the payments as something
other than commissions for income tax purposes under the substance‐
over‐form doctrine or on the ground that the payments lack a non‐tax
business purpose.
These circumstances, unique to DISCs, distinguish this case
from Repetto v. Comm’r, 103 T.C.M. (CCH) 1895 (2012)
(recharacterizing IRAs’ investment earnings as excess contributions).
There, a family set up an ordinary corporation, owned by IRAs, to
which the family paid fees for sham services that were never
performed. The corporation then transferred the fees thus “earned”
to the IRAs as investment earnings. But by contrast to the DISC
program, whereby Congress afforded both economic reality and tax
benefits to the payment of export income as DISC commissions (even
when the DISC did nothing to earn the commissions), nothing in the
tax code provides similar congressional approval for treating sham
fees as a deductible expense for the payor or genuine income to the
corporate payee.
The Commissioner, nevertheless, maintains that the DISC
payments here lacked economic reality because the taxpayers did not
19
avail themselves of the opportunity afforded by the DISC program to
defer, as well as reduce, taxes on export income. We hardly think that
the DISC form is exalted over its substance when taxes are paid
sooner rather than later. Indeed, we think it would be a greater
departure from the economic reality Congress intended in the DISC
program to deny Summa the deduction Congress afforded when, as
here, genuine export income has been paid as DISC commissions and,
instead, to impose tax obligations on both Summa and its
shareholders for that transfer. In sum, we conclude that the
substance‐over‐form doctrine did not warrant the Commissioner’s
recharacterizing Summa’s lawful, tax‐deductible commission
payments to a DISC as constructive dividends to Summa’s
shareholders. In the absence of that recharacterization, there is no
basis for the Commissioner’s deficiency notice to petitioners or the
Tax Court judgment against them. Accordingly, that judgment is
reversed.
In reaching that conclusion, we do not overlook the step
doctrine, which serves the substance‐over‐form doctrine by
permitting “‘steps’ in a series of formally separate but related
transactions involving the transfer of property” to be treated “as a
single transaction” for purposes of identifying economic reality “if all
the steps are substantially linked.” Greene v. United States, 13 F.3d 577,
583 (2d Cir. 1994).9 Here, such a link might be identified from the
parties’ stipulation that the “sole reason” for all the transactions at
9 The step‐transaction doctrine appears to have three strains. One looks to whether the
steps are so interdependent that the legal relations created by one transaction would have
been fruitless without completion of the series. A second looks to whether separate steps
constitute prearranged parts of a single transaction intended to reach an end result. A
third looks to whether a taxpayer was contractually obligated to complete all steps when
the first in the series of transactions was undertaken. See Bittker & Lokken, FEDERAL
TAXATION OF INCOME, ESTATES AND GIFTS ¶ 4.3.5 (2d/3d ed. 2018 & 2018 Cum. Supp. No. 2).
We need not decide which strain might be applicable here.
20
issue—from Summa’s DISC commission payments through JC
Holding’s dividend payments to the Benenson sons’ IRAs—was to
transfer money into those IRAs, where it could grow tax‐free. App’x
102. But even assuming that viewing all the transactions as one for
purposes of identifying economic reality were to yield an answer
favorable to the Commissioner, that does not necessarily mean that
the transactions must be treated as one for purposes of restoring
economic reality.
To explain: the step‐transaction doctrine, like the substance‐
over‐form doctrine is a tool of statutory construction, not of punitive
enforcement. Thus, while it is appropriate to view linked transactions
as one in order to determine if they belie economic reality or distort
the tax code in some respect, an affirmative answer does not
automatically mandate recharacterization of each transaction in the
chain. Rather, the doctrines warrant recharacterization only to the
extent necessary to restore reality and eliminate distortion. See
generally Commissioner v. Court Holding Co., 324 U.S at 334 (observing
that “incidence of taxation depends upon the substance of a
transaction” and that “[t]o permit the true nature of a transaction to
be disguised by mere formalisms, which exist solely to alter tax
liabilities, would seriously impair the effective administration” of
congressional tax policies); Grove v. Comm’r, 490 F.2d 241, 246 (2d Cir.
1973) (observing that step‐transaction doctrine applies to
“meaningless intervening steps in a single, integrated transaction
designed to avoid tax liability by the use of mere formalisms”). Once
that is achieved, further recharacterizations to maximize each
transaction’s tax consequences risks crossing the line from restorative
to punitive.
21
Here, even assuming, as the Commissioner maintains, that the
DISC commission payments, viewed together with all other
transactions, served to conceal excess contributions to the Benenson
sons’ IRAs, see generally TIFD III‐E, Inc. v. United States, 459 F.3d 220,
231 (2d Cir. 2006) (holding that transaction having economic
substance can nevertheless belie economic reality when considered in
light of totality of circumstances), that economic reality could be
restored by recharacterizing a single transaction: JC Holding’s
payments of non‐taxable dividends into the sons’ IRAs.10 With those
dividends recharacterized as excess contributions and the sons
obligated for excise taxes, no further recharacterization is necessary
to restore the Commissioner’s professed economic reality or to avoid
distortion of the tax code.
Of course, the First Circuit, which considered the sons’ appeal
in this case, held that no such recharacterization was, in fact,
warranted. We need not here decide whether we would reach the
same conclusion because the issue is not before us. The
Commissioner’s recharacterization of the JC Holding dividends as
excess IRA contributions did not contribute to petitioners’ tax
deficiency, the focus of this appeal. That deficiency depends on the
recharacterization of Summa’s DISC commission payments as
dividend distributions to Summa shareholders. We have already
explained why that transaction, based on genuine export income that
Congress intended to make tax‐deductible, does not defy the
economic reality of the DISC program. Our point here is that, even
when the DISC commissions are viewed as the first in a series of
transactions intended to conceal excess IRA contributions, the
10 The recharacterization would recognize that the sons’ IRAs had not acquired a true
investment interest in JC Holding, which, as noted supra in footnote 2, the Commissioner
has never urged here.
22
restoration of economic reality does not require that, in addition to
recharacterizing JC Holding dividends as IRA contributions,
Summa’s DISC commissions must be recharacterized as dividends to
its shareholders. See generally Benenson v. Comm’r, 887 F.3d at 525
(Lynch, J., dissenting) (observing that “[t]his case is not about whether
the IRS must honor the commissions paid from Summa Holdings to
JC Export for corporate income tax purposes; it is about whether the
IRS must honor the Benensons’ characterization of the flow of money
from Summa Holdings to the Benensons’ Roth IRAs for excise tax
purposes”).
The Commissioner argues that, even if Summa was entitled to
deduct its DISC commission payments from its income, those
payments are still properly treated as constructive dividends to
Benenson, Jr., because the dividends were paid “for the benefit of [his]
family.” Comm’r Br. at 56. In support, he cites Hillsboro Nat’l Bank v.
Comm’r, 460 U.S. 370 (1983), wherein the Supreme Court observed
that “a payment by a corporation for the benefit of its shareholders is
a constructive dividend,” id. at 392. The case does not help the
Commissioner here. At issue in Hillsboro was the proper construction
of 26 U.S.C. § 164(e), a tax code provision affording corporations a
federal deduction for state taxes paid on behalf of their shareholders.
The Court recognized such a tax payment as a constructive dividend
to the obligated shareholders, which would generally not be
deductible by the corporation. See id. The statute, however, expressly
afforded the deduction. See id. at 393 (“In at least some circumstances,
a deductible dividend is within the contemplation of the Code.”).
Moreover, as to the precise point in dispute, Hillsboro held the
deduction to apply even though the state, upon a change in law, had
there issued refunds to the shareholders. See id. at 394 (observing that
statutory focus was on “act of payment”; as long as payment was not
23
“negated by a refund to the corporation,” corporation was not
required to recognize income). Thus, in Hillsboro, what started as a
non‐deductible constructive dividend was made a corporate
deduction by Congress. There was no need for the Supreme Court to
apply the substance‐over‐form doctrine to identify Congress’s intent.
By contrast here, the transaction at issue—the payment of a
percentage of export income as DISC commissions—starts as a
congressionally authorized deduction. The Commissioner seeks to
recharacterize it as a constructive dividend, not because the
corporation satisfied any shareholder obligation; indeed, there was no
shareholder obligation here to fund the Benenson sons’ IRAs. Rather,
the Commissioner urges recharacterization because the shareholder,
at his discretion, had DISC assets directed to his sons’ IRAs. Nothing
in Hillsboro supports the Commissioner’s conclusion.
If Summa was entitled to a deduction for its DISC commissions,
as we conclude it was, and if the economic reality of excess
contributions to the Benenson sons’ IRAs could be restored by
recharacterizing JC Holding’s dividend payments as excess
contributions, then substance‐over‐form does not require that, at the
same time Summa is allowed to deduct its DISC commissions, those
commissions be recharacterized as dividends to Summa’s
shareholders, specifically, petitioner Benenson, Jr. That conclusion is
reinforced, moreover, by the fact that not only did Summa’s
commission payments to the DISC not defy the economic reality of
that program as established by Congress, but neither did the initial
transfer of those commission payments out of the DISC. That transfer
was in the form of dividends to DISC shareholder, JC Holding. The
Commissioner has not challenged JC Holding’s acquisition of the
DISC’s shares. Meanwhile, JC Holding paid the required corporate
taxes on the DISC distribution, which were likely more than the
24
dividend taxes Summa shareholders would have paid. 11 Thus,
whatever concerns might arise about the further transfer of funds from
JC Holding to the sons’ IRAs, the transactions up to that point, from
Summa to JC Export, and from JC Export to JC Holding, do not lack
the economic reality Congress intended in establishing the DISC
program.
This is evident if one considers a hypothetical scenario in which
JC Holding, upon receipt of the JC Export DISC dividends, made
distributions to the sons’ IRAs only in amounts equal to their eligible
contributions. That would not have distorted code limits on IRA
contributions nor have concealed excess contributions. That scenario
may be unlikely because it would offer the taxpayers here few, if any,
benefits. Nevertheless, the hypothetical demonstrates why we
remain of the view that, even if the transactions at issue, viewed as a
whole, were correctly determined by the Commissioner to conceal the
economic reality of excess IRA contributions, the only
recharacterization warranted would recognize JC Holding’s dividend
distributions to the Benenson sons’ IRAs as excess contributions. To
the extent the Commissioner went further and also recharacterized
Summa’s lawful commission payments to a DISC as non‐deductible
dividend distributions to Summa shareholders, and on that basis
identified a 2008 tax deficiency against petitioners, the Tax Court
judgment upholding that deficiency is hereby reversed.
11 Indeed, because no deficiency judgment was entered against Summa’s 76.05%
shareholder, the family trust, see supra at 4 n.1, the taxes the Commissioner seeks to recover
from petitioners by recharacterizing Summa DISC commissions as shareholder dividends
are only a small percentage of the corporate taxes JC Holding paid on the entirety of such
commissions in 2008.
25
CONCLUSION
To summarize, on this appeal, we review a Tax Court decision
supporting deficiency judgments for 2008 against petitioners, their
sons, and Summa Holdings, Inc., a family‐controlled corporation. We
conclude as follows:
1. Although the First and Sixth Circuits, upon review of the
same decision, concluded that the substance‐over‐form
doctrine did not support the deficiency judgments against
Summa or the petitioners’ sons, petitioners cannot
demonstrate the mutuality of parties necessary to preclude
the Commissioner from relying on the doctrine to defend
the judgment against them.
2. On de novo review, the substance‐over‐form doctrine does
not support recharacterization of Summa’s payment of tax‐
deductible commissions to a DISC as taxable constructive
dividends to Summa shareholders and, thus, cannot
support the tax deficiency attributed to petitioners.
3. Application of the step doctrine, together with the
substance‐over‐form doctrine, warrants no different
conclusion. While all related steps in a series of transactions
are properly considered as one in identifying the substance,
or economic reality, of those transactions, recharacterization
of the transactions is warranted only to the extent necessary
to restore economic reality and to avoid distortion of the tax
code. Here, even if, contrary to our sister circuits, we were
to view the DISC commission payments as the first step in a
series of transactions that had the economic reality
identified by the Commissioner, i.e., the concealment of
26
excess contributions to petitioners’ sons’ IRAs, a single
recharacterization suffices to restore reality, specifically,
recharacterizing JC Holding’s dividend payments to the
sons’ IRAs as excess contributions subject to excise tax. That
recharacterization does not support the deficiency judgment
against petitioners. And the recharacterization that does
support the judgment—the treatment of Summa’s DISC
commissions as constructive dividends to its shareholders—
is not warranted by the substance‐over‐form doctrine.
Accordingly, the judgment in favor of the Commissioner is
dismissed, and judgment is entered in favor of petitioners.
27