Mazzei v. Commissioner and the Impact on IC-DISC

On June 2, 2021, the United States Court of Appeals for the Ninth Circuit announced its decision in favor of the appellant taxpayer in Mazzei v. Commissioner, reversing a March 2018 judgement by the United States Tax Court and strengthening the case for individuals to use IC-DISCs to fund their Roth IRAs without limitation.

In Mazzei v. Commissioner, the appellants had established a Foreign Sales Corporation (“FSC”) under since-repealed provisions of Internal Revenue Code sections 921 through 927. The Mazzeis then made their Roth IRAs formal shareholders of their FSC. The appellants’ export corporation paid commissions into the FSC, upon which the FSC paid a modest amount of tax pursuant to the specific FSC tax rules.  The FSC’s after-tax income was then paid out as dividends and distributed to Mazzeis’ IRAs rather than to their export corporation. As a result, no tax was paid when the money was received into the Roth IRAs, and no tax would be paid on qualified withdrawals from the Roth IRAs. Under this arrangement the IRAs could receive these dividends as annual contributions without the usual limitations imposed on IRAs.

Taking issue with the facts above, the Commissioner of Internal Revenue argued in the United States Tax Court that the court should use substance-over-form doctrine to characterize the Mazzeis, not the IRAs, as the real owners of the FSC. Agreeing with this characterization, the United States Tax Court announced its decision in favor of the Commissioner on March 5, 2018. As a result, the appellants would be deemed to have received the dividends; their contributions to the Roth IRAs from the dividends would then exceed the statutory limits for such contributions, and they would consequently be liable for excise taxes on the excess contributions.

Upon appeal by the Mazzeis, the United States Court of Appeals for the Ninth Circuit concluded that the Tax Court erred by invoking substance-over-form principles to effectively reverse congressional judgment. In the decision, Judge Daniel P. Collins relied on three precedent cases involving IC-DISCs with similar Roth IRA structures, Benenson v. Commissioner, James Benenson III and Clement v. Commissioner, and Summa Holdings Inc. v. Commissioner, decided by the First, Second, and Sixth Circuits, respectively. Judge Collins stated, “All three courts reversed the Tax Court and disallowed the invocation of substance-over-form principles to undo the congressionally authorized separation of substance and form that is involved in a DISC.” He further explained that it is not the role of the courts to “save the Commissioner from the inescapable logical consequence of what Congress has plainly authorized.”

This decision bolsters the already strong case law supporting the strategy of using an IC-DISC to fund Roth IRAs, further establishing that substance-over-form doctrine cannot supplant what Congress has plainly authorized. As a result, companies should feel secure in using IC-DISCs to fund their Roth IRAs without limitation.