Captives Receive Great News, IRS loses on Substance over Form

Richard M. Colombik, of TLS Marketing and Management Services, LLC , and Jeremy P. Colombik, of Management Services International (MSI), discuss the IRS and their approach to substance over form.

One of the biggest areas the IRS has focused on in the captive industry in determining what they perceive as a valid captive. One of their favored arguments that they ultize is the issue of substance over form.

So what does substance over form mean?  Substance deals with the underlying type of the transaction, versus the form, the documentation,  of how the transaction should be recorded.

The Commissioner generally argues that the substance of the transaction and not the form must determine its tax consequences.

In Summa Holdings, Inc. v. Comm’r, T.C. Memo 2015-119, the 6th Circuit Appellate court has partially put a leash on the IRS Commissioner to argue that a transaction, if done solely for income tax purposes may be set aside, on substance-over-form arguments, if the transaction clearly follows the Tax Code! It does not sweep away this overly broad tool of the IRS to claim that a transaction should be recharacterized because a business chose the lowest tax method to structure the transaction, but allows such structure, if it is a path that Congress intended.

The IRS Commissioner cited the preeminent case of Gregory v. Helvering, 293 U.S. 465, 469-470, 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, 573, 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.

Essentially all the standard arguments were made and the tax court in Summa Holdings, ruled accordingly that this was a run of the mill substance over form case.  Government wins.

Wait a minute, why are we writing about this?

The Appellate Court for the 6th circuit said bunk!

The 6th circuit began their 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, 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. Thus, lowering one’s tax bills is an acceptable form of planning.

The Court further 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 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.

As to 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.”  So, Commissioner, per the 6th Circuit, you do not have the authority to recharacterize a transaction when done in accordance with the Code, solely because you want to increase taxation from the transaction.  A taxpayer may choose the lowest or lower tax path from a transaction.  This is, in essence, a narrower reading of the Court Holding doctrine,

Are Captives allowed by the Tax Code?  Yes, they are.  May a properly formed and properly structured Captive also assist not only in risk management and providing valuable insurance coverage, but also reduce a company’s income taxation?  Yes, it may.  Did Congress create and write legislation to allow insurance companies to exist and provide exceptions in the Code for taxation small captive insurance companies in IRC Sec.831(b)?  Yes, it did!

Therefore, if an insurance company is properly formed, risk shifting and risk distribution is followed and adequate capitalization and licensing are present is a Captive allowed to exist even if it saves a client money?  ABSOLUTELY!

It seems that the IRS’ biggest problem with captives has to do with the tax benefits small captives  are allowed under IRC Sec. 831(b) for  captive owners.  This case can now assist captive owners with the argument that it is irrelevant that owners of a captive receive tax benefits which can include a reduction in their taxation and that they should be allowed to receive these benefits of an insurance company by law.

The ruling of the 6th Circuit Appellate Court seems to confirm a well-established trend by courts to sanction structures that, even if purely tax-driven, comport with the expressed provisions of the Code.  E.g., UPS v. Commissioner, 254 F. 3d 1014 (11th Cir. 2001). Despite this, the IRS seems resigned to continue to fight to avoid allowance of the lowest possible taxation in a transaction.  However, provided the courts rein in and narrowly interpret the substance over form doctrine, the IRS  may find this doctrine has a lower utility value as a sword to try and smote well-thought-out tax planning.

By Richard M. Colombik, JD, CPA

Co-authored by Jeremy P. Colombik, CPA

Richard M. Colombik, JD, CPA is a member of TLS Marketing and Management Services, LLC a Puerto Rican Limited Liability Company that provides consulting and tax planning services.  Mr. Colombik has lectured extensively on income taxation and tax planning, as well as publishing articles on a national, local and regional basis.  He has been an IRS Liaison for State and National Bar Associations and has chaired State and Local Bar Association’s Tax Committees.  He is an honors Graduate from the John Marshall Law School, where he currently serves on its Alumni Board and has received a Distinguished Service award for his work on behalf of his alma mater.

Jeremy Colombik, CPA is an experienced, licensed financial professional.  He is a graduate of Western Illinois University, having obtained a bachelor of business degree with a major in finance.  Jeremy is a licensed CPA and a member of the American Institute of Certified Public Accountants, and the North Carolina Association of Certified Public Accountants.  Furthermore, he has been in the captive industry for over 10 years and is a member of the Captive Insurance Companies Association and the North Carolina Captive Insurance Association.  In addition, he serves as Chairman for the North Carolina Captive Insurance Association.  Jeremy is the President of Management Services International (MSI).  MSI currently manages over a hundred businesses that are utilizing a captive insurance company structure.  MSI currently is one of the largest captive managers in the state of North Carolina.  Jeremy specializes in IRC Sec. 831(b) captives.  He is a sought-after speaker for professional groups, such as: CPAs, lawyers and financial advisors, on how a captive structure works and could be a great benefit to their clients.


12 August 2024
5-6 November 2025

Michigan captive premium tops $3 billion

Captive premium for 2023 was up 25% on the previous year, with the number of captives in the...

Ratings affirmed of NextEra Energy captives

Includes ratings for new Delaware captive formed in 2022 providing coverage for specialty property, professional lines and other...

Berkley A&H expands captive leadership team with hire

Mike Madden rejoins Berkley Accident and Health after spending the last 12 years at Artex Risk Solutions  ...

New York State eyes new captive legislation

Several bills currently going through the New York State legislature to introduce new captive insurance rules   New...