Paul L. Caron

Monday, March 12, 2018

Lesson From The Tax Court: The Common Law Of Tax

When I go abroad and introduce U.S. law and legal systems to lawyers from civil law countries, they are generally surprised that U.S. judges have so much power. They rightly perceive that the “common law” is really a license of power to judges, a power that is only broadly constrained by other government actors. This power allocation to the judicial branch is, however, an essential part of the U.S. political system, a system designed to resist a corrosive and corrupting concentration of power into any one person or small group of people. Our system carves up power both horizontally—think legislative v. executive v. judicial—and vertically—think state v. federal.

Our law schools inculcate the common law tradition into our students starting in the first year. In fact, despite nods to leg/reg courses, the first year curriculum is still mostly about the common law.  And the Socratic method is, in large measure, a method that works to establish common law thinking methods in our students, notably in how it forces students to pay attention to facts. Facts matter in the common law. We teach them to matter to students. And some of those students eventually become Tax Court judges.

We tax lawyers tend to forget the great common law tradition that undergirds the U.S. legal system. After all, we work from that Bodacious Compendium of rules in the Internal Revenue Code and associated regulations. But even in such a textually bounded area of law as tax, the common law persists. For example, the tax question about “who” must pay tax on an item of income is largely common law, even when it intertwines with various tax statutes, notably the grantor trust rules in §671 et seq. When I teach assignment of income, I tell my students to leave their statutory supplements at home.  We're in common law country. 

The importance of common law to tax is the lesson I draw from the Tax Court’s opinion last week in the consolidated cases of Celia Mazzei v. Commissioner and Angelo L, and Mary E. Mazzei v. Commissioner, 150 T.C. No. 7 (March 5, 2018). The taxpayers in these cases played around with various entity structures to try and avoid the contribution limits to their Roth IRAs. The IRS caught them out. The Tax Court sustained the IRS NOD and the Judges wrote three opinions totaling 104 pages. The majority, in an opinion by Judge Thornton (joined by 11 others) uses common law rules developed in the assignment of income area to sustain the IRS’s Notice of Deficiency. Judges Paris and Pugh, who joined the majority, also pen a concurring opinion that emphasizes the common law question (and are joined by three of the others who also joined the majority). Judge Holmes (joined by three others) dissents, believing that the relevant tax statutes trump the common law.

The clash of opinions are good reading, not only for their very satisfying lesson about the role of common law in our system of taxation but also because they really do clash: Judge Holmes basically accuses the majority of channeling the Emperor Caligula and Judge Thornton labels some of Judge Holmes’s claims “bizarre.”

Details below the fold.

Mr. Mazzei invented new types of injector technology in the 1970’s, primarily for agricultural uses, but also for water treatment, win production, and spa manufacturing. He, his wife Mrs. Mary Mazzei, and their daughter, Ms. Celia Mazzei together own a couple of S Corps which together made up another pass-through entity called Mazzei Injector Co. Here’s their business website.

The Mazzeis made lots of money. They wanted to save a healthy portion of it for retirement. I’m no retirement expert and so I don’t know why they just did not create a SEP or other small-business retirement plan. Instead, they decided to play around with IRAs.

In 1997 Congress created the Roth IRA. It’s like a traditional IRA in that earnings in the account accumulate tax-free. It’s real upside, however, is that distributions are also untaxed. In contrast, the earnings accumulated within a traditional IRA are taxed when the taxpayer starts taking distributions. The upside to a traditional IRA, however, is that for taxpayers up to a certain income level, the contributions themselves are deductible from gross income. In contrast, contributions to a Roth IRA are never deductible. For most taxpayers—those who can choose to take a current deduction now or else enjoy tax-free distributions later—the difference is really a timing issue because the government gets the economically equivalent amount of tax either way, assuming all else is equal over time. But because individual circumstances change, timing might matter. The Tax Policy Center has this good explanation of these issues.

You might think that really wealthy taxpayers—those who would not be entitled to a deduction for contribution to a traditional IRA—would always contribute to Roth IRAs since the deduction benefit for traditional IRA contributions is not available. Nah. Congress thought of that and §408A prohibits really wealthy taxpayers from contributing anything to a Roth. Here’s the IRS website that gives the limits. Notice those limits are the same as the limits for taking deductions for contributions to regular IRAs. Bottom line: if you are too rich to get the deduction to the traditional IRA, you are too rich to get to use a Roth IRA. Instead, you are stuck with making a non-deductible contribution to your regular IRA, the earnings on which will also get taxed on distributions. Bummer. But hey, at least you’re rich.

These are the limits that the Mazzeis were trying to get around. Here's how they tried.  In 1998 each taxpayer created the following three-part structure to fund their Roth IRAs. First, they each created a Roth IRA and contributed $2,000 to it (while the Tax Court is skeptical that they were below the income cut-off to make such contributions, the government basically conceded the $2,000 contribution was legit). Second, they caused their Roth IRA to spend $500 to buy stock in Western Growers Shared Foreign Sales Corp., Ltd (“Western Growers FSC”). Third, Mazzei Injector Co. and Western Growers FSC signed a sales agreement whereby Western Growers FSC would pay certain amounts to Western Growers FSC each year. FSC would report those amounts as income and pay 15% income tax on them, then would distribute the balance into the Roth IRA’s.

This structure allowed the Mazzeis to transfer over $533,000 into their Roth IRAs between 1998 and 2002. They did so by making Mazzei Injector Co. pay Western Growers FSC $558,555 over those years. Western Growers FSC paid $25,499 in taxes on that income and then distributed the rest to the Roth IRAs.

Without this structure, §408A would have prohibited the Mazzeis from making any contribution to their Roth IRAs because they made too much. The Mazzeis, however, apparently did not escape the dot-com bust in 2001. Notes the Tax Court: “the sum of petitioners’ account balances at the close of 2002 was less than the $533,057 paid by the FSC because of investment losses in the Roth IRA accounts.”

The potential problem with this structure is that it is vulnerable to the assignment of income doctrine. That doctrine answers the “whose income is it” question. It says that a taxpayer must pay tax on the income earned by the taxpayer’s own efforts or property, even if a third party actually receives and enjoys the income. The classic example is Lucas v. Earl, 281 U.S. 111 (1930) where Mr. Earl, a lawyer, signed a contract with his wife in 1901 that provided any income he earned was to be received by both of them “as joint tenants and not otherwise.” The Earls argued that language meant that Mr. Earl’s earnings from his law practice became joint property the instant he earned them and so half of what he earned was really Mrs. Earl’s income. A very grumpy Justice Holmes rejected that argument by reading the statute as forbidding any “arrangement by which the fruits are attributed to a different tree from that on which they grew.”

Ever since 1930 the courts have developed the common law of the assignment of income doctrine. In addition to the undying metaphor of fruit and trees, one key principle courts use to figure out the proper attribution of income is the principle of control. The classic case on that idea is Helvering v. Horst, 311 U.S. 112 (1940). There, Mr. Horst tore off interest coupons from some bonds he owned and gave them to his son. The son collected the income from the interest coupons and had a good ole time. In holding that the payment of interest on the coupons was really dear ole dad’s income, the court focused on control: “The power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment, and hence the realization, of the income by him who exercises it.”

Last week’s case, however, is not an income tax case. That is because the IRS did not discover these payments until 2007, during an audit of one of the S corporations. By then, the period of limitation for assessing income tax deficiencies had run. So the assignment of income doctrine was not directly an issue.

Last week’s case is an excise tax case. That is, the IRS had dinged the taxpayers here for an excise tax under §4973. A taxpayer who contributes over the permitted limit to an IRA becomes liable for an excise tax of 6% of the lower of two amounts: (a) the excess contribution remaining in the account at the end of the year; or (b) the fair market value of the account at the end of the year. Since the Mazzeis had not filed a return reporting or paying that excise tax, the assessment period was still open.

So the question before the Court was not directly “whose income” was the payment by the FSC to the Roth IRAs.  But it was close.  Here’s how the Court framed the question:

"Under the plain terms of section 408A, value may enter a Roth IRA in only two ways: as a contribution, see sec. 408A(c), or as income on an investment held by the Roth IRA, see secs. 408A(a), 408(e)(1). Respondent argues that the payments were contributions by petitioners, whereas petitioners argue that the FSC paid dividends, i.e., a form of income, directly to the Roth IRAs. The critical question, then, is whether the funds transferred from the FSC to petitioners’ Roth IRAs were contributions (as respondent claims) or income (as petitioners claim) to the Roth IRAs."

Here’s how the Court ties that in to the common law assignment of income doctrines:

"On the record before us, it is evident that the payments from the FSC were dividends to someone--either to petitioners or to their Roth IRAs. An old and well-developed body of law explains how we are to decide who, in substance, receives income under the Code."

That is, the Court feels called upon to apply the same common law that answers the “whose income is it” question to this question of “who” was making the payments into the Roth IRA: the Western Growers FSC or the taxpayers through Mazzei Injector Co.  Judges Paris and Pugh emphasize this in their concurrence: “The sole issue we decide today is who in substance owned this FSC---petitioners or their Roth IRAs.”

Framing the question this way, Judge Thornton’s opinion is a masterful explication and application of the common law assignment of income. Basically, the opinion carefully walks through all of the transactions, showing how the individual taxpayers here retained control in every step.

Judge Holmes’s dissent takes issue with how Judge Thornton frames the question to begin with. Judge Holmes believes that the statutory structure creating FSCs prevents the Court from engaging in the “who” question at all. Judge Holmes points out that the entire purpose of the FSC statutes was to allow taxpayers to create shell companies that serve no independent purpose. Sure, the reason Congress did that may have been to give taxpayers engaged in international trade a safe harbor from certain complex transfer pricing rules, but hey! the form was permitted and Judge Holmes believes that the statutory scheme should constrain the Court’s power to use common law assignment of income doctrines to upset the taxpayer’s chosen structure.

Judge Thornton’s opinion takes Judge Holmes’s dissent very seriously, giving over nine pages of the opinion to refuting the various ideas contained in the dissent. Judge Thornton has a very nice explanation of what FSCs are for: they exist to “provide a lower corporate rate for qualifying export-related income...irrespective of who owned the FSC stock.” In other words, the statutory blessing for taxpayers to assign certain amounts of their export-related income to an entity whose sole purpose was to achieve lower tax rates on income was limited to just that: income tax rate reduction for certain qualified income. The structure was not a license to use the shell companies to avoid IRA contribution limitations. So the Court should not be restricted in using its common law powers to decide whose income was being used to fund the Roth IRA.

In my view, Judge Thornton has much the better reasoned opinion. Judge Holmes’s concern about judicial over-reach is laudable, but the concern is just as misplaced here as it was in the Sixth Circuit’s opinion in Summa Holdings Inc. v. Commissioner, 848 F.3d 779 (6th Cir. 2017). Judge Holmes in fact borrows from Summa opinion’s opening. He says the majority “acts like Caligula, who famously posted tax laws in fine print and so high that Romans could not read them.” But that is mindless hyperbole. Courts exercising common law powers are nothing like Caligula, a despot who worked to undermine the rule of law and concentrate power in his person.  He was a nasty piece of work.

If anyone in our time is acting like Caligula it’s the members of Congress who write the Tax Code. It is, in fact, the very accessibility of the Code’s language that allows very smart tax lawyers and advisors to concoct their schemes. The IRS is not despotic when it attempts to figure out whether those schemes comply with the law. And Courts do not act like despots when they exercise their common law powers to apply the law to the facts to come to a reasoned decision on a question that results from the gaps created by the very complexity of those accessible tax statutes.

Congress can restrict the common law power of courts. Go look at the grantor trust statutes, which partially codify the assignment of income common law as applied to trusts. Notice the focus of those statutes is on control. Treasury can also restrict the power of courts. The Supreme Court, in National Cable & Telecommunications Association v. Brand X Internet Services, 545 U.S. 967 (2005), has said that even court decisions about statutory meaning may be constrained by agency regulations. And go look at the regulations on hedging transactions in Treas. Reg. 1.1221-2(a)(3) where Treasury claims exclusive power to define hedging transactions, seemingly preventing courts from exercising their otherwise common law power, power the Supreme Court had exercised in prior cases, such as Corn Products and Arkansas Best.

Judges Thornton and Holmes disagree about whether Congress has here restricted the common law power of courts. It will be interesting to see what the Ninth Circuit says, if the taxpayers take an appeal.

Bryan Camp, Legal Education, New Cases, Tax | Permalink


@John: The answer to your last question is "probably not." I'm not real savvy on criminal law or tax crimes but the leading case on prosecution for evasion is Cheek v. U.S. 498 U.S. 192 (1991), available here: That case stands for the proposition that to be convicted of the crime of tax evasion, one must act "willfully" to evade tax and having a good faith but unreasonable belief that what one is doing is legal is not enough to support a conviction. ...I think I got that right!

Posted by: Bryan Camp | Mar 14, 2018 8:18:49 AM

Many thanks, Bryan. Your reply shows that there may sometimes be a difference between United States law and the law in many British Commonwealth jurisdictions. As I understand it, while mistake of fact is generally a good defence, both common law groups disallow mistake of law as a defence to a criminal charge, including charges of tax evasion in the sense of fraudulent under-reporting of income. Further, it is no defence that a mistake of law is caused by relying on advice from one's attorney. For instance, if a cuckold murders his wife's lover the cuckold cannot rely on advice from his attorney that killing adulterers is permitted.
From your post, it seems that in the USA mistake of tax law is a defence to a charge of evasion if the mistake comes from reliance on advice from a tax accountant, or, presumably, attorney. Presumably, this is an exception for tax law from the general proposition that mistake of law caused by wrongful advice is no defence.
The position in Commonwealth countries is not so clear. Cases go both ways, as I explain in the papers cited in my earlier post. What is tolerably clear, however, is that a mistake of tax law caused by bad advice is more likely to be accepted as a defence than a mistake in respect of non-tax law, though as far as I know no court has attempted to rationalise this distinction. Generally, a mistake as to the law under which one is charged is not a defence, but bad advice about law other than that under which one is charged may sometimes be a defence.
The question of reasonableness can add complexity. In criminal law, the relevant test is generally the accused's actual belief, even if unreasonable. But in prosecutions for tax evasion it is sometimes said that reliance on advice can be a defence only if the reliance was reasonable. For instance, could a US taxpayer defend a charge of evasion on the basis of too-good-to-be-true advice from Jenkens & Gilchrist?

Posted by: John Prebble | Mar 14, 2018 8:09:58 AM

@John: Yes, the U.S. statutes have a similar provision. Section 6501(c) provides that the limitation period for assessment is unlimited when a taxpayer submits a false or fraudulent return with an intent to evade tax. The IRS has the burden to prove fraud by clear and convincing evidence. It does not appear that the Mazzeis were anywhere near that line, however. They were relying on a structure that various folks told them was a legit method to circumvent Roth contributions limits. And, as others have noted, they had decent case law support in the Summa holding. Notice that the Tax Court majority refused to allow even the accuracy related penalties because it found the Mazzeis has reasonably relied on their return preparer, a CPA.

Posted by: Bryan Camp | Mar 13, 2018 9:57:32 AM

In the Mazzei consolidated case, should the tax inspector have conceded without a fight that the IRS was time-barred in respect of an amended assessment of income tax? Section 108(2) of the New Zealand Tax Administration Act 1994 provides that there is no time bar where the tax return is fraudulent or misleading or does not mention income which is of a particular nature or was derived from a particular source. Is there a similar provision in the US Code? The arguments for applying a rule like section 108(2) are:
1. (A common law rule) Where one party (the Commissioner) has a legitimate interest in information (the circumstances of the contributions to the Roth IRAs) it is fraudulent for the other party (the Mazzeis) to fail to bring that information to the attention of the Commissioner. See my papers and
2. The Mazzeis' income that went into the Roth IRAs and that would have come out again had the Mazzeis correctly returned it was "of a particular nature or derived from a particular source".
I know of no case where a Commissioner has run arguments along these lines, but Mazzei might have been a good test bed. In fact, since it seems that the US Commissioner has not issued amended assessments in respect of the Mazzeis' tax deficiencies that opportunity may still be available if the US Code includes a provision like the New Zealand section 108(2).
John Prebble.

Posted by: John Prebble | Mar 13, 2018 9:47:38 AM

Is 104 pages a record for a Tax Court decision? What is the shortest decision that gives reasoning?

Posted by: Eric Rasmusen | Mar 13, 2018 7:33:02 AM

As the courts take over the task of creating just results from defective laws they create a moral hazard for legislators. Unjust results are, in fact, the best penalty for sloppy legislating. Out legislators need to be properly embarrassed rather than bailed out by the courts.

Posted by: AMTbuff | Mar 12, 2018 1:57:05 PM

Great article, Bryan. These opinions sound like a good way to learn a lot about tax jurisprudence. Should somebody write a law review article on the opinions?

Posted by: Eric Rasmusen | Mar 12, 2018 11:50:52 AM

Thanks for this post, Bryan.

With the caveat that I only know the DISC regime and am assuming the FSC regime’s similarity, I think the dissent gets it right (although it is hyperbolic). Jasper Cummings’ analysis of the Summa case strikes me as on point: “If the exporter can shift export income to shareholders, it can shift export income to the shareholders’ kids. And if it can shift the income to the shareholders’ kids, it can shift the income to the shareholders’ IRA. And if to an IRA, why not a Roth IRA?” See . That article does note an argument it wishes the government made against DISCs, which resembles the majority’s position in Mazzei (trying out an assignment of income/tax ownership argument), but even it agrees the argument “is a stretch.”

The majority states that “the text of section 925 extends exceptions [from substance doctrines and transfer pricing], specifically, to a very narrow set of circumstances, i.e., (1) commission payments, sales, etc. that are (2) related to export sales in a very clearly defined way (3) between parties that are related (under the section 482 definition of a related party), one of which is a qualifying FSC.” But that should mean the dissent is right, as the issues of tax ownership, assignment of income, and transfer pricing are intimately bound up. That is, transfer pricing’s entire methodology is based on looking at the distribution of risk and upside potential among related parties in order to appropriately assign income to its true earner. And per Frank Lyon, tax ownership depends on exposure to risk and upside potential. Thus, by giving a formula-based replacement to the transfer pricing regime, the DISC/FSC regimes implicitly require a similar deemed allocation of risk and upside potential. This in turn must mean that conventional understandings of tax ownership must be replaced for purposes of FSCs/DISCs.

Resultantly, the majority’s insistence on using conventional understandings of tax ownership leads to nonsensical outcomes. The dissent rightly notes that the majority’s reasoning makes it hard to understand how anyone could own FSC stock, as clearly any FSC stock owner is exposed to no risk from owning the shares, nor any upside potential (except to the extent the commission-paying corporation decides to play nice). And as the dissent notes, “the majority . . . says that because Injector Co. controlled how much cash went into the FSC, an unrelated Roth IRA couldn't have expected any upside benefits from its small investment. That's true, but proves too much — any commonly controlled corporations between which the owners could readjust contractual rights at any time would be in the same situation.” Of course, the Code polices other commonly controlled corporations using transfer pricing, giving such transactions a more economically-bound allocation of risk/reward and thus tax ownership, but that was already addressed in the previous paragraph.

All that said I will admit I think courts have over-enlarged their common law powers, to the detriment of the development of the tax law (as deep readings of statutes, and the creation of statute-specific common law, are too often replaced with reliance on the substance doctrines as a general purpose tool for disposing of cases).

Posted by: Mark Mullin | Mar 12, 2018 11:39:36 AM

Victor is too modest! Anything he writes is worth reading. Here's a link to the first edition of his book (2003): The second edition (2016) is co-authored with Kim Brooks and Borbala Kolozs and available here:

Posted by: Bryan Camp | Mar 12, 2018 10:24:30 AM

I am not sure that such a sharp distinction between civil and common law countries, in particular in the tax area, is warranted. Those interested in this question can find further discussion in my book Comparative Tax Law.

Posted by: Victor Thuronyi | Mar 12, 2018 10:17:56 AM