The Four Questions Q3: Why does the U.S. employ a “substance over form” tax system?


Jack Brister

Founder, International Wealth Tax Advisors

Jack Brister, Founder of International Wealth Tax Advisors, is a noted international tax expert, with over 25 years of experience. Jack specializes in U.S. tax planning and compliance for non-U.S. families with international wealth and asset protection structures. Jack is a frequent featured speaker at numerous international financial conferences and has been named a Citywealth Top 100 U.S. Wealth Advisor.

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The overarching concept of the U.S. tax system is to tax the economic substance of a transaction or series of transactions.

The principle of substance-over-form is the cornerstone of the U.S. tax system and can be a lethal weapon in the U.S. tax authority’s arsenal.  This doctrine allows the tax authorities to ignore the legal form of an arrangement and to look at the substance of the transaction(s) in order to prevent artificial structures from being used for tax avoidance purposes.

It is likely the origins of the U.S. tax system employing substance-over-form rather than form-over-substance is derived from the U.S. legal system and its basic principles of taxation.

The U.S. legal system is a common law system which is one of two primary legal systems in the world: common law and civil law.

The U.S. common law system has its origins from the English courts of equity for which the primary purpose was to provide appropriate remedies to complaints based on equitable principles taken from various sources.   These principles were then used to employ the concept of judicial precedent.  Hence, substance-based rulings.

Civil law on the other hand is believed to originate from the code of laws compiled by the Roman Empire under the rule of Emperor Justinian.  These rules are more rigid because judgements are primarily reliant on the written statutes whereas the common law system is heavily based on principles of equity.

The basic principles of the U.S. federal income tax system encompass the basic principles of taxation: efficiency, certainty and simplicity, flexibility, effectiveness and fairness, neutrality and citizenship which have been further developed through the basic principles of U.S. common law or judicial precedent.

The principal of efficiency states a system of taxation be organized and cost-effective.

The principle of certainty and simplicity state the tax laws be easily understood even without a background in law or accounting; and the principle of flexibility provides that the law can change to meet the government’s need for revenue.   Unfortunately, there are many that would say that the U.S. system does not employee the principle of simplicity but certainly applies the principle of flexibility.  The original tax code enacted in 1913 that met the U.S. constitutional standards was 800 pages.  Currently it is over 10,000 pages. This is partly because the Internal Revenue Code (United States Code, Title 26) changes the law as needed by exceptions to the general rule, and exceptions to the exceptions when the law requires changes (i.e., flexibility).

The principle of effectiveness and fairness requires consequences for not paying the tax due.  In addition, the system is a progressive system and therefore requires those who can pay more will pay the majority of the bill.  In some recent statistics 97{24b144b2367bbb07d5d4fda493087790376b70e35be933d1efb47b5fb6de27b5} of the total U.S. income taxes is paid by the upper 50{24b144b2367bbb07d5d4fda493087790376b70e35be933d1efb47b5fb6de27b5} of the income earners.  Of this group the top 1{24b144b2367bbb07d5d4fda493087790376b70e35be933d1efb47b5fb6de27b5} pay 37{24b144b2367bbb07d5d4fda493087790376b70e35be933d1efb47b5fb6de27b5} of the income tax collected, the next group (2{24b144b2367bbb07d5d4fda493087790376b70e35be933d1efb47b5fb6de27b5} to 5{24b144b2367bbb07d5d4fda493087790376b70e35be933d1efb47b5fb6de27b5}) of the top income earners pay 20{24b144b2367bbb07d5d4fda493087790376b70e35be933d1efb47b5fb6de27b5} of the total income taxes collected.  So, the top 5{24b144b2367bbb07d5d4fda493087790376b70e35be933d1efb47b5fb6de27b5} income earners pay almost 60{24b144b2367bbb07d5d4fda493087790376b70e35be933d1efb47b5fb6de27b5} of the total income taxes collected.  This means the top 5{24b144b2367bbb07d5d4fda493087790376b70e35be933d1efb47b5fb6de27b5} of the income earners pay the majority of the U.S. income taxes.

 The U.S. principle of neutrality entails that the tax laws apply to all individuals and businesses equally and should not affect the person’s spending decisions (i.e., not hinder overall economic flow / decisions).

 The principle of taxation by citizenship provides that a U.S. person (including U.S. entities, trusts and estates) is taxed as a result of being a citizen or having permanent resident status regardless if they live in the U.S. or abroad.  It is a system of taxing a person’s worldwide income, the income from wherever derived.  Of all the industrialized countries, the U.S. system is the only system of income taxation that is based on the citizenship.  Under U.S. tax law a person includes U.S. entities, trusts and estates because they have separate legal and fiscal personalities; and an individual person with permanent resident status is treated as a citizen for U.S. tax purposes.

Hence, by encompassing the principles of taxation into one simple doctrine, substance-over-form, the U.S. courts have guaranteed the taxation of worldwide economic substance (a common law principle of equity) and minimized tax evasion and avoidance with the use of domestic and international structures by U.S. persons.