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Second Circuit Reverses Tax Court; Roth IRA Arrangement Did Not Lack Economic Substance

(Parker Tax Publishing January 2019)

The Second Circuit held that approximately $2.2 million in commissions paid by a corporation to a domestic international sales corporation (DISC) were improperly recharacterized by the Tax Court as constructive dividends under the substance over form doctrine. The Second Circuit found that the commission payments were legitimate DISC transactions, not sham transfers, because (1) the commissions represented a percentage of genuine export income, and (2) the DISC's corporate shareholder paid corporate income tax when the DISC distributed the income as dividends. Benenson v. Comm'r, 2018 PTC 431 (2d Cir. 2018).


Summa Holdings, Inc. (Summa Holdings) is a C corporation and the parent of a consolidated group of manufacturing companies with export sales. Summa Holdings was 99 percent owned by its founder, James Benenson, Jr. (Benenson), and a family trust benefitting Benenson's two adult sons. Benenson controlled Summa Holdings through his majority ownership of the company's voting shares.

In 2001, Benenson's sons each formed Roth IRAs and deposited $3,500 into them. The Roth IRAs then paid $1,500 for 1,500 shares in JC Export, a newly formed domestic international sales corporation (DISC). DISCs were created by Congress in 1971 to subsidize domestic exporting companies. A DISC pays no federal income tax and can receive export income as commissions, which it typically pays out as dividends to the export company's shareholders. The net effect of the DISC is to distribute export revenue to shareholders without taxing it first as corporate income.

The Roth IRAs sold their shares in JC Export to JC Holding, a C corporation formed by the Benensons. Each Roth IRA received a 50 percent stake in JC Holding. JC Export then began receiving commissions from the subsidiaries of Summa Holdings and transferred the funds to JC Holding. JC Holding paid corporate income taxes on the funds and distributed the remainder to the Roth IRAs as dividends. In 2008, JC Holding transferred approximately $1.4 million to the Roth IRAs. By the end of 2008, each of the Benensons' Roth IRAs was worth over $3.1 million.

Benenson and his sons acknowledged that these transactions 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. Neither of the sons made any further contributions to the Roth IRAs after the initial contributions in 2001 and, indeed, by 2008, each son's income was too high to allow him to do so.

The IRS conceded that this arrangement was lawful in form. Nevertheless, in 2012, it determined that, in substance, the transactions amounted to excess contributions to the Roth IRAs. For 2008, the IRS issued notices of deficiencies not only to Benenson's sons but also to Summa Holdings, Benenson, and the family trust. According to the IRS, what Summa had treated as deductible DISC commissions was properly recharacterized as nondeductible dividends from Summa Holdings to its shareholders. The IRS determined that Summa owed corporate tax on the DISC commissions, Benenson and the family trust owed income tax on unreported constructive dividends received from Summa Holdings, and the dividends JC Holding paid to the Roth IRAs were actually excess contributions on which the sons owed excise tax.

The Tax Court affirmed the IRS's determination in Summa Holdings, Inc. v. Comm'r, T.C. Memo. 2015-119. The Tax Court recharacterized the transaction under the substance over form doctrine, finding that its purpose was to shift funds into the Roth IRAs in violation of the statutory contribution limits.

Summa Holdings appealed to the Sixth Circuit, Benenson's sons appealed to the First Circuit, and Benenson appealed to the Second Circuit. In Summa Holdings, Inc. v. Comm'r, 2017 PTC 58 (6th Cir. 2017), the Sixth Circuit reversed the Tax Court's decision, finding no basis for recharacterizing the transactions because the DISC and Roth IRAs were used for their congressionally authorized purposes of tax avoidance. The First Circuit also reversed, holding in Benenson v. Comm'r, 2018 PTC 98 (1st Cir. 2018) that JC Holding's payment of dividends into the Roth IRAs comported with economic reality because the Code expressly allows 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.

Before the Second Circuit, Benenson argued that the IRS was precluded from defending the Tax Court's recharacterization of the Summa Holdings' commissions as dividends because the Sixth Circuit had already rejected it. He also contended that the Second Circuit should conclude for itself that the substance over form doctrine did not support the Tax Court's recharacterization. The IRS maintained that the DISC payments lacked economic reality and argued that, under the step transaction doctrine, all of the steps of the transaction should be treated as a single scheme whose purpose was to transfer money into the Roth IRAs. The IRS also contended that, even if Summa Holdings was entitled to deduct the DISC commissions, the payments should be treated as constructive dividends to Benenson because the dividends were paid for the benefit of Benenson's family.


The Second Circuit rejected Benenson's preclusion argument because it found that he did not control Summa Holding's conduct in the litigation before the Sixth Circuit. However, the Second Circuit agreed with the First and Sixth Circuits that the Tax Court's recharacterization was not supported by the substance over form doctrine.

The Second Circuit found that Summa Holding's payment of deductible DISC commissions was grounded in economic reality and not distortive of the Code provisions establishing the DISC program. The court reasoned that Congress created DISCs specifically to provide a tax incentive for domestic companies to increase exports. In the court's view, Congress 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. The court reasoned that as long as the (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 the DISC's shareholders.

The step transaction doctrine did not help the IRS's case, in the view of the Second Circuit. The court explained that the step transaction doctrine is a tool of statutory construction, not of punitive enforcement, that warrants recharacterization only to the extent necessary to restore economic reality and eliminate distortion of the Code. Thus, even if the DISC commissions were viewed as the first in a series of transactions intended to conceal excess IRA contributions, the court reasoned, recharacterization of the DISC commissions as shareholder dividends was not required to restore economic reality. The court pointed out that the recharacterization of the JC Holding dividends as excess IRA contributions did not contribute to Benenson's deficiency; that deficiency depended only on the recharacterization of Summa Holdings' DISC commissions as dividends.

The Second Circuit also rejected the IRS's argument that the DISC commissions were constructive dividends to Benenson. In the court's view, the IRS was seeking to recharacterize the congressionally sanctioned deduction for the payment of DISC commissions as a constructive dividend, not because the corporation satisfied any obligation of Benenson, but because Benenson, at his discretion, had DISC assets directed to his sons' IRAs. The court found no support for such a recharacterization.

For a discussion of the taxation of Roth IRA transactions and DISCs, see Parker Tax ¶135,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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