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Substance-Over-Form Doctrine Doesn't Authorize IRS to Reclassify Transfers from DISC to Roth IRAs

(Parker Tax Publishing March 2017)

The Sixth Circuit reversed the Tax Court and held that, because a corporation used a domestic international sales corporation and Roth IRAs for their congressionally sanctioned purposes - tax avoidance - the IRS had no basis for recharacterizing transactions involving the transfer of funds from the DISC to the Roth IRA accounts. Nor, the court said, did the IRS have any basis for recharacterizing the law's application to the transactions at issue. Summa Holdings v. Comm'r, 2017 PTC 58 (6th Cir. 2017).


Summa Holdings is the parent corporation of a group of companies that manufacture a variety of industrial products. Its two largest shareholders are James Benenson, Jr. (who owned 23.18 percent of the company in 2008) and the James Benenson III and Clement Benenson Trust (which owned 76.05 percent of the company in 2008). James Benenson, Jr. and his wife serve as the trust's trustees, and their children, James III and Clement, are the beneficiaries of the trust. In 2001, James III and Clement each established a Roth IRA and contributed $3,500 apiece to the IRA. Just weeks after the Benensons set up their accounts, each Roth IRA paid $1,500 for 1,500 shares of stock in JC Export, a newly formed domestic international sales corporation (DISC).

Observation: DISCs were designed by Congress to incentivize companies to export goods by deferring and lowering their taxes on export income. The exporter avoids corporate income tax by paying the DISC "commissions" of up to 4 percent of gross receipts or 50 percent of net income from qualified exports. The DISC pays no tax on its commission income (up to a specified amount) and may hold onto the money indefinitely, though the DISC shareholders must pay annual interest on their shares of the deferred tax liability. Once the DISC has assets at its disposal, it can invest them, including through low-interest loans to the export company. Money and other assets in the DISC may exit the company as dividends to shareholders. Dividends paid to individuals are taxed at the qualified dividend rate, which (since 2003) is lower than the corporate income rate that otherwise would apply to the company's export revenue. Generally, the DISC's shareholders are the same individuals who own the export company. In those cases, the net effect of the DISC is to transfer export revenue to the export company's shareholders as a dividend without taxing it first as corporate income. Corporations and other entities, including IRAs, may own shares in DISCs. A corporation that owns DISC shares still has to pay the full corporate income tax on any dividends, which cancels out any tax savings. For a time, tax-exempt entities like IRAs paid nothing on DISC dividends, which enabled export companies to shield active business income from taxation by assigning DISC stock to controlled tax-exempt entities like pension and profit-sharing plans. But Congress closed this gap in 1989 and required tax-exempt entities to pay an unrelated business income tax, set at the same rate as the corporate income tax, on DISC dividends.

Traditional IRAs or Roth IRAs, each of which has different qualities, may be shareholders in a DISC. Traditional IRA owners deduct contributions to the IRA and pay income tax on withdrawals, including accrued gains in their accounts. Roth IRAs work in the other direction. Roth IRA owners do not deduct their contributions from pre-tax income, but they take withdrawals, including accrued gains, tax-free. Contribution limits are imposed on traditional and Roth IRAs. In 2008, the maximum annual contribution to each was $5,000. The maximum annual contribution to a Roth IRA decreases as an individual's income increases. In 2008, single filers who made over $116,000 could not make any contributions to a Roth IRA.

For tax advantageous reasons, the owner of a closely held export company might want to transfer money from his company to a DISC and pay some or all of that money as a dividend to the DISC shareholders, which may include Roth IRAs. The IRA account holder would have to pay the high unrelated business income tax when the DISC dividends go into the IRA. But once the Roth IRA receives the money, the account holder can invest it freely without having to pay capital gains taxes on increases in the value of each share or incomes taxes on the dividends received - just like other Roth IRA owners who buy shares of stock in companies that generate considerable dividends and rapid growth in share value. As with all Roth IRAs, the owner would not have to pay any individual income or capital gains taxes when the assets leave the account after he hits the requisite retirement age.

The Benensons, in order to prevent the Roth IRAs from incurring any tax-reporting or shareholder obligations by owning JC Export directly, formed another corporation, JC Holding, which purchased the shares of JC Export from the Roth IRAs. From January 31, 2002, to December 31, 2008, each Roth IRA owned a 50 percent share of JC Holding, which was the sole owner of JC Export. With this chain of ownership in place, the family, trust, and company were a few steps away from the possibility of considerable future tax savings. Summa Holdings paid commissions to JC Export, which distributed the money as a dividend to JC Holding, its sole shareholder. JC Holding paid a 33 percent income tax on the dividends, then distributed the balance as a dividend to its shareholders, the Benensons' two Roth IRAs. From 2002 to 2008, the Benensons transferred approximately $5.2 million from Summa Holdings to the Roth IRAs in this way, including approximately $1.5 million in 2008. By 2008, each Roth IRA had accumulated over $3 million.

In 2012, the IRS issued notices of deficiency to Summa Holdings, the Benensons, and the Benenson Trust for the 2008 tax year but did not do so for the earlier tax years. The IRS informed Summa Holdings that it would apply the substance-over-form doctrine and reclassify the payments to JC Export as dividends from Summa Holdings to its major shareholders. As recast, the transfers did not count as commissions from Summa Holdings to JC Export. That meant Summa Holdings had to pay income tax on the DISC commissions it deducted, and JC Holding obtained a refund for the corporate income tax it had paid on its dividend from JC Export. The commissions became dividends to Benenson Jr. and the Benenson Trust, all in proportion to their ownership shares. The IRS determined that each Roth IRA received a contribution of approximately $1.1 million. Because James III and Clement both made over $500,000 in 2008, they were not eligible to contribute anything to their Roth IRAs. The IRS imposed a 6 percent excise tax penalty under Code Sec. 4973 on the contributions and imposed a $56,000 accuracy-related penalty on Summa Holdings.

Summa Holdings and the Benensons challenged the IRS's action in the Tax Court. The Tax Court upheld the IRS's recharacterization of the transactions but not the accuracy-related penalty. Summa Holdings challenged that decision in the Sixth Circuit. The Benensons and the Benenson Trust have related appeals pending before the First and Second Circuits.

Sixth Circuit's Decision

The Sixth Circuit reversed the Tax Court and held that, because the transactions at issue were legal, Summa Holdings did not owe the IRS a dime. According to the court, the IRS had denied relief to a set of taxpayers who complied in full with the printed and accessible words of the tax laws. The Benenson family, the court noted, had the time and patience and money to understand how a complex set of tax provisions could lower its taxes. Tax attorneys advised the family to use a congressionally innovated corporation a DISC to transfer money from their family-owned company to their sons' Roth IRAs. When the family did just that, the court observed, the IRS balked. The IRS, the court stated, acknowledged that the family had complied with the relevant tax provisions and acknowledged that the purpose of the relevant provisions was to lower taxes, but reasoned that the effect of these transactions was to evade the contribution limits on Roth IRAs and applied the substance-over-form doctrine.

According to the court, when the IRS said that the transaction at issue amounted in substance to a Roth IRA contribution, the IRS was really saying that the purpose of the transaction was to funnel money into the Roth IRAs without triggering the contribution limits. And the court agreed that this was the end result. However, the court said, the substance-over-form doctrine does not authorize the IRS to undo a transaction just because taxpayers undertook it to reduce their tax bills. The transactions at issue, the court stated, were not against the law.

In conclusion, the Sixth Circuit opined that if Congress sees DISCRoth IRA transactions of this sort as unwise or as creating an improper loophole, it should fix the problem. Until then, the court observed, DISCs will continue to provide tax savings to the owners of U.S. export companies, just as Congress intended even if subsequent changes to the Code have increased the scale of the savings beyond Congress's original estimation. The last thing the federal courts should be doing, the court said, is rewarding Congress's creation of an intricate and complicated Internal Revenue Code by closing gaps in taxation whenever that complexity creates them.

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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