Compensation & Benefits Alert - March 2017

March 2017

Tax Free Accumulation of DISC Dividends in Roth IRA Upheld by Sixth Circuit Court of Appeals  


The United States Court of Appeals for the Sixth Circuit unanimously ruled against the Internal Revenue Service (IRS) on February 16, 2017, in Summa Holdings, Inc. v. Commissioner, No. 16-1712, 2017 U.S. App. LEXIS 2713 (6th Cir.) and held that the taxpayer’s combination of a domestic international sales corporation (DISC) and Roth Individual Retirement Accounts (Roth IRA) was proper, even though the structure resulted in the avoidance of income tax.

In the United States Tax Court proceedings in Summa, the IRS was successful with its “substance-over-form” argument, which would have reclassified the deductible DISC commissions from Summa Holdings, Inc. (Summa) as non-deductible dividends distributed directly to Summa’s shareholders. These reclassified distributions would have been fully taxable to Summa’s shareholders.

In addition to the lost tax exclusion, the stripping of the DISC’s income would have eliminated the subsequent distribution to the DISC’s sole owner, a C Corporation, that in turn paid dividends to its ultimate owners, the Roth IRAs. Under the Roth IRA rules, these dividends avoided taxation even upon distribution to the Roth IRA owners.  However, the IRS’s position would have stripped the Roth IRAs of its dividends and deemed the cash inflow to the Roth IRAs as contributions that were disallowed because the Roth IRA owners did not satisfy the requirements to make a contribution. Accordingly, the excess contributions would have to be withdrawn, and the earnings taxed to the Roth IRA owners.  

While binding on the Tax Court only in the Sixth Circuit, the opinion highlights the federal courts’ reluctance to close tax loopholes created by a complicated and intricate Internal Revenue Code and limits the IRS’s ability to use the “substance-over-form” doctrine at its leisure to avoid a tax consequence that it believes is unintended.  In addition, the opinion defers to Congress the task of closing unintended loopholes while suggesting that taxpayers may take advantage of tax savings so long as they fully comply with the “printed and accessible words of the tax laws.”  

BDO Observations

IRS Notice 2004-8 designates Abusive Roth IRA Arrangements as “listed transactions.” Fact patterns similar to Summa may require disclosure to the IRS, thus inviting IRS scrutiny.

Factual Background

A family owned a manufacturing company, Summa.  In 2001, two sons each established and contributed to a Roth IRA. Subsequently, each Roth IRA paid $1,500 for 1,500 shares of stock in JC Export, a newly formed DISC.[1] The family formed another corporation, JC Holding, which purchased the shares of JC Export from the Roth IRAs to prevent the Roth IRAs from incurring any tax-reporting or shareholder obligations by owning JC Export directly. Between 2002 and 2008, each Roth IRA owned a 50-percent share of JC Holding, the sole owner of JC Export.

Under this structure, Summa paid commissions to JC Export, which distributed money as a dividend to JC Holding, the sole shareholder. JC Holding paid a 33-percent income tax on the dividends, then distributed the balance as a dividend to its shareholders, the two Roth IRAs. From 2002 to 2008, the family transferred over $5 million from Summa to the Roth IRAs. By 2008, each Roth IRA had accumulated over $3 million.

The Commissioner informed Summa that the “substance-over-form” doctrine would be applied to reclassify the payments to JC Export as dividends from Summa to its major shareholders. Consequently, the transfers would not count as commissions from Summa to JC Export, meaning that Summa had to pay income tax on the DISC commissions. Additionally, the Commissioner determined that each Roth IRA received a contribution in excess of the Roth IRA contribution limit, and since each son made over $500,000 in 2008, they were ineligible to contribute anything to their Roth IRAs.

Court Analysis

The Court of Appeals reasoned that the Code expressly permits the transaction at issue; consequently, these transactions, as consummated, fully complied with the Code. The Commissioner asserted that the “substance-over-form” doctrine grants him the authority to reclassify Code-compliant transactions to “respect overarching…principles of federal taxation.” The Court disagreed and concluded that, although the Commissioner is permitted to recharacterize the economic substance of a sham transaction, it is another matter to allow the Commissioner “to recharacterize the meaning of the statutes—to ignore their form, their words, in favor of his perception of their substance.”

Furthermore, the Court of Appeals reasoned that the Code authorizes companies to create DISCs as shell corporations that can receive commissions, pay dividends that have no economic substance, and defer corporate income tax. Consequently, DISCs are all form and no substance, making it inappropriate for the Commissioner to utilize the “substance-over-form” doctrine with respect to Summa’s use of DISCs. Moreover, Roth IRAs are also designed for tax-reduction purposes, and the family used them for their intended purpose.
Finally, the Court of Appeals concluded that the Commissioner cannot, under the guise of the “substance-over-form” doctrine, invalidate a transaction just because taxpayers undertook it to reduce their tax liability. Congress established the DISC regime to for the purpose of lowering taxes. Moreover, Roth IRAs were established with the authority to own shares in DISCs for the purpose of reducing taxes. Consequently, “[t]he Commissioner cannot place ad hoc limits on them by invoking a statutory purpose (maximizing revenue) that has little relevance to the text-driven function of these portions of the Code (minimizing revenue).”

For more information please contact Peter Klinger or Joan Vines.
[1]  DISCs incentivize companies to export their goods by deferring and lowering their taxes on export income. The exporter reduces its 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 of up to $10 million. However, DISC shareholders must pay an annual interest charge on their share of the deferred tax liability on the DISC’s accumulated earnings. See IRC §§ 991, 995(b)(1)(E), 995(f); see also Treas. Reg. § 1.991-1(b).