The Sixth Circuit held that the IRS could not recharacterize, under the substance-over-form doctrine, commissions paid by a domestic international sales corporation (DISC) to two Roth IRAs as dividends to the Roth IRA owners that they then contributed to the Roth IRAs.
DISCs and Roth IRAs
DISCs are a special type of corporation designed to provide incentives to export companies by deferring and lowering the tax they pay on export income. An export company can set up a DISC and use it to avoid corporate income tax by paying the DISC deductible "commissions" of up to 4% of gross receipts or 50% of income from qualified exports. The DISC pays no tax on its commission income (up to $10 million) and may hold onto the income earned indefinitely. However, the DISC shareholders must pay annual interest on their shares of the deferred tax liability.
A DISC can transfer money and other assets it holds to its shareholders by paying them dividends. The dividends are treated as qualified dividends to the shareholders, who can be and often are the same individuals who own the export company. Through a DISC, an export company can transfer its export revenue to its shareholders as dividends without paying a corporate-level tax on the revenue.
A Roth IRA can own shares in a DISC. When a DISC owned by a Roth IRA pays dividends to the Roth IRA, the IRA account holder must pay unrelated business income tax on the dividends. However, once the money is in the Roth IRA, the owner of the account can invest it like any other money contributed to the account and benefit from the tax-free growth a Roth IRA offers. In addition, the account owner can take tax-free distributions of the funds after he or she reaches the requisite age for qualified withdrawals. Thus, an owner of a DISC can realize considerable tax savings by contributing his or her DISC shares to a Roth IRA.
A DISC shareholder's ability to transfer DISC shares to a Roth IRA, however, may be limited by the Roth IRA annual contribution limit, which was $5,000 for 2008 (the year at issue). After the modified adjusted gross income (MAGI) of a Roth IRA owner passes a threshold amount ($101,000 for 2008), the limit is subject to phaseout. For 2008, a taxpayer filing as single with MAGI of more than $116,000 could not make a Roth IRA contribution.
Summa Holdings and the Benensons
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. and the James Benenson III and Clement Benenson Trust (Benenson Trust). James Benenson Jr. and his wife serve as the 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. Just weeks after the two set up the Roth IRAs, each account paid $1,500 for 1,500 shares of stock in JC Export, a newly formed DISC. To prevent the Roth IRAs from incurring any tax-reporting or shareholder obligations by owning JC Export directly, the Benensons formed another corporation, JC Holding, which purchased the shares of JC Export from the Roth IRAs. From Jan. 31, 2002, to Dec. 31, 2008, each Roth IRA owned a 50% share of JC Holding, which was the sole owner of JC Export.
Summa Holdings paid commissions to JC Export, which distributed the money as a dividend to JC Holding. JC Holding paid a 33% income tax on the dividends and then distributed the balance as a dividend to its shareholders, the Benensons' two Roth IRAs. From 2002 to 2008, the Benensons transferred $5,182,314 from Summa Holdings to the Roth IRAs, including $1,477,028 in 2008. By 2008, each Roth IRA had accumulated over $3 million.
The IRS believed that Summa Holdings and the Benenson clan, although they had technically complied with the DISC and the Roth IRA provisions of the Code, had impermissibly skirted the Roth IRA contribution limits and lowered their tax liabilities through the DISC—Roth IRA transactions. Therefore, the IRS issued notices of deficiency to Summa Holdings, the Benensons, and the Benenson Trust for 2008 in which, based on the substance-over-form doctrine, it reclassified the payments to JC Exports as dividends from Summa Holdings to Benenson Jr. and the trust. The notices treated Benenson Jr. and the trust as contributing the dividends to the Roth IRAs.
James III and Clement were not eligible to make any contributions to their Roth IRAs because their incomes exceeded the MAGI limit. Consequently, the IRS treated the contributions ($1,119,503 to each Roth IRA) as excess contributions and imposed the 6% penalty for excess contributions on them. In addition, under the IRS's theory, the payments did not count as commissions, and Summa Holdings had to pay tax on the DISC commissions it deducted, while JC Holding got a refund for the tax it paid on its dividend from JC Export. The IRS imposed a $56,182 accuracy-related penalty on Summa Holdings.
The Benensons and Summa Holdings challenged the IRS's determination in the Tax Court, which upheld the recharacterization of the transactions but nixed the accuracy-related penalty. Summa Holdings, which is based in Ohio, appealed the Tax Court's decision to the Sixth Circuit. The Benensons and the trust also appealed, but their appeals went to the First and Second Circuits, where they are currently pending.
The Sixth Circuit's decision
The Sixth Circuit reversed the Tax Court and held that the IRS could not recharacterize Summa Holdings' transactions or the law's application to them. Because the transactions, although allowing Summa Holdings to avoid taxes, fully complied with both the DISC and Roth IRA provisions in the Code, the court found the IRS had no basis for invoking the substance-over-form doctrine to recharacterize them.
The IRS claimed in its briefs to the court that under the substance-over-form doctrine, the IRS could reclassify transactions that literally complied with the applicable Code provisions to respect "overarching . . . principles of federal taxation." As the court explained, under the IRS's version of the doctrine, when two potential structures for a transaction exist and a taxpayer chooses to use the structure that results in a lower tax, the IRS has the power to recharacterize the transaction to the structure that results in the higher tax, even if the structure used complies with the applicable sections of the Code.
The Sixth Circuit rejected the IRS's broad interpretation of the scope of the doctrine. It found that the doctrine should only be used, as it traditionally had, "when the taxpayer's formal characterization of a transaction fails to capture economic reality and would distort the meaning of the Code in the process." Thus, the IRS could not recharacterize a transaction that literally complied with the law based on the taxpayer's motive to minimize taxes. Regarding Summa Holdings' situation, the court stated, "[a]lthough the distinction between transactions that obscure economic reality and Code-compliant, tax-advantaged transactions may be difficult to identify in some cases, the transactions in this case are clearly on the legitimate side of the line." The court found that the IRS's characterization of the transactions did not reflect economic reality any better than Summa Holdings' characterization, and that in the transactions Summa Holdings and the Benensons had not followed a "devious path" to avoid the tax consequences of a straight path.
The Sixth Circuit further found that even if the IRS had the power it claimed and could disregard a taxpayer's chosen structure for a transaction and recharacterize it because of the tax-minimizing motives for using the structure, the IRS could not use that power in Summa Holdings' case. The court stated, "[n]o court has used this power to override statutory provisions whose only function is to enable tax savings, as the [IRS] seeks to do in this instance." The court observed that the Code authorizes taxpayers to use DISCs and Roth IRAs for tax-avoidance purposes and the point of the entities is tax avoidance. Thus, the IRS could not place 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)."
The IRS also maintained that the critical point of its argument for recharacterizing the transactions was that tax benefits that Summa Holdings received through them were unintended by both the DISC and Roth IRA provisions of the Code. The Sixth Circuit admitted that this might be but found that the substance-over-form doctrine did not allow the IRS to correct oversights or policy missteps made by Congress. According to the court, if Congress determined that DISC-Roth IRA transactions led to improper tax results, it should fix the problem legislatively.
As is noted in the opinion, separate cases involving the Benensons and the trust are currently pending in the First and Second Circuits, so the litigation over the DISC-Roth IRA transaction is far from over. A decision in favor of the IRS by either of those circuits would result in a circuit split, which might prompt Supreme Court review of the issue.
Summa Holdings, Inc., No. 16-1712 (6th Cir. 2/16/17)