May Roth IRAs Receive DISC Dividends?

Interpretation of an ambiguous picture can be in the eye of the beholder. For example, an 1888 German postcard featured an image entitled “My Wife And My Mother-In-Law,” seemingly depicting both in a single image. It was later published by British cartoonist William Ely Hill (1887–1962).¹

In Summa Holdings, Inc. v. Commissioner, ² the Tax Court and the U.S. Court of Appeals for the Sixth Circuit experienced a similar phenomenon when confronted with two Roth individual retirement accounts that received a domestic international sale corporation’s (DISC) dividends. The Tax Court saw an abusive transaction to be remedied by applying the doctrine of substance over form, but the Sixth Circuit saw a legitimate use of congressionally intended tax breaks. 

DISCs

DISCs are authorized and regulated under the Internal Revenue Code.³ Generally, to qualify as a DISC, a corporation must be established and an election made to be treated as a DISC. 95 percent or more of its gross receipts must consist of qualified export receipts. Its qualified export assets at the close of the taxable year must have adjusted basis equal to or exceeding 95 percent of the DISC’s aggregate adjusted basis of all assets. The DISC must not have more than one class of stock and the par or stated value of its outstanding stock must be at least $2,500 on each day of the taxable year.

Income taxation of DISCs and DISC shareholders is prescribed exclusively in DISC provisions. DISC income taxes are avoided if all DISC income is paid out currently as dividends to its shareholders. The shareholders generally pay no income taxes on those dividends until the amount of the dividends exceeds $10 million. But, a corporation that owns DISC shares does pay income taxes on a portion of DISC dividends at corporate rates.⁴

Benenson Family Holdings

Clement C. Benenson (Clement) and James Benenson III (James III) are the children of James Clement Benenson, Jr. (James Jr.) and Sharen Benenson.

Summa Holdings, Inc. (Summa), a C corporation established and owned by James Jr., James III and Clement, owned and operated several subsidiary corporations engaged in manufacturing and exporting industrial products.

JC Export, a corporation established on Jan. 31, 2002 by the Roth IRAs of Clement and James III, made a tax election to be treated as an interest charge DISC.

To avoid imposition of unrelated business income (UBI) excise taxes on dividends distributed from the DISC to the IRAs, the IRAs established JC Holding to hold the DISC.⁵

Summa’s subsidiaries and JC Export entered into an agreement requiring the subsidiaries to pay DISC commissions to JC Export on their international sales. Because JC Export was established as an interest charge DISC, the commission amounts were based on interest rates set by statute.

Clement and James III each established a Roth IRA in 2001, each contributing $3,500 in cash. After a series of transactions occurred, each Roth IRA owned half of JC Holding, a C corporation. JC Holding was the sole shareholder of JC Export, a newly-formed corporation that elected to be treated as a DISC. Interposing JC Holding between JC Export and the two Roth IRAs avoided imposition of excise taxes on IRA UBI income.⁶

During 2008, Summa paid commissions to JC Export (the DISC) totaling $3,048,569 and paid $1,083 of expenses on behalf of both the DISC and JC Holding. During 2009, Summa paid the DISC commissions of $53,833. 

Summa claimed an income tax deduction for its DISC commission payments. JC Holding paid income taxes on dividends it received from the DISC. JC Holding, in turn, paid dividends out of its after-tax income to each of its two equal shareholders, the Roth IRAs of James III and Clement.

By the end of 2008, James III’s Roth IRA was worth $3,145,086; Clement’s Roth IRA was worth $3,135,236.

The Internal Revenue Service examined James III’s and Clement’s 2008 income tax returns and assessed income taxes and penalties based on its determination that each of them made an excess contribution to his Roth IRA. The IRS concluded this result was appropriate under the doctrine of substance over form. The IRS recast the DISC commission amounts as dividends paid from Summa’ subsidiaries to each of James III and Clement, followed by Roth IRA contributions by each of them. As a result, the IRS disallowed Summa’s claimed deductions for DISC commission payments and claimed that excess contributions were made to the Roth IRAs, triggering the 6 percent excise tax on excess contributions.

IRS Notice 2004-8

In the time between 1997 (when the Roth IRA was added to the IRC) and 2004, the IRS became concerned about preserving the integrity of annual contribution limits, specifically that a Roth IRA’s ownership of a business could become a means to make an end run around annual Roth IRA contribution limits. In Notice 2004-8, the IRS announced its concern,⁷ providing three examples: a sale of property for less than fair market value; gifts or bargain sales from third parties; and “any other arrangement between the Roth IRA Corporation and the Taxpayer, a related party described in section 267(b) or 707(b), or the Business that has the effect of transferring value to the Roth IRA Corporation comparable to a contribution to the Roth IRA.”    

The Notice said that the IRS could seek to recast Roth IRA transactions, including treating the business as having transferred the amount involved to the taxpayer, rather than to the Roth IRA. The taxpayer would, in turn, be treated as having contributed that amount to the taxpayer’s Roth IRA. In Benensen, it was that remedy that the IRS sought and the court considered.

Tax Court Applies Substance Over Form Doctrine

The court summarized IRS Notice 2004-8 and then turned to the doctrine of substance over form. That time-honored doctrine dates back to Gregory v. Helvering, a 1935 U.S. Supreme Court decision.⁸ Finding there were no non-tax business reasons for the Roth arrangement, the Tax Court concluded that the substance of the transactions was to accomplish what Notice 2004-8 had said was an impermissible end-run around Roth IRA contribution limits. It held that the DISC dividends were constructively paid to James Jr., James III and Clement, followed by Roth IRA contributions in excess of contribution limits. That resulted in imposition of income taxes on the dividends, as well as excise taxes on the Roth IRA excess contributions.⁹

Appeals Court Reverses

The Sixth Circuit reversed because the DISC and Roth IRAs were used for their congressionally intended purposes. The Commissioner may not arbitrarily apply the substance over form doctrine to maximize the government’s revenues. Indeed, the court observed that because there’s an excise tax imposed on DISC dividends paid to a tax-exempt entity, the IRC “expressly contemplates that tax-exempt entities like traditional IRAs may own DISC shares.” The opinion further notes that Roth IRAs and DISCs were each added to our tax laws to incentivize taxpayers to attain a congressional goal at the expense of the government: DISCs are meant to encourage international trade; Roth IRAs are meant to encourage retirement savings of after-tax income.

It’s worth noting that dicta contains a lengthy and thoughtful discussion of the substance over form doctrine, tracing its evolution and application. 

Where Next?

In future cases, the Tax Court could follow the Sixth Circuit in all cases, or alternatively, it could do so in that district only. If so, future cases might then be appealed in other circuits. If conflict among the circuits emerges, a U.S. Supreme Court decision would be needed. In addition, the IRS could issue either an acquiescence or a nonacquiescence.

Endnotes

1. My Wife and My Mother-in-Law, Wikepedia.org.
2. Summa Holdings, Inc. v. Commissioner, CA-6, No. 6476-12 (Feb. 16, 2017), rev’g. T.C. Memo. 2015-119 (Jun. 29, 2015).
3. Internal Revenue Code Sections 991 through 997, inclusive.
4. IRC Section 995.
5. Section 995(g).
6. IRAs are subject to excise taxes imposed by section 511 (relating to imposition of tax on unrelated business income of charitable, etc. organizations). IRC Section 408(e)(1).
7. Notice 2004-8, I.R.B. 333 (Jan. 26, 2004).
8. Gregory v. Helvering, 293 U.S. 465, 469-470 (1935).
9. IRC Section 4973 imposes an excise tax of 15 percent on contributions in excess of IRA and Roth IRA contribution limits.