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Appeals Court Allows Huge Shift of Funds to Roth IRAs

Roth IRAs, those special individual retirement accounts funded with nondeductible contributions, have a yearly contribution limit of $5500. Unlike other tax-qualified retirement plans, all earnings from a Roth can be tax-free if taxpayers wait until age 59 ½ to withdraw their funds. Roth IRAs also are subject to phase-out rule that disallows regular contributions once a taxpayer’s adjusted gross income (AGI) reaches $133,000 for singles and $196,000 for married couples. So, how did a taxpayer transfer millions from a family-owned corporation into Roth IRAs owned by his sons? He used a perfectly legal combination of the domestic international sales corporation (DISC) rules and the Roth rollover rules, according to the 6th Circuit Court of Appeals* in Summa Holdings Inc., v. Commr., which upheld the transactions.

Details of the Plan

Summa Holdings is the parent corporation of a group of companies that manufacture industrial products. Its two largest shareholders are James Benenson, Jr. and the “James Benenson III and Clement Benenson Trust.” Benenson and his wife serve as the trustees, and their sons are the beneficiaries of the Trust.

In 2001, the sons each established a Roth IRA and contributed $3,500 apiece. Each Roth IRA then 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 January 31, 2002 to December 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, its sole shareholder. JC Holding paid a 33% income tax on the dividends, then distributed the balance as a dividend to its shareholders, the sons’ two Roth IRAs. From 2002 to 2008, the Benensons transferred $5,182,314 from Summa Holdings to the Roth IRAs in this way, including $1,477,028 in 2008. By 2008, each Roth IRA had accumulated over $3 million.

The IRS challenged these transactions, applying a “substance-over-form” doctrine, and recharacterized the deductible commission payments as nondeductible dividend payments to shareholders followed by contributions by those shareholders to their Roth IRAs. This had the effect of making the sons ineligible to contribute anything to their Roth IRAs. The IRS then imposed a six-percent excise tax penalty on the excess ROTH IRA contributions.

Substance Over Form Not a Problem, Court Says

The Court rejected the IRS’s substance-over-form argument and found for the taxpayers. The IRS and courts sometimes challenge a tax position by looking at the substance of a transaction rather than the particular form the parties use to achieve tax savings. If the transaction is found to lack substance, the tax benefits may be denied. In the Summa Holdings case, the 6th Circuit Court found that, even though the purpose of the DISC/Roth IRA transactions was to lower taxes, all elements of the plan were expressly authorized by the Internal Revenue Code.

IC-DISCs

An interest charge domestic international sales corporation (IC-DISC) is a special entity that provides tax incentives to manufacturers, producers, resellers, and exporters of goods produced in the United States for export. An IC-DISC reduces its shareholders’ income tax liability by converting commissions from sales to foreign parties into dividends, which have a lower tax rate.

Postscript

The 6th Circuit’s colorful lead-in to its opinion is worth reprinting:

Caligula posted the tax laws in such fine print and so high that his subjects could not read them. Suetonius, The Twelve Caesars, bk. 4, para. 41 (Robert Graves, trans., 1957). That’s not a good idea, we can all agree. How can citizens comply with what they can’t see? And how can anyone assess the tax collector’s exercise of power in that setting? The Internal Revenue Code improves matters in one sense, as it is accessible to everyone with the time and patience to pore over its provisions.

In today’s case, however, the Commissioner of the Internal Revenue Service denied relief to a set of taxpayers who complied in full with the printed and accessible words of the tax law.

* The 6th Circuit covers Michigan, Ohio, Kentucky, and Tennessee.

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