Substance-over-form doctrine used to nix growth within Roth IRAs

Purported DISC commissions paid to Roth IRAs as owners of a holding company are recharacterized as dividends to shareholders and excess contributions.
By Warren L. Baker, J.D.

The Tax Court held that payments made by a corporation to a domestic international sales corporation (DISC) that was indirectly owned by two Roth IRAs were not DISC commissions but rather dividends to individual shareholders followed by excess contributions to their Roth IRAs, resulting in excise tax and penalties.

Facts: In 2001, two Roth IRAs were established by brothers James Benenson III and Clement C. Benenson, and $3,500 was contributed into each account. Between 2001 and 2008, the brothers did not make any additional contributions to their Roth IRAs. In 2002, the Benenson Roth IRAs each purchased 1,500 shares of stock of JC Export (JCE), which elected to be characterized as a DISC. The Benenson Roth IRAs then transferred their shares of JCE to JC Export Holding (JCH), a C corporation, in exchange for 1,500 shares of JCH stock. (It was stipulated that this was done, in part, so that the Benenson Roth IRAs would not have unrelated business taxable income and the IRA custodian's involvement would be minimized.) JCE was wholly owned by JCH, which in turn was 100% owned by the Benenson Roth IRAs.

Summa Holdings was the parent corporation of a consolidated group of manufacturing companies and, during the period in question, was controlled by the Benensons' father, James Benenson Jr., directly and through a trust.

In 2002, several of Summa's subsidiaries and JCE entered into a series of agreements under which the subsidiaries paid more than $2.2 million to JCE in 2008 and an additional $53,833 in January 2009. JCE subsequently distributed the funds to JCH, which in turn distributed them equally to the Benenson Roth IRAs.

In 2012, the IRS issued notices of deficiency, arguing that the payments from the subsidiaries to JCE were, in substance, dividends to Summa's shareholders and subsequent contributions to the Benenson Roth IRAs.

Issues: The key question before the court was whether the substance-over-form doctrine should be applied to recharacterize purported earnings within the Roth IRAs to Roth IRA contributions, thereby resulting in excess contributions under Sec. 408A and excise tax under Sec. 4973(a).

Holding: The court first noted the taxpayers' acknowledgment that their sole reason for entering into the transactions was to transfer money into the Benenson Roth IRAs so that income on assets could accumulate and be distributed tax-free. The taxpayers also stipulated that there was no nontax business purpose for the transactions. The court, citing several Tax Court and U.S. Supreme Court cases, agreed with the IRS's argument that the form of the transaction did not necessarily control the tax result.

The taxpayers argued that the three possible grounds for adjustment listed in Notice 2004-8 could not be applied against them, so the transaction was valid. In Notice 2004-8, the IRS announced three theories under which it would challenge schemes where a taxpayer's preexisting business enters into transactions with a corporation owned by the taxpayer's Roth IRA to avoid the Roth contribution limits. The Tax Court rejected the taxpayers' argument, finding that the third theory announced in Notice 2004-8, that the substance of the transaction is that the amount of the value shifted from the preexisting business to the corporation is a payment to the taxpayer, followed by a contribution by the taxpayer to the Roth IRA and a contribution by the Roth IRA to the corporation, did apply to the taxpayers' transactions.

Finally, the court emphasized that the problem with the transactions was not that a DISC was involved but rather the underlying substance of the transaction. The court stated, "The choice of the business entity does not affect the substance of the transaction," and "These transactions, like the transaction in Repetto [T.C. Memo. 2012-168] were used for the purpose of shifting millions of dollars into Roth IRAs in violation of the statutory contribution limits. In this situation recharacterization under substance over form principles is appropriate."

  • Summa Holdings, Inc., T.C. Memo. 2015-119

—By Warren L. Baker, J.D., a tax attorney with Fairview Law Group PS in Seattle who specializes in representing self-directed IRA investors on various legal and tax matters.


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