The Sixth Circuit reversed the Tax Court by refusing to apply the substance-over-form doctrine to transactions that involved the transfer of funds from a family business to Roth IRAs through a domestic international sales corporation (DISC).
Facts: Summa Holdings Inc. was the parent company to a group of manufacturing companies. In 2008, James Benenson Jr. and the James Benenson III and Clement Benenson Trust owned the majority of the company.
In 2001, James Benenson III and Clement Benenson each established a Roth IRA. Shortly thereafter, each Roth IRA purchased stock in JC Export, a DISC. JC Holding was set up to purchase the shares of JC Export from the Roth IRAs. In 2008, each Roth IRA owned a 50% share of JC Holding, the sole owner of JC Export.
Summa Holdings paid DISC commissions to JC Export, which distributed the money as a dividend to JC Holding, which paid an income tax on the dividends and distributed the balance to the Roth IRAs.
In 2012, the IRS issued notices of deficiency to Summa, the Benensons, and the Benenson Trust for the 2008 tax year. Although it admitted that the transactions complied with the relevant provisions of the Code, the IRS applied the substance-over-form doctrine to reclassify the commission payments from Summa Holdings to JC Export as dividends to the shareholders that they had contributed to the Roth IRAs. Because in this view of the transaction, the shareholders had contributed more than $1.1 million to each Roth IRA in 2008, when neither taxpayer was eligible to make any contributions due to the Roth IRA contribution limits, the IRS assessed the 6% excise tax on excess contributions against the shareholders. The IRS assessed a deficiency against Summa Holdings for additional tax due to the disallowed deduction for the commission payments and assessed an accuracy-related penalty against Summa Holdings.
Summa and the Benensons challenged the IRS's determination in the Tax Court. The court agreed with the IRS that the use of the DISC by Summa to transfer funds to the Roth IRAs was an attempt to evade contribution limits on the IRAs that did not have a business or economic purpose (see "Tax Matters: Substance-Over-Form Doctrine Used to Nix Growth Within Roth IRAs," JofA, Oct. 2015). Thus, it upheld the IRS's recharacterization of the transactions and the tax assessment against Summa Holdings. However, it did not uphold the accuracy-related penalty.
Issue: The substance-over-form doctrine often is invoked by courts when taxpayers construct transactions with the goal of tax minimization. Under the doctrine as traditionally applied, where the taxpayer's characterization of a transaction fails to capture economic reality and would distort the meaning of the Code in the process, the IRS may recharacterize the transaction to reflect its economic substance. Transactions undertaken purely for tax purposes that have no independent business purpose are generally held to be subject to recharacterization under the doctrine. However, in this case, the Sixth Circuit asserted that the IRS was expanding the doctrine to apply to any transaction, regardless of its economic substance, where the taxpayer could have structured the transaction to result in a higher tax but instead structured the transaction to result in a lower tax.
Congress enacted the DISC to stimulate export activity through tax incentives. Sec. 991 provides for the payment of a commission by an export company to a DISC of up to 4% of gross receipts or 50% of net income from qualified exports. The DISC pays no tax on the commission payments, and the payments are passed through to the DISC shareholders (which are often the shareholders of the export company) as qualified dividends, thereby allowing the owners of the export company to avoid corporate-level taxation on the company's export income. Sec. 995(g) permits Roth IRAs to own DISCs. Roth IRA owners can therefore transfer DISC stock to the Roth IRA, subject to contribution limits. DISC earnings are subject to tax when transferred to a Roth IRA, but any growth on the earnings once in the Roth IRA are tax-free. Using a Roth IRA to hold a DISC can yield considerable tax benefits to the owners of an export company.
The issue was whether the IRS could recharacterize transactions that complied with the Code and had economic substance. Summa had combined two tax-saving strategies, the DISC and the Roth IRA. In applying the substance-over-form doctrine, the IRS argued that the strategies should not be combined to avoid tax, although both complied with the Code. The IRS argued recharacterization was justified because the tax benefits to Summa Holdings and the Benensons were "unintended by both the Roth IRA and DISC provisions."
Holding: The Sixth Circuit held that the substance-over-form doctrine did not apply to Summa's transactions, finding that the doctrine did not "authorize the Commissioner to undo a transaction just because taxpayers undertook it to reduce their tax bills." The court concluded that because Summa used the DISC and the Roth IRAs for the congressionally sanctioned purpose of tax avoidance and the transactions had economic substance, the IRS had no basis for recharacterizing the transactions.
- Summa Holdings, Inc., No. 16-1712 (6th Cir. 2/16/17)
—By Maria M. Pirrone, CPA, J.D., LL.M., assistant professor of taxation, St. John's University, Queens, N.Y.