The First Circuit reversed the Tax Court, holding that the IRS did not have the authority to call a transaction a violation of the Code when the transaction did not violate the plain intent of the relevant statutes.
Facts: In 2001, James Benenson III and Clement Benenson each established a Roth IRA. Shortly thereafter, each Roth IRA invested $1,500 in JC Export, a newly formed domestic international sales corporation (DISC). The Roth IRAs then sold their JC Export shares to JC Holding, a C corporation the Benensons formed. The Benensons' family-owned business, Summa Holdings, paid DISC commissions to JC Export, which distributed the money as a dividend to JC Holding, which paid income tax on the dividends and distributed the balance to the Roth IRAs.
In 2012, the IRS issued notices of deficiency to Summa and its shareholders — the Benensons and a family 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. In this view of the transaction, the shareholders had contributed more than $1.4 million to the Roth IRAs in 2008, when neither taxpayer was eligible to make any contributions due to the Roth IRA contribution limits.
The Benensons, their trust, and Summa Holdings challenged the IRS's determination in Tax Court. The court agreed with the IRS that Summa's use of the DISC 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 (Summa Holdings, Inc., T.C. Memo. 2015-119).
Summa Holdings appealed to the Sixth Circuit, which reversed the Tax Court's decision in Summa Holdings, Inc., 848 F.3d 782 (6th Cir. 2017) (see "Tax Matters: Sixth Circuit Upholds DISC Dividends Paid to Roth IRAs," JofA, May 2017). As Massachusetts residents, the Benensons appealed the Tax Court's decision to the First Circuit.
Issues: 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, 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.
Congress enacted the DISC provisions to stimulate export activity through tax incentives. Sec. 994(a) provides for the payment of a commission by an export company to a DISC of the greater of 4% of gross receipts on the DISC's sale of qualified export property 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 tax-exempt organizations including 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 the transactions as Roth contributions by the Benensons, who 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, even though both complied with the Code.
Holding: The First Circuit held in a divided opinion that the transaction violated neither the letter nor the purpose of the relevant statutory provisions, and it reversed the Tax Court. In the court's view, the substance-over-form doctrine is a tool of statutory interpretation that applies only where the objective economic realities of a transaction are contrary to the plain intent of the Code. The court found that Congress created DISCs to enable export companies and their shareholders to defer tax. Although the court found merit in the IRS's argument that Roth IRAs were intended to provide a savings mechanism to taxpayers of more modest means than the Benensons, they were qualified to make their initial contributions, and it was not contrary to the statute's purpose to allow their contributions to grow through investment in qualified companies.
In a dissenting opinion, Judge Sandra L. Lynch said the taxpayers' own testimony indicated the transactions served no nontax business purpose and that their use of a DISC as an intermediary to circumvent Roth IRA contribution limits was "clearly incompatible with congressional intent."
- Benenson, Nos. 16-2066; 16-2067 (1st Cir. 4/6/18)
— By Maria M. Pirrone, CPA, J.D., LL.M., associate professor of taxation, St. John's University, Queens, N.Y.