IRS Cannot Recharacterize Transaction Between DISC and Roth IRA Shareholder Using Substance-over-Form Doctrine (Summa Holdings, Inc., CA-6)

The Tax Court improperly held that the parent of a closely held manufacturing group’s payments to a Domestic International Sales Corporation (DISC) were not commissions and that the dividends the DISC paid to its Roth IRA shareholders were excess contributions. The Sixth Circuit Court of Appeaqls found that the parent used the DISC and Roth IRAs for their legislative purposes. Therefore, the Tax Court had no basis for recharacterizing the transactions or the law’s application to them.

The children of the taxpayer’s shareholder set up Roth IRAs. With the children’s initial contributions, the Roth IRAs purchased shares of the DISC. Ultimately, each Roth IRA owned 50 percent of a holding company that was the DISC’s sole owner. The taxpayer paid commissions to the DISC, which then distributed the money as a dividend to the holding company. The holding company paid income tax on the dividends and then distributed the balance to its shareholders, the two Roth IRAs. The two Roth IRAs quickly accumulated millions of dollars.

The IRS used the substance-over-form doctrine to recharacterize the parent company’s payments as dividends to the DISC followed by Roth IRA contributions. The IRS argued that the doctrine allowed it to recharacterize the transaction because its purpose was to sidestep the contribution limits on Roth IRAs and lower the tax obligations of the children.

However, while the IRS can recharacterize the economic substance of a transaction to honor the fiscal realities of what taxpayers have done, it cannot recharacterize the meaning of statutes to favor its perception of their substance. Congress designed DISCs to enable exporters to defer corporate income tax. The Code authorizes companies to create DISCs as shell corporations that can receive commissions and pay dividends that have no economic substance at all. Therefore, by congressional design, DISCs are all form and no substance, making it inappropriate to apply the substance-over-form doctrine.

Similarly, Roth IRAs were designed for tax-reduction. At the time, the Code permitted traditional and Roth IRAs to own DISC shares and, for reasons of its own, Congress allowed both types of IRAs to be treated the same. All IRAs are permitted to hold shares of stock, some of which may increase markedly in value and some of which may generate considerable dividends over time. While Congress’s decision to permit Roth IRAs to own DISCs might have been an oversight, it was the law. Moreover, while the IRS’s claim that the purpose of the transaction was to funnel money into the Roth IRAs without triggering the contribution limits was true, the substance-over-form doctrine did not authorize the IRS to undo a transaction just because taxpayers undertook it to reduce their tax bills.

Comment. “This is one of the most taxpayer favorable judicial doctrine cases that I can remember in years,” said Lawrence M. Hill, partner, Winston & Strawn LLP. “The Sixth Circuit criticized the IRS for seeking to apply the substance-over-form doctrine, where the form of the transaction was expressly authorized by the Internal Revenue Code. The Court was attentive in grasping what many courts in the past have inexplicably failed to focus on: that “form is substance when it comes to the law.” This is persuasive precedent for other statutorily sanctioned tax-favored investment structures, such as, for example, those seen in the insurance context.”

Reversing the Tax Court, 109 TCM 1612, Dec. 60,335(M), TC Memo. 2015-119.

Summa Holdings, Inc., CA-6, 2017-1 ustc ¶50,155

Other References:

Code Sec. 408A

CCH Reference – 2017FED ¶18,930.022

CCH Reference – 2017FED ¶18,930.65

Code Sec. 995

CCH Reference – 2017FED ¶29,033.25

Code Sec. 4973

CCH Reference – 2017FED ¶34,362.30

Tax Research Consultant

CCH Reference – TRC RETIRE: 66,750 CCH Reference – TRC RETIRE: 66,754



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