The Sixth Circuit Court of Appeals has reversed the Tax Court’s “substance-over-form” ruling in the case of Summa Holdings Inc. v. Commissioner. Contrary to the Tax Court, the Sixth Circuit found that the IRS went too far when it applied substance-over-form arguments to disallow transactions involving a Domestic International Sales Corporation (DISC) and two Roth IRAs.
OUR TAKE ON SUMMA
Summa and its owners certainly were not the first to avail themselves of a DISC-plus-Roth IRA structure, and they may not be the last. The case has garnered national attention, especially for the large amounts that were salted away into the Roth IRAs. Taxpayers wishing to emulate Summa’s owners should consider the IRS’ position on the structure, as well as the reality that, with the structure in full public view, the IRS may not be done contesting the structure. Taxpayers wishing to apply this structure should proceed with due caution and consult their tax advisors.
A DISC is a legal creation of Congress that provides a tax incentive to exporters. This incentive operates by permitting exporters to defer and reduce taxes on export income. Typically, the exporting corporation pays a related but separate U.S. corporation that has elected to be a DISC an export “commission.” The DISC pays no tax and can retain the commission income, although the DISC shareholders are subject to an interest charge on their share of the tax liability on the deferred DISC income. The DISC can even invest the commission proceeds by making low-interest loans to the related exporting company. Alternatively, the DISC can pay out the commission proceeds in the form of a dividend to its shareholders. That dividend typically is taxed to the shareholders of a DISC at a tax rate that is lower than the exporting corporation’s rate, thus resulting in a tax rate “arbitrage” advantage on the DISC commission.
Roth IRAs permit taxpayers to contribute after-tax funds annually, and to withdraw the funds plus accumulated earnings without tax in the future. The amount that can be contributed annually to a Roth IRAs is quite limited, but importantly, dividends arising from investments held in the Roth IRA don’t count towards the annual contribution limit.
FACTS IN THE CASE
In the Summa case, a DISC received export commissions from Summa Holdings and its subsidiaries. The DISC was owned by a Subchapter C corporation, which was held by two Roth IRAs belonging to two individuals who also were shareholders in Summa Holdings. Their father owned the majority of Summa Holdings.
Relying on the principle that dividends arising from investments held in the Roth IRA don’t count towards the annual contribution limit, the above structure operated as follows:
- Summa and its subsidiaries paid export commissions to the DISC;
- The DISC paid dividends to the C-Corporation;
- The C-Corporation paid 33% federal income tax on the DISC dividends and remitted the remainder to the two Roth IRAs as dividends;
- The dividends to the Roth IRAs were not taxed since the Roth IRA is a tax-exempt vehicle;
- The two owners of the Roth IRAs would not incur individual income or capital gains taxes when distributions are paid from the Roth IRAs after they reach retirement age.
Over six years, and counting the income earned in the Roth IRAs, each of these had accumulated over $3 million – a massive amount compared with the typical annual Roth IRA contribution limit of a few thousand dollars.
FINDINGS IN THE CASE
Not surprisingly, the IRS argued that the result of the Summa structure wasn’t what Congress intended DISCs and Roth IRAs to do, and attacked the structure under “substance over form” arguments. Although the Tax Court had ruled in favor of the IRS, the Appeals Court did not, stating:
“The substance-over-form doctrine, it seems to us, makes sense only when it holds true to its roots—when the taxpayer’s formal characterization of a transaction fails to capture economic reality and would distort the meaning of the Code in the process. But who is to say that a low-tax means of achieving a legitimate business end is any less “substantive” than the higher-taxed alternative?”
THE LAST WORD – FOR NOW?
The Sixth Circuit Court of Appeals allowed the Summa structure to stand and did not accept the IRS’ challenges under the substance-over-form arguments. Instead it said that, if anyone were to address the Summa structure, it had to be Congress:
“If Congress sees DISC-Roth IRA transactions of this sort as unwise or as creating an improper loophole, it should fix the problem. Until then, the DISC will continue to provide tax savings to the owners of U.S. export companies, just as Congress intended -- even if subsequent changes to the Code have increased the scale of the savings beyond Congress's original estimation.”
One additional cautionary note – this structure would not have worked if the investors had sought to contribute an existing DISC to Roth IRAs, as that would have raised significant valuation and annual Roth IRA contribution concerns. FGMK’s tax specialists can help you evaluate the pros and cons of the Summa structure and implement the DISC structure that is right for you.
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