IRS loses second appeal regarding DISC - Roth IRA transaction
Following a prior decision of the Sixth Circuit Federal Court of Appeals, the First Circuit rejected the IRS’ attempt to use the substance-over-form doctrine to re-characterize distributions made by a Domestic International Sales Corporation (DISC) to a Roth IRA as excess contributions made by the individual owner of the IRA. In Benenson v. Commissioner, T.C. No. 16-2067 (2018), a separate appeal of the Tax Court’s holding in Summa Holdings, Inc et al v. Commissioner, TC Memo 2015-119 (June 29, 2015), the First Circuit concluded that the IRS’ application of the substance over form doctrine was inappropriate, and reversed the Tax Court’s ruling treating DISC dividends as excess Roth IRA contributions.
The transaction at issue in both the First and Sixth Circuit appeals cases involved the taxpayer’s strategy to combine the tax benefits of a DISC with those of a Roth IRA. Specifically, the taxpayers established a DISC to receive commissions on export sales from a family owned company. The DISC was owned by a separate C corporation holding company, the stock of which, in turn, was owned by the two taxpayers’ Roth IRAs. The holding corporation, after receiving payments from the DISC and setting aside amounts it would owe for federal income taxes, distributed the remaining funds to the Roth IRAs as dividends. For the tax years in question, the dividends paid to the Roth IRAs were well in excess of the congressionally established contribution limits placed on such retirement accounts.
The IRS argued, and previously the Tax Court had agreed, that while both the DISC and the Roth IRA were enacted for the purpose of providing tax benefits to their owners and beneficiaries, the taxpayers used these provisions to improperly sidestep the Roth IRA contribution limitations. The IRS claimed this was contrary to congressional intent, and the Tax Court had ruled that the dividends should be re-characterized as an excess Roth IRA contribution. The First Circuit, however, disagreed.
In a majority opinion, the First Circuit concluded that the application of the substance over form doctrine to reclassify the dividends as excess contributions was inappropriate. The First Circuit, following the Sixth, noted that the DISC and Roth IRA rules were both designed by Congress to serve as tax reduction tools, and the taxpayers in this case complied in full with the statutes governing both. In reaching their conclusion, the court stated that the taxpayers, “used DISCs, a unique, congressionally designed corporate form their family's business was authorized to employ, and Roth IRAs, a congressionally designed retirement account all agree they were qualified to establish, to engage in long-term saving with eventual tax-free distribution. Such use violates neither the letter nor the spirit of the relevant statutory provisions.”
Perhaps more interestingly, however, was the First Circuit's final comment regarding the use of the substance over form doctrine. Specifically, the court stated that, “The substance-over-form doctrine is not a smell test. It is, in this circuit, a tool of statutory interpretation. When, as here, we find that the transaction does not violate the plain intent of the relevant statutes, we can push the doctrine no further.” Thus, while First Circuit notes that the substance over form doctrine is clearly still a useful tool, the opinion appears to narrow the scope of the doctrine.
With this decision, the First and Sixth Circuit courts have now agreed that the application of the substance-over-form doctrine to re-characterize a DISC/Roth IRA transaction is inappropriate, further weakening the IRS’ position. There is still a remaining appeal of the Tax Court’s decision in Summa pending in the Second Circuit, however, so this story may not yet be over.
For more information regarding the Sixth Circuit’s ruling, see our previous alert, Tax Court decision on abusive DISC commissions to Roth IRA overturned.