The Sixth Circuit Court of Appeals upheld the IC-DISC Roth IRA tax strategy in In Summa Holdings, Inc. v. Commissioner, No. 16-1712 (2017). This tax strategy allows business owners to sidestep the annual Roth IRA contribution limits, thereby allowing the taxpayers to amass sizable amounts in their Roth IRAs to grow tax-free. The case is noteworthy as it addresses the limits of the IRS’s ability to use the substance over form doctrine to recast otherwise legitimate tax strategies.
The Facts & Procedural History
The facts and procedural history of the case are as follows:
- The case involved a family-owned manufacturing business.
- Two of the owner’s children established Roth IRAs in 2001 and contributed $3,500 to each IRA.
- Each Roth IRA then purchased shares in a newly created legal entity (“DISC Entity”) in 2001 for $1,500.
- The family formed another legal entity that purchased the DISC Entity (“Holding Entity”).
- So the Roth IRAs each owned 50% of the Holding Entity and the Holding Entity owned 100% of the DISC Entity.
- The family business paid more than $5 million in commissions to the DISC Entity.
- The DISC Entity distributed this $5 million commissions as dividends to the Holding Entity.
- The Holding Entity paid a 33% income tax on the $5 million dividends and distributed the amounts to the Roth IRAs.
- The IRS issued notices of deficiency to the family business for 2008, arguing that the amounts paid to the DISC Entity were not commissions but rather dividends. This precluded the use of the IC-DISC rules. This also resulted in the family business not being entitled to the deductions it took for the commissions it paid.
- The IRS’s notice of deficiency was based on the substance over form doctrine.
- The U.S. Tax Court agreed with the IRS’s determination.
On appeal, the court was tasked with deciding whether the substance over form doctrine should be used when the actual transactions complied with the law and were consistent with the Congressional intent underlying the relevant tax statutes.
The IC-DISC Rules
The IC-DISC rules are intended to be an incentive for taxpayers to export U.S. products. It accomplishes this by allowing the business to deduct commissions paid to an entity set up to receive the commissions and the entity that receives the commissions may be able to pay tax on the income at the lower dividend tax rate. The resulting tax reduction can prove to be a significant monetary incentive for U.S. manufacturers. The tax reduction can be even greater when, as in this case, the IC-DISC is combined with a Roth IRA–assuming the arrangement is upheld by the courts.
The Importance of Tax Reduction Statutes
This brings us back to the case at hand. The IRS argued that it should be allowed to disregard the formalities of the Roth IRA-IC-DISC transaction, which satisfied the formalities of the law requirement as the transaction complied with the law, to look to the substance of the transactions. To the IRS, the substance of the transaction was to avoid the annual Roth IRA contribution limits.
The appeals court did not agree. The appeals court focused on the fact that the Roth IRA and IC-DISC rules are tax reduction statutes. Congress made it clear that these statutes were intended to be used by taxpayers to reduce their tax liabilities:
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. See 26 C.F.R. § 1.994-1(a); Addison Int’l, Inc. v. Comm’r, 887 F.2d 660, 666 (6th Cir. 1989); Jet Research, Inc. v. Comm’r, 60 T.C.M. (CCH) 613 (1990). By congressional design, DISCs are all form and no substance, making it inappropriate to tag Summa Holdings with a substance-over-form complaint with respect to its use of DISCs. The same is true for the Roth IRAs. They, too, are designed for tax-reduction purposes.
When the Substance Over Form Doctrine Applies
According to the appeals court, the substance over form doctrine should only apply to transactions that are a labeling game sham (i.e., calling a dog a cow and seeking an incentive that applies to cows) and transactions that defy economic reality. The substance over form doctrine is not to apply when two potential options for structuring a transaction lead to the same end and the taxpayers choose the lower-tax path, when these types of tax reduction statues are in question.