By Nathan J. Richman
The IRS has lost a second appeal of its attempt to reclassify transactions between a domestic international sales corporation and Roth IRAs, unsuccessfully arguing that the substance-over-form doctrine should apply.
According to Stewart Karlinsky, executive director of the Pacific Tax Policy Institute, the result shows it is time for Congress to address DISC-Roth IRA arrangements. “The Roth IRA was really meant to be for the small guy,” he said. The First Circuit joined the Sixth Circuit with an April 6 decision in Benenson v. Commissioner, Nos. 16-2066, 16-2067 (1st Cir. 2018), reversing the U.S. Tax Court’s holding that the substance-over-form doctrine prevents using a DISC as a way around the Roth IRA contribution limits. The case is a separate appeal of the Tax Court’s holding in Summa Holdings Inc. v. Commissioner, T.C. Memo. 2015-119 (2015), and a third is pending in the Second Circuit.
The transactions at issue in all of the cases involve a family using a DISC to transfer money from their family-owned company to two Roth IRAs owned by their sons. DISCs were designed by Congress to encourage companies to export goods by deferring and lowering taxes on export income. Export companies can avoid corporate income tax by paying commissions to a DISC, which pays no tax on the commission income. Money can exit the DISC as dividends to shareholders. The two sons were the appellants in Benenson. They stipulated that the transactions sending DISC shares into Roth IRAs were purely tax motivated. The taxpayers had attempted to argue that the Sixth Circuit’s decision in Summa Holdings precluded an independent determination by the First Circuit, but the court distinguished between the parties to the two appeals and rejected the taxpayers’ comity argument.
The majority of the First Circuit went on to agree with the Sixth Circuit’s conclusions, finding that “the transaction violates neither the letter nor purpose of the relevant statutory provisions.” The First Circuit went on to agree that the tax-reduction purposes of both the DISC and Roth IRA provisions operate as approval of their use for reducing tax liabilities. Instead of imposing a judicial solution, the majority invoked sections 995(g) and 246(d) as Congress’s chosen tax avoidance backstops. Like the Sixth Circuit, the First Circuit majority was unimpressed with the IRS’s invocation of Notice 2004-8, 2004-1 C.B. 333, noting that the IRS never actually challenged the valuation of the shares transferred to the Roth IRAs.
Karlinsky pointed out that the closely held nature of the companies at issue makes it very difficult to discern the value of the shares transferred. “When you are buying publicly traded stocks and bonds, you have a value, but here they can manipulate it any way they want to make it work,” he said. The First Circuit also distinguished the Tax Court’s recent holding in Mazzei v. Commissioner, 150 T.C. No. 7 (March 5, 2018). In Mazzei, the Tax Court again applied the substance-over-form doctrine to a Roth IRA contribution, this time involving a foreign sales corporation. The First Circuit distinguished the cases on both the differences between the FSC and DISC provisions and the lack of valuation challenge in Benenson.
Stuart Bassin of the Bassin Law Firm PLLC said Mazzei was not that distinguishable from the situation in Summa Holdings and Benenson. The majority further agreed with the Sixth Circuit that Congress should fix the situation if it sees a problem with the result the Benensons achieved. According to the majority, “some may call the Benensons' transaction clever. Others may call it unseemly. The sole question presented to us is whether the Commissioner has the power to call it a violation of the Tax Code. We hold that he does not.” Judge Sandra Lynch dissented from the majority decision, asserting that “Congress did not intend DISCs to cut through common law tax doctrines under any and all circumstances.”
Karlinsky said the First Circuit’s agreement with the Sixth is interesting, especially in light of the Tax Court “sticking to their guns” in Mazzei. He said the strategy of appealing the Tax Court’s decision in Summa Holdings to three separate circuit courts may be clever, but that it risks the Second Circuit disagreeing and creating a circuit split.
Bassin said that the government will have to think hard about whether to appeal from the First Circuit’s opinion, even with the Tax Court holding a separate view. The government could be placing much of its separate tax shelter jurisprudence at risk before a Supreme Court that has not been particularly friendly in tax cases in recent years.
Bassin said that Congress may need to step in, but that the specific situation raised by the Benensons’ tax strategy — combining Roth IRAs and DISCs — is not the most important issue. Most critical is the general circumstance in which the taxpayer says to the IRS “I beat you fair and square” and the IRS disagrees, he said. When Congress creates things like DISCs and Roth IRAs, which start with artificial results, a court may have a difficult time determining what outcomes from the combination of those provisions are too artificial, Bassin said. Reliance on judicial doctrines such as substance over form is not a particularly good solution to either that problem or to the general problem of a complicated tax code leading to unintended interactions because awaiting the outcome of a court case creates uncertainty, he said.