In Summa Holdings v. Commissioner, the Sixth Circuit has reversed the Tax Court to hold that the IRS erred in applying the substance-over-form doctrine to recharacterize certain transactions involving Roth IRAs and a domestic international sales corporation (DISC) for a family-owned company. The IRS argued that dividends from the DISC that were paid to the Roth IRAs were essentially excess Roth IRA contributions. The court disagreed with the IRS's use of the substance-over-form doctrine, stating: "Because Summa Holdings used the DISC and Roth IRAs for their congressionally sanctioned purposes — tax avoidance — the Commissioner had no basis for recharacterizing the transactions and no basis for recharacterizing the law's application to them."

The taxpayer in the case is Summa Holdings and the tax assessment being adjudicated by the Sixth Circuit is Summa Holding's deduction. However, the rationale of the Sixth Circuit's opinion undercuts the IRS's argument that excess contributions had been made to the Roth IRAs.

Background

With advice of tax counsel, the Benenson family utilized a DISC to transfer money from a family-owned business — Summa Holdings — to the sons' Roth IRAs. At the time of the transaction, Summa Holdings was the common parent of a group of companies that manufactured industrial products and was owned 23.18% by James Benenson, Jr., the father, and 76.05% by a trust established for his two sons. The sons each established a Roth IRA and contributed $3,500 to their accounts. Within a few weeks, each of the Roth IRAs paid $1,500 for 1,500 shares of stock in a newly formed DISC named "JC Export." The Benensons also formed JC Holding, which purchased from the Roth IRAs the shares in JC Export so that the Roth IRAs, instead, owned JC Holding, which in turn owned JC Export. This transaction was entered into to prevent the Roth IRAs from incurring any tax-reporting or shareholder obligations that would have resulted from owning JC Export directly.

Summa Holdings then paid commissions to JC Export, which distributed the commissions in the form of dividends to JC Holding; JC Holding paid income tax on the dividends at a 33% rate and distributed the balance to the two Roth IRAs. Between 2002 and 2008, approximately $5.18 million was transferred from Summa Holdings to the Roth IRAs, including nearly $1.48 million in 2008. The IRS issued a deficiency notice for the 2008 tax year, by which time the Roth IRAs had accumulated more than $3 million each.

The IRS asserted that, although the Benensons had complied in form with relevant Code provisions, "the effect of these transactions was to evade the contribution limits on Roth IRAs" and the transactions should be recharacterized as "dividends from Summa Holdings to the Benensons followed by excess Roth IRA contributions." The IRS applied the substance-over-form doctrine to reclassify the payments to JC Export. In effect, the IRS recharacterization ignored the presence of JC Export and the DISC, and treated payments as dividends paid from Summa Holdings directly to its shareholders who then made excess contributions to the Roth IRAs. Accordingly, the IRS also imposed a 6% penalty under Section 4973 on the Roth IRA contributions, as well as an accuracy-related penalty under Section 6662 on Summa Holdings.

Sustaining the Service's determination, the Tax Court specifically noted the issuance of Notice 2004-8, 2004-1 C.B. 333, in which the IRS addressed transactions used to avoid Roth IRA contribution limits. Notice 2004-8 provides that when a taxpayer enters into transactions with a corporation owned by the taxpayer's Roth IRA, not fairly valuing the shares being transferred may "have the effect of shifting value into the Roth IRA." One of the ways the Notice indicates that the IRS would challenge these transactions is to apply a substance-over-form argument and recharacterize the value shifted from the preexisting business as a payment to the taxpayer followed by an excess contribution to the Roth IRA.

Sixth Circuit's decision

The Sixth Circuit did not follow the Tax Court's analysis that the transaction was a "value shift" to the Roth IRA that should be recharacterized. Instead, the Sixth Circuit took the IRS to task for applying the substance-over-form doctrine to transactions that had been structured to utilize particular Code sections as they were intended to be used. The court stated:

"Each word of the 'substance-over-form doctrine,' at least as the Commissioner has used it here, should give pause. If the government can undo transactions that the terms of the Code expressly authorize, it's fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is."

The Sixth Circuit emphasized that the "Code authorizes companies to create DISCs as shell corporations that can receive commissions and pay dividends that have no economic substance at all … 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."

The Sixth Circuit further explained the tax benefits of the transactions as follows:

"The owner of a closely held export company could transfer money from the company to the DISC, as the statute encourages, and pay some (or all) of that money as a dividend to its shareholders, allowing the money to enter the Roth IRA and grow there. The IRA account holder, it is true, would have to pay the high unrelated business income tax — here roughly 33% — when the DISC dividends go into the IRA. But once the Roth IRA receives the money, the account holder could invest it freely without having to pay capital gains taxes on increases in the value of each share or incomes taxes on the dividends received — just like other Roth IRA owners who buy shares of stock in companies that generate considerable dividends and rapid growth in share value. As with all Roth IRAs, the owner would not have to pay any individual income or capital gains taxes when the assets leave the account after he hits the requisite retirement age."

Ultimately, the "Internal Revenue Code allowed Summa Holdings and the Benensons to do what they did," and the Commissioner may not "recharacterize the meaning of statutes — to ignore their form, their words, in favor of his perception of their substance," the court concluded. Accordingly, the Sixth Circuit reversed the Tax Court, which allows Summa Holdings' deductions and the Benensons' exclusion of the deducted amount from income.

Implications

Although the taxpayers prevailed, it may be appropriate to view this case as limited to its facts and limited to the particular benefits afforded payments to DISCs. The sole question before the Sixth Circuit was whether Summa Holdings' deduction for payments to the DISC should be denied and recharacterized. There may be other potential questions about Roth IRA transactions with an owner's preexisting business, such as whether the valuation of the shares purchased by the IRAs is reasonable or whether the sale or exchange results in a prohibited transaction, neither of which appears to have been raised and, therefore, not considered in an appellate review by the Sixth Circuit.

An underpinning of the Tax Court opinion was that an inappropriate "value shift" had occurred between the corporations and the Roth IRAs. The Sixth Circuit explicitly notes, however, that the IRS never challenged the valuation of the shares purchased by the Roth IRAs. Each Roth IRA paid $3,500 for shares that in approximately seven years yielded an IRA balance of $3 million each. While the Sixth Circuit did not agree with the substance-over-form recharacterization that the IRS sought to impose on Summa Holdings, the appeals court did not overrule Notice 2004-8, and the provisions of Notice 2004-8 and its reporting requirements for Roth IRAs continue, including the rules on certain "listed transactions."

This case will have broader interest to taxpayers and their advisors seeking to understand the parameters of potential substance-over-form arguments by the IRS. This case will likely be cited by taxpayers in the future as a defense to substance-over-form arguments in areas of law well beyond the IRA/DISC arena. Although the taxpayers in Summa Holdings were able to use the IRA/DISC as a shield against IRS attacks, taxpayers should be cognizant that the effectiveness of this shield in other courts, and on different facts, is yet to be seen.

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