Roth IRA Can be DISC Shareholder

March 1, 2017

In a very recent case, Summa Holdings, Inc. v. Comm (2/16/2017), the Court of Appeals for the Sixth Circuit, reversing the Tax Court, has upheld the taxpayers’ use of a domestic international sales corporation (“DISC”) to transfer money from a “C” corporation to his sons’ Roth IRAs.  The DISC transferred over $3 million to each IRA in a short period of time.  The amount transferred was well in excess of the amount an individual could transfer into an IRA.  But the Appeals Court found that, while the purpose of the transactions was clearly tax avoidance, the taxpayers’ actions were “congressionally sanctioned,” and the IRS’s application of the “substance over form” doctrine was not appropriate.

Roth IRA

A DISC is a special entity authorized by the Internal Revenue Code (“IRC”) in an attempt to increase the volume of domestically produced products that are exported for sale outside the US. Under the IRC, a corporation is permitted to take a tax deduction for the “royalty” amount paid to the DISC.  The royalty amount is equal to the greater of 50% of export income or 4% of export revenue.  The DISC is not itself taxed on the royalty it receives.  Rather, each of the DISC’s shareholders is taxed on their share of the DISC’s earnings in the form of an actual or deemed distribution.  The DISC shareholder’s pay federal income tax on such distribution at the qualified dividend rate (currently 20%) rather than the ordinary income tax rate (could be as high as 39.6%).  The use of a DISC allows for both deferral of taxation and taxation of income at a lower rate.

Contributions to a Roth IRA are not tax deductible, but all earnings accumulate tax-free, and all qualified distributions are tax-free. The IRC establishes a maximum aggregate amount that an individual can contribute to all of his Roth IRAs for a tax year.  The IRC imposes for each tax year an excise tax of 6% for excess contributions to a Roth IRA.

IRS Notice 2004-8 provides that when a taxpayer’s business enters into transactions with a corporation owned by the taxpayer’s Roth IRA, the transactions may not be fairly valued, with the effect that shifting excess value into the Roth IRA. This notice identified 3 ways that the IRS would challenge these transactions. One of these ways was to assert a “substance over form” argument. That is, the substance of the transaction was a payment by the DISC to the individual taxpayer, followed by a contribution by the taxpayer to the Roth IRA.  The other ways, not argued in the Summa Holdings case are that the transactions amount to “prohibited transactions” under IRC section 4975, or that the transactions are “listed transactions” under Treasury Regulation section 1.6011-4, and in either case should be characterized to reflect appropriate economic realities.

In the Summa Holdings case, Summa was a “C” corporation manufacturer that was owned by James Benenson and his Trust. The beneficiaries of the Trust were James’ two sons. Each of the sons established Roth IRAs.  The Roth IRAs were made the shareholders of the Summa DISC.

Summa had significant export revenue and income and paid several million dollars of royalties to the DISC. The DISC in turn paid most of these amounts to the Roth IRAs.  Summa deducted the royalty amounts it paid the DISC, and the DISC reported its receipt of the royalty amounts from Summa.  The IRS issued notices of deficiency in which it determined that the payments that Summa made to the DISC were, in substance, dividends to Summa’s shareholders including James and the Trust, followed by contributions by the Trust to the Roth IRAs.

Summa and James brought suit in Tax Court. The parties stipulated that: (1) the taxpayers’ sole reason for entering into the transactions was to transfer money into the Roth IRAs so that the money could be invested, appreciate tax free and be distributed tax-free; and (2) the taxpayers had no non-tax business purpose for creating the DISC, paying the royalties to the DISC and having the DISC pay dividend to the Roth IRAs.

Applying the “substance over form” doctrine, the Tax Court held that the payments that Summa made to the DISC were not really DISC commissions, but rather were deemed dividends to Summa’s shareholders followed by contributions to the Roth IRAs. The IRS argued that the taxpayers shifted value to the Roth IRAs far in excess of the annual contribution limits, and that simply labeling the payments as DISC commissions did not protect the payments from the application of “substance over form” principles.

The Court of Appeals for the Sixth Circuit overruled the Tax Court and found that, while the purpose of the transactions was admittedly to lower taxes, it was expressly authorized under the IRC. The Court determined that the IRS’s application of the “substance over form” doctrine was not effective to undermine an IRC sanctioned transaction. The Appeals Court reasoned that DISCs were intended to give taxpayers tax incentives to export domestically produced goods.

Prior to enactment of IRC section 995(g), tax-exempt entities paid no tax on DISC dividends.  This allowed export companies to shield active business income from tax. But under IRC section 995(g), tax-exempt entities are required to pay an unrelated business income tax, thus making it less attractive for a traditional IRA to own shares in a DISC.  However, given the fact that Roth IRAs accept after tax contributions, grow tax-free and make tax-free distributions, it is still potentially advantageous from a tax standpoint for a Roth IRA to own shares in a DISC.

The owner of a closely-held export corporation which has set up a DISC with Roth IRAs as the DISC shareholders, can have the corporation transfer royalty money to the DISC and have the DISC pay some or all of the money to the DISC shareholders, thereby allowing the money to enter the Roth IRA and grow there. The Roth IRA account holder would have to pay the unrelated business income tax when the DISC dividends go into the Roth IRA account, but these funds could then be invested freely and grow without further tax consequences.

If you are interested in setting up a DISC to reduce and defer tax on export income, or want to consider having a Roth IRA be a DISC shareholder so that the amounts transferred to the Roth IRA can grow tax free, please contact one of our tax attorneys at 937-223-1130 or JSenney@pselaw.com.

©2017 Pickrel, Schaeffer, and Ebeling

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