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First Circuit Reverses Tax Court; Roth IRA Arrangement Did Not Lack Economic Substance

(Parker Tax Publishing April 2018)

The First Circuit held that approximately $1.4 million in dividend distributions from a domestic international sales corporation to two Roth IRAs was not an excess contribution subject to excise tax. The First Circuit reversed the Tax Court's holding that the distributions were in essence dividends to the owners of the Roth IRAs under the substance over form doctrine because it found that the transactions were a permitted tax avoidance arrangement under the Code and were consistent with Congress's intent in permitting DISC distributions to Roth IRAs. Benenson v. Comm'r, 2018 PTC 98 (1st Cir. 2018).


Summa Holdings, Inc. is a C corporation and the parent of a consolidated group of manufacturing companies with export sales. Summa Holdings' shareholders include Clement and James Benenson III, a married couple. This case arose from a transaction the Benensons and Summa Holdings engineered to reduce their taxes through the use of a domestic international sales corporation (DISC) and Roth IRAs.

In 2002, the Benensons formed Roth IRAs and deposited $3,500 into them. Each Roth IRA then paid $1,500 for 1,500 shares in JC Export, a newly formed DISC. DISCs were created by Congress in 1971 to subsidize domestic exporting companies. A DISC pays no federal income tax and can receive export income as commissions, which it typically pays out as dividends to the export company's shareholders. The net effect of the DISC is to distribute export revenue to shareholders without taxing it first as corporate income.

The Roth IRAs sold their shares in JC Export to JC Holding, a C corporation formed by the Benensons. Each Roth IRA received a 50 percent stake in JC Holding. The purpose of JC Holding was partly to ensure that the Roth IRAs would avoid having unrelated business income. JC Export then began receiving commissions from the subsidiaries of Summa Holdings and transferred the funds to JC Holding. After setting aside an estimated amount for federal income taxes, JC Holding paid out the remainder to the Roth IRAs as dividends. In 2008, JC Holding transferred approximately $1.4 million to the Roth IRAs. By the end of 2008, each of the Benensons' Roth IRAs was worth over $3.1 million.

The Benensons stipulated that the sole reason for entering into the transactions was to transfer money into their Roth IRAs so that income could accumulate and be distributed on a tax free basis. They also stipulated that they had no nontax business purpose for establishing the Roth IRAs, JC Export, or JC Holding.

In 2004, the IRS issued Notice 2004-08, which described transactions intended to avoid the statutory limits on Roth IRAs. The transactions involved a taxpayer who owned a preexisting business, a Roth IRA maintained for the taxpayer's benefit, and a corporation acquired by the Roth IRA. The taxpayer's business would then transfer value to the corporation owned by the Roth IRA. The Notice described how either the Roth IRA's purchase of shares in the corporation or the transaction between the taxpayer's business and the corporation would not be fairly valued and would therefore have the effect of shifting value into the Roth IRA in excess of the contribution limits. The Notice declared the IRS's intent to deny or reduce deductions made using these transactions.

Summa Holdings and the Benensons received notices of deficiency in 2012, determining that the DISC commissions paid to JC Export in 2008 were in substance dividends to the shareholders of Summa Holdings. The IRS viewed the resulting payments from JC Holding to the Roth IRAs not as dividends but as contributions to the Roth IRAs in excess of the contribution limits allowed by law.

The Tax Court affirmed the IRS's determination in Summa Holdings, Inc. v. Comm'r, T.C. Memo. 2015-119 (2015). The Tax Court recharacterized the transaction under the substance over form doctrine, finding that its purpose was to shift funds into the Roth IRAs in violation of the statutory contribution limits. Summa Holdings appealed to the Sixth Circuit, which reversed the Tax Court's decision in Summa Holdings, Inc. v. Comm'r, 2017 PTC 58 (6th Cir. 2017). The Sixth Circuit found no basis for recharacterizing the transactions because the DISC and Roth IRAs were used for their congressionally authorized purposes of tax avoidance.

As Massachusetts' residents, the Benensons appealed the Tax Court's decision to the First Circuit. On appeal, the IRS argued that Congress created Roth IRAs to incentivize savings among America's working population and that the contribution limits reflected Congress's intent to limit Roth IRAs' impact on tax revenue and were meant to ensure that Roth IRAs would not be used to divert unlimited business funds into tax shelters. The IRS also saw the Benensons' transaction as different from other investments in privately held companies because it argued that there was no risk involved in the transaction.


The First Circuit reversed the Tax Court and held that the arrangement violated neither the letter nor purpose of the relevant statutory provisions. In the court's view, the substance over form doctrine is a tool of statutory interpretation that applies only where the objective economic realities of a transaction are contrary to the plain intent of the Code, and did not apply to the Benensons' arrangement, which the court found was authorized by the Code.

First, the court found that Congress created DISCs to enable export companies and their shareholders to defer tax. The court explained that DISCs were intended to stimulate economic activity and increase exports as well as to place domestic exporters on an equal footing with companies using foreign subsidiaries. According to the court, Congress understood that DISCs would be used in part to increase returns for shareholders. The court found that DISCs were envisioned by Congress as shell corporations with no economic substance. This purpose was reflected in Reg. Sec. 1.994-1(a), which provides that the DISC commission pricing rules do not depend on the extent to which the DISC performs substantial economic functions. In the court's view, a DISC was, by design, a way for domestic companies to defer tax and pay dividends using a structure that might otherwise run afoul of the Code.

The court found merit in the IRS's argument that Roth IRAs were intended to provide a savings mechanism to taxpayers of more modest means than the Benensons. Notwithstanding, the court found that the Benensons were qualified to make their initial contributions in 2002 and reasoned that there was no limit on the amount of dividends a Roth IRA can earn on the stock it holds. The court explained that for wealthy taxpayers, Roth IRAs are strategic vehicles for investing in private companies which may pay out substantial dividends. This use of a Roth IRA was consistent with the purpose of incentivizing long term savings and investment for retirement. As long as the owner of the Roth IRA was qualified to make the initial contributions, the court found that it was not contrary to the statute's purpose to allow their contributions to grow through investment in qualified companies, even during periods where the taxpayers' high income disqualified them from contributing to the Roth IRA.

Next, the court found that Roth IRA and corporate ownership of DISC shares is authorized by the Code. Under Code Sec. 995(g), tax exempt shareholders of DISCs (including Roth IRAs) incur unrelated business income tax on DISC dividends at the corporate income tax rate. Code Sec. 246(d) provides that a corporate shareholder of a DISC is subject to corporate income tax on DISC dividends. Considering Code Secs. 995(g), 246(d) and 408A together, it appeared to the court that Congress contemplated Roth IRAs holding DISC proceeds. The court also noted that in this case, JC Holding paid income tax on the $2.1 million it reported as distributions from JC Export at the corporate tax rate. The court found it was reasonable to assume that when Congress created Roth IRAs, it was aware that traditional IRAs could receive dividends from both C corporations and DISCs and was comfortable with Roth IRAs engaging in the same transactions, as long as a tax equal to the corporate income tax (either under Code Sec. 246(d) or Code Sec. 995(g)) was paid.

The court rejected the IRS's argument that the Benensons' arrangement involved no risk. To the extent risk was required, the court found that it was present in the commissions the DISC received, which depended on the success and profitability of Summa Holdings' export companies. The court added that if the transaction involved a lower risk than other investment structures, it was due to the unique, congressionally designed DISC corporate form.

Notice 2004-8 did not save the IRS's position because, in the court's view, it did not appear that the Benensons' transaction fell with the Notice's scope. Notice 2004-8 describes transactions in which shares are not fairly valued. However, the court found that the IRS never challenged the valuation of the shares the Roth IRAs purchased in either JC Export or JC Holding.

Observation: In a dissenting opinion, one judge would have affirmed the Tax Court's opinion. The dissenting judge reasoned that the purpose of DISCs was to defer corporate income tax, not to implicitly set aside the limits on Roth IRA contributions. The dissenting judge would have found that the transaction was devoid of substance because the companies and Roth IRAs were all owned by members of the same family, the DISC shares were not purchased at market prices, and the sole reason for the transaction was to circumvent the Roth IRA contribution limits.

For a discussion of the taxation of Roth IRA transactions and DISCs, see Parker Tax ¶135,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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