How can $7,000 in Roth IRA contributions turn into a $6 million tax-free gain? And can you help your clients take advantage of the strategy that allows this to happen?
Before you jump in, however, there’s another question: Should you help your clients take advantage of this strategy? Examining a recent court ruling helps explain the risks involved — and why this approach should be used with caution.
In a surprising outcome, the 6th Circuit Court of Appeals in February reversed a Tax Court decision in the case of Summa Holdings v. Commissioner, and allowed for the tax-free transfer of millions into a Roth IRA, using domestic international sales corporation transactions.
The story began all the way back in 1983, when James Benensen Jr. founded Cleveland-based Summa (first known as Arrowhead Holdings). Summa became the parent corporation of a group of manufacturing companies that manufactures industrial components including aircraft products.
ESTABLISHING THE ROTH IRAS
Fast-forward to 2001, when James’ two sons, Clement and James Benenson III, established Roth IRAs. Each brother then transferred $3,500 to their respective accounts. Between 2002 and 2008, they never made another personal contribution to their Roth IRAs.
In 2002, both Roth IRAs purchased 1,500 shares of stock in JC Export, a Delaware corporation, in exchange for $1,500. JC Export had already filed an election for a domestic international sales corporation, also known as a DISC, which became effective for the tax year beginning Jan. 1, 2002.
On Jan. 31, 2002, the Roth IRAs each transferred shares of JC Export stock to another corporation the Benensons formed, called JC Holding, and received shares of JC Holding stock. From that time until Dec. 31, 2008, each IRA owned a 50% share of JC Holding, which owned JC Export.
That year, Summa and JC Export entered into agreements through which Summa made a series of payments to JC Export. Each time JC Export received a payment from Summa, it immediately transferred the entire amount of the payment to JC Holding as a dividend. Each time JC Holding received a payment from JC Export, it paid a 33% income tax on the dividends and made payments, also in the form of a dividend, to each of the Roth IRAs.
THE IRS TAKES NOTICE
By the end of 2008, each brother’s Roth IRA had accumulated over $3 million. Not surprisingly, this caught the attention of the IRS.
In 2012, the IRS issued notices of deficiency to the Benenson brothers for the 2008 tax year. The IRS said the payments the Summa subsidiaries made to JC Export were, in substance, dividends followed by excess contributions to the Roth IRAs. The case went to the Tax Court, where the IRS prevailed.
Then Summa appealed the ruling.
The 6th Circuit Court of Appeals overturned the Tax Court’s decision and held that the strategy of using DISC transactions to fund Roth IRAs was permissible.
As noted by the court, “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.”
WHEN A DISC MEETS A ROTH IRA
To understand the court’s decision, you must understand how a DISC and Roth IRA can work together. While Roth IRAs are a common feature of retirement planning, DISCs are encountered far less frequently by most advisers. DISCs were created by Congress to subsidize U.S. exports, and using them can reduce tax rates on income from exports.
The court gives a good explanation of how a DISC could potentially be used with an IRA. First, the owner of an export company could transfer money from the company to the DISC, which then pays some of that money as a dividend to its shareholders, allowing the money to enter the Roth IRA and grow there.
The IRA owner must pay the high unrelated business income tax when the DISC dividends are transferred to the Roth IRA. But once the Roth IRA receives the money, as with all Roth IRAs, the owner would not have to pay any taxes if the funds are distributed as a qualified distribution. This means the Roth IRA funds have been held for at least five years, and the Roth IRA owner is age 59 ½ or older.
The court said the transactions, as conducted, complied in full with the tax code. The Benenson family used tax attorneys who advised the family to use a DISC to transfer money from their family-owned company to the brothers’ Roth IRAs.
They complied with all the rules regarding DISCs and Roth IRAs. They correctly paid 33% in taxes on the dividends before paying them to the Roth IRA. The tax code permits both traditional and Roth IRAs to own DISCs. The IRS did not dispute that the Benensons had complied with all relevant provisions of the law.
IRS OVERPLAYED ITS HAND
In the court’s view, the IRS overplayed its hand by using a very broad interpretation of the substance-over-form doctrine. It did not buy the IRS’ argument that, under this doctrine, it could override any given transaction based on facts and circumstances.
In fact, the court acknowledged that “by congressional design, DISCs are all form and no substance.” The court stated that the tax code “authorizes companies to create DISCs as shell corporations that can receive commissions and pay dividends that have no economic substance at all.”
The court noted that, if the IRS can override transactions that the tax code expressly authorizes, then the written tax code has no purpose. It also acknowledged that Congress probably did not intend taxpayers to combine Roth IRAs and DISC provisions for a huge tax windfall.
However, it did not see that as a problem for the courts. Essentially, because Congress created the problem when making the law, they own it. If Congress sees DISC–Roth IRA transactions as creating an improper loophole, then they must fix the law by taking legislative action.
NOT A STRATEGY FOR MOST CLIENTS
If they hear the news of this case, which is very favorable to the taxpayer, clients may ask if they should consider similar plans for their Roth IRAs. Advisers should be extremely wary of this unprecedented ruling, and should proceed with caution for several reasons.
First, this story is not over. As of this writing, the IRS has not announced whether they will appeal this decision to the Supreme Court. Statistics show the 6th Circuit is a court often reversed by the Supreme Court.
On the other hand, the IRS may not want to roll the dice with a Supreme Court that can be unpredictable and set a precedent greatly limiting the IRS’ options for challenging tax shelters. The IRS may prefer to let the decision stand and interpret it narrowly. Two related cases are also still winding their way through the court system.
Additionally, while the taxpayers in this case got a good result from the Court, their circumstances were exceptional. The family business qualified as an export business, which could use a DISC. It is unlikely that many clients are as well-suited to establish a DISC.
The court itself noted that the Benenson family, to its “good fortune,” had the time, patience and money necessary to use two complex sets of tax provisions to lower their taxes. They could afford to pay for the advice of expert attorneys who made sure every box was checked.
Also, the attorney they hired to argue the case in appeals court — Neal Block, senior counsel at Baker McKenzie — is a nationally recognized authority on export law who has testified before Congress as a DISC expert. It would be an expensive proposition for most clients to engage this kind of high-powered legal representation. Even then, the client would have to evaluate whether the legal cost would be worth the benefit.
To top it off, the Benenson brothers had an extraordinary investment return, with $7,000 combined growing to $6 million in just seven years. Other clients will probably not be so lucky. Even if all transactions are done properly, the Roth IRA investment would have to produce a stellar return to offset the cost to set it up, not to mention potential legal fees if the strategy is challenged by the IRS.
While the full implications of this case are not yet known, what’s likely is that the IRS will continue to scrutinize these transactions and attack them in court, using an endless variety of legal strategies. Few clients will want (or be able to afford) the many years of ongoing litigation the Benenson family signed on for in this case. And if a transaction is determined to be invalid, clients could face significant penalties, and possibly the loss of their retirement savings.
In short: When it comes to using this strategy, the old adage, “If it seems too good to be true, it probably is” typically applies.