WARNING: Do not try the following strategy unless, at least:
- Your daddy built a big company that exports products
- You have the nerve to battle the IRS for many years
- You have creative and careful tax advisors (like me!)
- You have the money to hire white-shoe lawyers, who probably charge $1,000 per hour, to represent you in Tax Court
- Preferably, you live within or relocate to be within the geographic boundaries of the Sixth Circuit Court of Appeals (MI, OH, KY or TN)
If you qualify, then read on, oh lucky, wealthy and intrepid taxpayer.
In my last blog, I urged caution when considering the acquisition of alternative investments in IRAs. I still so urge. However, the Sixth Circuit’s recent decision in Summa Holdings does inspire one to consider being creative.
Let’s start with the headline, as stated by nationally renowned IRA expert Ed Slott: “$7,000 in Roth IRA contributions that became $6 million in tax-free gains.”
Do I have your attention?
Next, we consider quick explanations of two important tax-beneficial provisions of the Internal Revenue Code: Roth IRAs and DISCs (Domestic International Sales Corporations).
A taxpayer may contribute after-tax dollars to a Roth IRA. The earnings and gains within the Roth are, in most cases, not taxed. If a taxpayer owns the Roth for at least 5 years and is at least 59 ½ years of age, distributions to the owner of the IRA are not taxed. Sweet. Why not put all my after-tax earnings in a Roth? The limits on contributions to Roth IRAs are low, if your income is below a certain threshold that permits you even to make a Roth IRA contribution. If you are not at least 50 years of age, then in 2017 you can contribute no more than $5,500. The limit was $3,500 in 2001, when the Benenson brothers started the series of actions that resulted in the Summa Holdings case.
DISCs were created by Congress to subsidize U.S. exports. Using DISCs can reduce tax rates on income from exports. An exporter avoids corporate income tax by paying the DISC “commissions” of up to 4% of gross receipts or 50% of net income from qualified exports. The DISC pays no tax on its commission income (up to $10,000,000 in a year) and may hold on to the money indefinitely, though the DISC shareholders must pay annual interest on their shares of the deferred tax liability.
Money and other assets in a DISC may exit the DISC as dividends to shareholders. Individuals treat the dividends as qualified dividends and pay taxes on the dividends at long-term capital gains tax rates. If an IRA owns the DISC, it must pay tax on its dividends at the high unrelated business income tax rates.
What kind of business operations must the DISC conduct to earn these benefits for its shareholders? None, nothing, nada.
So what did the Benenson brothers do?
- In 2001, each contributed $3,500 to his Roth IRA.
- Through a series of transactions, their Roth IRAs formed companies that resulted in a DISC.
- The DISC contracted with Summa Holdings, owned primarily by a trust for their benefit, to receive export commissions.
- The DISC made distributions to the Roths, which paid UBIT and retained the after-tax distributions.
- By the end of 2008, the two Roths initially funded with $3,500 each had each accumulated over $3,000,000. Earnings on the non-DISC investments of the Roth will never be taxed to the Roth and distributions will never be taxed to the Roth owners, if distributions don’t occur before age 59 ½.
The IRS came a-calling. The Revenuers claimed that the “substance-over-form” doctrine applied to negate the transactions and the benefits. The IRS recast the transaction as dividends from Summa Holdings to its shareholders (the trust and the boys’ parents). The Tax Court agreed.
The Sixth Circuit disagreed with the IRS and the Tax Court. The Court stated that the IRS stretched substance-over-form past its limits, which, in the Court’s opinion, are when the taxpayer’s formal characterization of a transaction fails to capture the economic reality and would distort the meaning of the Code.
The Sixth Circuit said that the taxpayers’ transactions fit well within the boundaries of the statutes enacted by Congress. If Congress wants to change the statute, it can; the IRS cannot change the statute. The Sixth Circuit pointed out that the whole DISC idea is a form-over-substance arrangement authorized by Congress to promote exports.
So, the taxpayers got a great result. The general issue is probably not resolved. Two similar cases are being pursued in two other Federal Circuits. A statute addressing economic substance has been enacted since the taxable years under consideration. The Sixth Circuit’s apparent narrowing of the ubiquitous substance-over-form doctrine may have much broader reverberations.
In any case, under the right circumstances, being creative, bold and an IRA owner can be quite lucrative.
Ending Note. On an evening that you have nothing better to do, you might read the Summa Holdings opinion written by Judge Sutton. One can surmise that any court opinion starting with references to the bat-crazy Roman Emperor Caligula is going to be entertaining.