On February 16, 2017, the Sixth Circuit Court of Appeals in Summa Holdings, Inc. v. Commissioner of Internal Revenue, rebuffed an IRS challenge to a family of savvy taxpayers' literal application of the Internal Revenue Code. The dispute involved Roth IRAs' investments in an innovative Congressionally authorized business entity known as a "domestic international sales corporation" (a "DISC"). The IRS asserted that distributions from the DISC to the Roth IRAs were in substance contributions in excess of the annual contribution limits. The taxpayers' innovative strategy was designed and implemented based on a literal interpretation of the tax laws. The IRS took exception, arguing that the spirit of the tax law (using the economic substance doctrine) is binding over the letter of the law. The Sixth Circuit Court of Appeals unanimous opinion began with the following:
"Caligula posted the tax laws in such fine print and so high that his subjects could not read them. That's not a good idea, we can all agree. How can citizens comply with what they can't see? And how can anyone assess the tax collector's exercise of power in that setting? The Internal Revenue Code improves matters in one sense, as it is accessible to everyone with the time and patience to pore over its provisions. In today's case, however, the Commissioner of the Internal Revenue Service denied relief to a set of taxpayers who complied in full with the printed and accessible words of the tax laws."
With that introduction, the court's opinion only became worse for the IRS.
The substance of the transaction at issue involves two corporations: an export company taxed under Subchapter C and the DISC. To encourage the export of American products, Congress created a legal tax avoidance mechanism by which the export company can receive an ordinary income tax deduction by paying commissions to a DISC. The DISC pays no entity level tax on commission income when received. Instead, the DISC shareholders pay taxes at dividend rates on funds distributed. In Summa Holdings, the taxpayers' savvy advisors crafted a structure that placed the ownership of the taxpayers' DISC into the taxpayers' Roth IRAs by way of a holding company. The result to the taxpayers was (1) an ordinary income tax deduction to the export company for commissions paid to the DISC, (2) the DISC received the commission income tax free, and (3) the DISC distributed its commission income as a dividend to its shareholder holding company which in turn distributed the funds it received to its shareholder Roth IRAs.
As implemented, the dividends received from the DISC by the holding company were currently taxable, however, when the funds were later distributed to the Roth IRAs as a dividend from the holding company, the Roth IRAs received the money tax free. At first blush, this complex transaction may seem to avoid only the export corporation's double taxation imposed by Subchapter C. The true purpose of the transaction becomes clear only when the DISC's ownership by the Roth IRAs is considered. The Roth IRAs acquired their indirect interests in the DISC when the DISC was newly formed and minimally valued. The Roth IRAs were thus able to acquire substantial interests in the DISC with little capital. When the strategy was placed into motion, the DISC was able to distribute large sums of cash, $6,000,000 over 6 years, to the Roth IRAs as dividends.
Summa Holdings establishes a victory for effective tax planning and showcases the utility of the Roth IRA as a wealth-building tool. Through careful planning, the Sixth Circuit Court of Appeals vindicated the taxpayers' use of Roth IRAs to quickly funnel millions of dollars into tax advantaged accounts in complete compliance with the tax laws.
The tax planning attorneys at McLaughlinQuinn LLC regularly work with clients to structure tax-efficient wealth building tools incorporating tax advantageous accounts such as Roth IRAs. For more information on this client alert or to discuss how the Summa Holdings strategy may be modified to apply to your particular situation, please contact tax planning partner Cory J. Bilodeau, Esq., at