On February 16, 2017, the United States Court of Appeals for the Sixth Circuit unanimously overturned a June 2015 Tax Court decision that sided with the Commissioner. In the Tax Court decision, a family-owned export company’s tax-favorable export commissions, which were contributed to Roth IRAs, were recast as dividends to the shareholders. The well-reasoned Sixth Circuit opinion in Summa Holdings, Inc. v. Commissioner[1] questioned the legitimacy of the substance-over-form doctrine and found that the transactions complied with the Internal Revenue Code in all respects.


Transaction Structure

Summa Holdings (“Summa”) is the parent corporation of a group of companies that manufacture industrial products. James Benenson Jr. and a trust for the benefit of his sons, James III and Clement, owned over 99 percent of Summa. In 2001, James III and Clement each contributed $3,500 to newly formed Roth IRAs. Each Roth IRA then purchased shares of JC Export, Inc. (“JC Export”), a newly formed domestic international sales corporation (“DISC”). JC Export Holding, Inc. (“JC Holding”), a newly formed corporation, then purchased the shares of JC Export from the Roth IRAs. As a result, from January 2002 to December 2008, each Roth IRA owned 50 percent of JC Holding, which was the sole owner of JC Export.[2]

A DISC is entitled to receive up to $10 million of tax-free commissions from qualified exports in conjunction with an export company. The DISC may pay dividends, which are taxed to its shareholders at their applicable rates.3 Dividends from a C corporation are not taxable to a Roth IRA and the owner of a Roth IRA does not pay tax on gains on withdrawals.[4]

From 2002 to 2008, Summa transferred $5,182,314 as DISC commission to JC Export. JC Export distributed the entirety of the commissions to JC Holding, which paid 33 percent income tax on the dividend and distributed the balance as a dividend in each shares to each Roth IRA. After the Roth IRA contributions, the funds were able to grow and could be withdrawn without additional tax. By 2008, each Roth IRA had accumulated over $3 million.

Procedural History

In 2012, the Commissioner issued notices of deficiency to Summa, the Benenson family, and the trust for the 2008 year in which approximately $1.5 million was transferred to the Roth IRAs. Applying the “substance-over-form” doctrine, the Commissioner reclassified the payments as dividends from Summa to its shareholders, then contributions to the Roth IRAs. As such, the commissions would not be deductible to Summa, the commissions would not be taxable to JC Holding, and the commissions would become dividends to Benenson and the trust. Perhaps more importantly, the Commissioner’s reclassification of the transaction led to excess Roth IRA contributions of $1.1 million to James III and Clement. The Commissioner imposed a six percent excise penalty on the excess Roth IRA contribution, and also imposed an accuracy-related penalty on Summa. The taxpayers challenged the Commissioner’s determination in Tax Court.

After considering dispositive motions filed by both parties, the Tax Court sided with the Commissioner,[5] citing IRS Notice 2004-8,[6] which identifies several abusive transactions between a taxpayer’s existing business and the Roth IRAs, which would subvert the IRA contribution limits. Among the transactions the IRS will challenge are those the substance of which is a payment to the taxpayer, followed by a contribution by the taxpayer to the Roth IRA.

The Tax Court did not find persuasive taxpayers’ argument that the statutes do not explicitly prohibit Roth IRAs from owning DISCs. Specifically, the Tax Court stated, “Section 995(g) was enacted in 1988, almost 10 years before the enactment of the Roth IRA provisions. . . . Congress could not have been aware of the type of abusive transaction involving Roth IRAs at issue here at the time of enactment of section 995(g).”[7] In holding for the Commissioner, the Tax Court clearly felt the transaction was abusive, despite being couched within provisions of the Code.

Sixth Circuit Opinion

On appeal, the Sixth Circuit unequivocally sided with the taxpayer,[8] finding clear compliance with the statutes and their “congressionally sanctioned purposes—tax avoidance. . . .”[9] The court agreed that there are instances where the Commissioner has the power to recast transactions, but found it dispositive that the Code expressly authorizes the creation of DISCs, which are essentially shell companies with “no economic substance at all,” and Roth IRAs, which are “designed for tax-reduction purposes.”[10] The court continued that “[b]efore long, allegations of tax avoidance begin to look like efforts at text avoidance.”[11]

Clearly, the taxpayer chose a structure that would reduce its taxes, which the circuit court found to be within the taxpayer’s rights. The court queried, “[W]ho is to say that a low-tax means of achieving a legitimate business end is any less ‘substantive’ than the high-taxed alternative?”[12] The court quoted Professor Joseph Isenbergh, who stated:

When someone calls a dog a cow and then seeks a subsidy provided by statute for cows, the obvious response is that this is not what the statute means. It may also happen that rich people who would not otherwise have cows buy them to gain cow subsidies. Here, when people say (as they do) that this is not what the statute means, they are in fact saying something quite different.[13]

In addition, the court found that the Commissioner is not authorized to recast a transaction “just because taxpayers undertook it to reduce their tax bills.”[14] The court is in full favor of tax subsidies, confirming that DISCs are used to reduce burdens on exporters and Roth IRAs are used to encourage saving for retirement.

Lastly, the Sixth Circuit rejected the Commissioner’s position that Congress did not intend for benefits of both the DISC and Roth IRA provisions in conjunction with one another, concluding:

[The Commissioner] may be right that permitting these DISC–Roth IRA arrangements amounts to dubious tax policy. But the substance-over-form doctrine does not give the Commissioner a warrant to search through the Internal Revenue Code and correct whatever oversights Congress happens to make or redo any policy missteps the legislature happens to take.[15]

The Sixth Circuit concluded with a stinging rebuke to the Commissioner, stating, “The last thing the federal courts should be doing is rewarding Congress’s creation of an intricate and complicated Internal Revenue Code by closing gaps in taxation whenever that complexity creates them.”[16] “This is one of the most taxpayer favorable judicial doctrine cases that I can remember in years,” Lawrence M. Hill, partner, Winston & Strawn LLP, New York, told Wolters Kluwer.[17] Hill added: “The Sixth Circuit criticized the IRS for seeking to apply the substance over form doctrine, where the form of the transaction was expressly authorized by the Internal Revenue Code. The court was attentive in grasping what many courts in the past have inexplicably failed to focus on: that ‘Form is substance’ when it comes to the law.” “This is persuasive precedent for other statutorily sanctioned tax-favored investment structures, such as, for example, those seen in the insurance context.”[18]

The Sixth Circuit’s opinion is a favorable win for the taxpayer, and the court challenged the fundamental legitimacy of the substance-over-form doctrine in light of the “highly reticulated Internal Revenue Code, which uses language, lots of language, with nearly mathematical precision.”[19] The court struck a blow against the Commissioner’s attempt to recast a transaction that complied with the letter of the Code. But, the court also found that the Code provisions at issue were specifically enacted for tax-avoidance. There are certainly other taxpayer-friendly provisions within the Code that permit tax-advantaged transactions. Summa leaves unanswered the question whether the substance-over-form doctrine should properly apply to transactions where taxpayers apply Code provisions to structure their transactions in unanticipated tax-reducing ways. It should be noted that Benenson and the trust have related appeals pending in the First Circuit and Second Circuit.