Appeals Court Upholds Use of DISC Tax Strategy to Avoid Limitations on Roth IRAs
On February 16, 2017, the U.S. Court of Appeals for the 6th Circuit upheld a taxpayer’s use of an interest charge domestic international sales corporation (IC-DISC) being created and held inside of the taxpayer’s Roth IRA. This Court of Appeals decision overturned a Tax Court decision. In this case, a family that owns a manufacturing company was able to transfer over $5 million in DISC dividends to their sons’ Roth IRA accounts over a six-year period. By holding that the dividends paid by the related manufacturing company were not Roth IRA contributions, the dividends were allowed to be paid in excess of the Roth IRA annual contribution limits.
What is a DISC?
A DISC is a tax incentive that was created by Congress in 1971 to promote exports and help U.S. companies better compete in the global marketplace. Utilizing this structure, a qualifying manufacturing company enters into a written agreement with the IC-DISC. The company then pays tax-deductible commissions to the DISC based on qualifying export activity. These commissions are fully deductible by the operating company, and the IC-DISC is exempt from tax on the commission income. When the IC-DISC pays dividends to its shareholders, those dividends are taxed at the preferential qualified dividend rate (rather than the ordinary income rate) – leading to a significant tax reduction.
At least this is how Congress designed IC-DISCs to work.
What makes this case unique?
In this particular case, the family that owns Summa Holdings, Inc. opened Roth IRA accounts for the owner’s two sons. Those Roth IRAs purchased the shares of the company’s DISC (JC Export). The family then formed a new company (JC Holding) which bought the DISC shares from the IRAs. As a result, JC Holding became the sole owner of JC Export (the DISC), and each IRA was a 50% shareholder in JC Holding.
Under this structure, Summa Holdings, Inc. paid tax-free commissions to JC Export on its qualifying exports. These commissions were ultimately distributed as dividends to JC Holding. The dividends were taxed at the unrelated business income tax rate (approximately 33%), and the remaining balance was then contributed to the sons’ Roth IRAs. Since dividends earned on investments held in a Roth IRA are not considered contributions (and are thus not subject to the Roth IRA contribution limits), the family was able to transfer over $5 million in dividends to the two Roth IRAs over a six-year period. This was a very good deal for the sons since earnings from these Roth IRAs grow tax free and are not subject to taxation when they are ultimately distributed at retirement. But the IRS thought the deal was too good.
By combining these two separate tax-saving provisions, the IRS felt that the tax benefits enjoyed by Summa Holdings were unintended by both the Roth IRA and DISC provisions when they were created by Congress.
The IRS utilized the ‘substance-over-form’ doctrine to recharacterize the dividend payments to the DISC and contributions to the Roth IRAs. This resulted in Summa Holdings owing income tax on DISC commissions and the sons owing large penalties for overfunding their Roth IRAs. The IRS argued that it should be allowed to disregard the formalities of the DISC/Roth IRA structure (which they acknowledge complied with the law), to look to the substance of the transactions. To the IRS, the substance of the transaction was to avoid the annual Roth IRA contribution limits, as the DISC was used only to take advantage of the exception for dividends earned on Roth IRA investments. To the Commissioner, the substance (to evade the contribution limits on Roth IRAs) preceded form (the words or text of the Code), giving him the authority to recharacterize the dividend payments.
The appellate decision
The Court of Appeals disagreed, and found it telling that both sides agreed that the DISC-Roth IRA transactions in this case complied with the Code. In their decision, the Sixth Circuit court focused on the fact that both Roth IRAs and IC-DISCs are statutes that Congress intended to be used by tax payers to reduce their tax liabilities. According to the court’s 21-page opinion, “Congress created the DISC and empowered it to engage in purely formal transactions for the purpose of lowering taxes. And Congress established Roth IRAs and their authority to own shares in corporations (including DISCs) for the purpose of lowering taxes. That these laws allow taxpayers to sidestep the Roth IRA contribution limits may be an unintended consequence of Congress’s legislative actions, but it is a text-driven consequence no less.”
Since lawmakers awarded tax breaks to DISCs and Roth IRAs to promote certain activities, “the Commissioner cannot fault taxpayers for making the most of the tax-minimizing opportunities Congress created.”
“If Congress sees DISC-Roth IRA transactions of this sort as unwise or as creating an improper loophole, it should fix the problem. Until then, the DISC will continue to provide tax savings to the owners of U.S. export companies, just as Congress intended – even if subsequent changes to the Code have increased the scale of the savings beyond Congress’s original estimation. 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.”
This ruling leaves the door open for exporters to arrange similar DISC-Roth IRA structures in their organizations – at least until Congress decides whether or not this is a loophole they seek to close. To undertake a similar structure, however, a business must have the excess cash reserves required to sustain such a cash drain on the company’s operations, since the dividends generated through export sales aren’t being reinvested back into the company.
Clark Schaefer Hackett advisors can review your company and its exports to see if you qualify for the benefits of an IC-DISC. Please contact Lisa Wineland at email@example.com for more information or to discuss your company’s specific situation.
For a more in-depth look at this topic, see The ABCs of an IC-DISC, a CSH lite paper.
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