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Taxpayers Can't Use DISC to Disguise Excessive Contributions to Roth IRAs.

(Parker Tax Publishing July 6, 2015)

Commissions from an operating corporation to a DISC, which was indirectly owned by Roth IRAs belonging to the sons of the operating corporation's founder, were properly characterized as contributions to the Roth IRAs which exceeded the annual contribution limits and, thus, were subject to excise tax penalties. Summa Holdings, Inc. v. Comm'r, T.C. Memo. 2015-119.

Background

James Jr. and Sharen Benenson are the parents of Clement and James III. In 2001, James III and Clement each established a Roth IRA (James III Roth IRA and Clement Roth IRA; collectively, Benenson Roth IRAs) and transferred $3,500 to each IRA. In 2002, the Benenson Roth IRAs each purchased 1,500 shares of stock in JC Export. JC Export filed an election to be treated as an Interest Charge DISC. The Benenson Roth IRAs then transferred their shares of JC Export stock to JC Export Holding, Inc. in exchange for JC Holding stock. Thus, JC Export was wholly owned by JC Holding, which was owned 50 percent by the James III Roth IRA and 50 percent by the Clement Roth IRA.

Summa Holdings, Inc. was founded by James, Jr. and is the parent corporation of a consolidated group of manufacturing companies (Summa subsidiaries) that make a wide variety of industrial products. James, Jr. owned approximately 23 percent of the shares outstanding, with most of the remaining shares being owned by the Benenson Trust, the beneficiaries of which were James III and Clement. The Summa subsidiaries and JC Export entered into a series of agreements, pursuant to which the Summa subsidiaries paid JC Export over $2.2 million in 2008. JC Export, in turn, paid the same amount to JC Holding in the form of dividends. Each time JC Holding received a payment from JC Export, it estimated the tax due as a result of the payment, withheld the estimated tax, and immediately transferred as a dividend one-half of the remainder of the payment to each of the Benenson Roth IRAs.

From the organization of JC Export through 2008, JC Export received commissions from the Summa consolidated group that, if treated as contributions to the Benenson Roth IRAs, exceeded the annual contribution limits. For 2008, neither Clement nor James III attached to their tax returns a Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. Additionally, neither their parents nor the Benenson Trust reported any dividend distributions. JC Export filed a 2008 Form 1120-IC-DISC, Interest Charge Domestic International Sales Corporation Return, and on Schedule K, Shareholder's Statement of IC-DISC Distributions, reported almost $2.2 as a taxable distribution. JC Holding filed a Form 1120 in which it reported the same amount as dividend income. On its 2008 tax return, Summa claimed a deduction of approximately $2.1 million for DISC commissions.

The IRS issued deficiency notices to the taxpayers in 2012, contending that the transactions at issue shifted value to the Benenson Roth IRAs far in excess of the annual contribution limits. According to the IRS, simply labeling the payments as DISC commissions did not immunize the payments from the application of substance over form principles. The payments made by Summa and its subsidiaries to JC Export during 2008, the IRS said, were not DISC commission payments but dividends to Summa's shareholders followed by contributions to the Roth IRAs.

As a result, the IRS concluded that (1) James, Jr. received over $2.2 million in dividends from Summa; (2) Summa's shareholders contributed over $1.1 million to each of the Benenson Roth IRAs and, since the contributions exceeded the annual contribution limits for Roth IRAs, James III and Clement were each liable for an excise tax deficiency; and (3) Summa was liable for penalties under either Code Sec. 6662A or Code Sec. 6662.

Analysis

Code Sec. 4973 imposes for each taxable year an excise tax of 6 percent for excess Roth IRA contributions, computed on the lesser of (1) the amount of the excess contribution, or (2) the value of the account as of the end of the taxable year. The tax applies each year until the excess contributions are eliminated from the taxpayer's Roth IRA. An excess contribution is defined in part as a contribution to a Roth IRA that exceeds the amount allowable as a contribution. Dividends paid on stock held by a Roth IRA are considered earnings of the Roth IRA itself, rather than contributions by the owner of the Roth IRA, and do not count towards the contribution limits.

In Notice 2004-8, the IRS identified tax-avoidance type transactions in which a preexisting business enters into transactions with a corporation owned by the taxpayer's Roth IRA and in which the transactions have the effect of shifting value into the Roth IRA. The IRS said it would challenge such transactions using a number of theories, including substance over form.

The taxpayers, citing several cases including Hellweg v. Comm'r, T.C. Memo. 2011-58, argued that reclassification of the transactions using substance over form principles was improper because it would result in disregarding the DISC transactions. Hellweg involved a situation where a DISC was indirectly owed by Roth IRAs, which were owned by individuals who held ownership interests in an operating company that paid commissions to the DISC. In Hellweg, the Tax Court stated that, in the absence of fraud or an illegal purpose behind the transaction at issue, the IRS could not challenge the substance of the transaction for income tax purposes because to do so would require the DISC to be disregarded. The taxpayers also argued that since Congress could have prohibited transactions involving DISCs owned by IRAs but chose not to do so, Congress was comfortable with IRAs holding DISC stock.

The Tax Court agreed with the IRS and held that the payments to JC Export were not DISC commissions, but rather dividends to Summa's shareholders followed by contributions to the Benenson Roth IRAs. The Tax Court distinguished the holding in Hellweg, noting that in the instant case, the IRS was not arguing that the DISC should be disregarded but rather was arguing that a transaction involving a DISC should be recharacterized to prevent an abusive transaction.

The Tax Court rejected the taxpayers' argument that Congress could have prohibited transactions involving DISCs but didn't, saying the argument logically erroneous. Congress' choice to prevent one particular abusive transaction involving DISCs and IRAs, the court observed, did not indicate that Congress approved of all other abusive transactions involving DISCs and IRAs.

For a discussion of Roth IRA transactions that the IRS considers abusive, see Parker Tax ¶135,160. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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