Originally published on Forbes.com.
Sometimes it seems too good to be true and it turns out to be true anyway. That might be the lesson in the First Circuit decision in the case of brothers James Benenson III and Clement Benenson. The clever “too good to be true” idea that they had was to have their Roth IRAs invest in a DISC. There is a good chance that you know what a Roth is. You put non-deductible dollars into a retirement account. There is no tax on the earnings of the Roth and no tax on distributions. The Roth is an alternative to deductible IRAs (There is also a 401(k) version) meaning the amount that you can put in is pretty limited and phased out at higher adjusted gross income levels. It is one of those things for the “little people.”
DISCs are more big-time stuff. DISCs are special type of flow-through entity. The DISC shelters export earnings. The DISC, itself, does not have to have a lot of substance. The company doing the exporting pays commissions to the DISC which then can have it taxed to the shareholders or retain up to $10 million tax deferred with an interest charge. Generally, the expectation is that the operating company and the DISC will have the same shareholders. That is not a requirement though and that is what created the apparent opportunity.
The Plan
The Benensons had their Roth IRAs each invest $1,500 in JC Holding which owned JC Export, a newly formed DISC, in 2002. Then they had their family-owned manufacturing business Summa Holdings pay commissions on its exports which sent $5,182,314 to JC Export from 2002 to 2008. JC Holding had to pay corporate income tax (If JC Export had been owned outright the Roth would have had to pay the tax on unrelated business income). The after-tax balance ended up in the Roth ready to be invested tax free. They were not interested in the deferral feature. The whole point was to fatten up the Roth IRA with some of Summa’s after-tax income.
Unscrambling The Egg
The IRS attacked the transaction in a notice of deficiency in 2012. It is a bit like unscrambling an egg. Here is the summary from the consolidated Tax Court decision.
Respondent (1) disallowed the DISC commission deductions that Summa claimed for the payments it made on January 18 and April 23, 2008, and $768 of the deduction for $1,083 of expenses that it paid on behalf of JC Export and JC Holding during 2008; (2) determined that James Jr. received $2,239,006 in dividends from Summa as the sole shareholder of Summa (or in the alternative, that he received $519,002 and the Benenson Trust received $1,702,764 in dividends from Summa on the basis of their respective ownership interests in Summa); and (3) determined that Summa’s shareholders contributed $1,119,503 to each of the Benenson Roth IRAs. Since the contributions to the Benenson Roth IRAs exceed the annual contribution limits for Roth IRAs, respondent determined that James III and Clement each had an excise tax deficiency under section 4973 of $67,170 for 2008. Respondent also determined that Summa is liable for a penalty under either section 6662A or 6662 of $56,182 for its taxable year ending on April 30, 2008.
Substance Over Form
The Tax Court ruled in favor of the IRS citing the venerable “substance over form” doctrine. How venerable? “Substance over form” is mentioned in tax litigation several years before the invention of sliced bread.
On appeal due to diverse jurisdictions the case is no longer consolidated. The Sixth Circuit got the first crack based on Summa Holdings domicile. The Sixth Circuit decision created quite a stir calling good old “substance over form” into question.
Each word of the “substance-over-form doctrine,” at least as the Commissioner has used it here, should give pause. If the government can undo transactions that the terms of the Code expressly authorize, it’s fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is. “Form” is “substance” when it comes to law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence—to allow him to determine the substance of a law and to make it govern “over” the written form of the law—and to call it a “doctrine” no less
I covered the decision here and the reaction to the decision here. Barry Weisman of Anchin, Block and Anchin pointed out that there would be more coming.
This is an important decision because it provides a clear statutory construction framework for analyzing substance over form. Whether the IRS will appeal this case to the Supreme Court may depend on how it fares in two related cases in the First (Boston) and Second (New York) Circuits. This is a nebulous area in which asking for clarity from the tax-adverse Supreme Court may create even greater uncertainty
Not A Smell Test
So now we have heard from the Second Circuit which rules on the Benenson brothers who live in Massachusetts. Their father James Benenson Jr. lives in New York. The First Circuit heard oral arguments on April 10. If the First Circuit justices work at the same pace as Second Circuit, we can expect their decision in the fall. Maybe when the leaves change. That would be nice.
The Second Circuit opinion goes on at some length about why the holding by the Sixth Circuit does not constrain them. Ho hum. They end up with essentially the same holding. The Benenson plan is a perfectly fine combination of two different benefits in the Code – like a Mounds bar combining chocolate and coconut or a Reese’s peanut butter cup. Judge Norman Stahl, who was appointed by George Bush The First, did not use the candy analogy in his opinion. You can blame that on me. Here is Judge Stahl:
For some taxpayers, Roth IRAs are safe places to squirrel away $5,000 in cash per year, with a hope of modest returns and tax-free distribution at retirement. For other, often wealthier, taxpayers, Roth IRAs are strategic vehicles for investments in companies, which may pay out substantial dividends. See Summa Holdings, 848 F.3d at 789. Both uses comport with § 408A’s fundamental purpose: to incentivize long-term savings and investment for retirement.
That reminds me of that Anatole France quote – “In its majestic equality, the law forbids rich and poor alike to sleep under bridges, beg in the streets and steal loaves of bread.”
And then Judge Stahl goes on to make my day:
Some may call the Benensons’ transaction clever. Others may call it unseemly. The sole question presented to us is whether the Commissioner has the power to call it a violation of the Tax Code. We hold that he does not. The substance over form doctrine is not a smell test. It is, in this circuit, a tool of statutory interpretation.
“Smell test” – that is one of the few expressions from my days at Joseph B. Cohan and Associates that would not violate the contributor standards. I could not resist seeing if “smell test” has showed up in other tax decisions. It has. There are fourteen instances. It seems that the “smell test” may be OK in criminal and bankruptcy cases, but overall it tends to be frowned on it income tax matters.
Judge Stahl finishes with an analogy:
In such circumstances, to the extent we accept “the government’s proposition that these taxpayers have found a hole in the dike, we believe it one that calls for the application of the Congressional thumb, not the court’s.”
Dissent
For what it was worth, there was dissent from Clinton appointee, Judge Sandra Lynch. Judge Lynch graduated from Wellesley a year ahead of Hillary Clinton, for whatever that is worth.
The transaction here was tax-gaming, devoid of substance. The companies and Roth IRAs involved were all owned by members of the same family, the DISC shares were not purchased at market prices, and the sole reason for the transaction was to circumvent the contribution limits for Roth IRAs. In addition, the parties agree that JC Export and JC Holding would not exist but for this scheme, that those entities engaged in no business of any kind, and that they served no purpose other than funneling money into the Benensons’ Roth IRAs.
The majority argues that if there is a problem here, it is for Congress to resolve. My response is that Congress created the DISC provisions against the background of decades of common law tax doctrines, under which such transactions are forbidden.
So we can all wait on pins and needles for what the Second Circuit does with the case.
Generally I have rooted for the taxpayers except when they are being really lame, which is not the case here. I think I am rooting for the IRS on the next round, though, because it will create some drama and maybe a trip to the Supremes.
Other Coverage
KPMG had a brief summary.
RSM also did a summary noting as I did the “smell test.”
Perhaps more interestingly, however, was the First Circuit’s final comment regarding the use of the substance over form doctrine. Specifically, the court stated that, “The substance-over-form doctrine is not a smell test. It is, in this circuit, a tool of statutory interpretation. When, as here, we find that the transaction does not violate the plain intent of the relevant statutes, we can push the doctrine no further.” Thus, while First Circuit notes that the substance over form doctrine is clearly still a useful tool, the opinion appears to narrow the scope of the doctrine.