Form vs. substance plays out in tax court — with international tax implications
One family puts a clever twist on an IC-DISC — but the IRS quickly disputed its creativity. Who will emerge triumphant?
Conflict lies at the heart of every good story. How interesting would Moby Dick be without Captain Ahab? And Batman is just a goofball with a cool car absent the Joker.
In the tax world, the eternal adversaries are form and substance. Taxpayers push the envelope and try to fit a transaction into a particular form that creates tax benefits. The IRS pushes back and argues that the form is meaningless without economic substance. In creative tax planning, taxpayers and advisors have to strike a balance between the two. A notable case with international tax implications, Summa Holdings v. Comm’r., has emerged from the 6th Circuit and has tax advisors’ ears perked.
The case hinges on an interest charge domestic international sales corporation (IC-DISC), which provides a tax incentive to exporting U.S. manufacturers. The Benenson family, clever protagonists in the Summa Holdings tale, amped up the benefits of an IC-DISC by having it held in a Roth IRA owned by the younger generation. This type of transaction forsakes the traditional benefits of an IC-DISC and enables one to funnel significant funds into an IRA. The maximum annual contribution to an IRA when the case was brought was $5,000 per year. Over seven years, the Benensons transferred over $5 million into their Roth IRAs.
The IRS challenged the arrangement on the grounds of substance over form and recast the arrangement as earnings in the form of dividends from the Benensons’ company, followed by a contribution to the Roth IRAs far in excess of the limits and subject to a 6 percent penalty excise tax. The U.S. Tax Court ruled in favor of the IRS, and the Benensons appealed.
In a colorful beatdown citing Caligula, the appellate court reversed the Tax Court decision and held for the Benensons. The case will have much broader implications and will serve as a limit on the substance-over-form doctrine. As the court noted in its decision, “What started as a tool to prevent taxpayers from placing labels on transactions to avoid tax consequences they don’t like runs the risk of becoming a tool that allows the Commissioner to place labels on transactions to avoid textual consequences he doesn’t like.”
Tax advisors can settle in with their popcorn and enjoy the spectacle of the 6th Circuit punching the IRS in the nose. But, like the Joker, you know the IRS will be back another day.
If your business has significant export sales, please talk to your Plante Moran international tax specialist to determine if there’s an IC-DISC strategy that works for your situation.