The time may be right for Roth IRA-owned IC-DISCs
Between a 2021 court case that reinforced the tax-saving value that Roth IRA-owned IC-DISCs provide and a likely lack of forthcoming tax changes, now is a great time to evaluate this opportunity.
In 2021, a Ninth Circuit ruling reinforced the value of a Roth IRA-owned IC-DISC structure as a retirement/estate tax planning tool for export businesses that qualify under the rules. The court held that the doctrine of analyzing a transaction’s economic substance over its form shouldn’t apply in instances where Congress has explicitly sanctioned specific transactions with no substance.
In 2021, Congress proposed changes as part of the Build Back Better Act that would have eliminated the ability for taxpayers to benefit from this structure. The legislation was ultimately not enacted, and the proposed change did not get included with any subsequent legislative action. Additionally, with the 2022 midterm elections resulting in a split Congress, there could be an opening for taxpayers to consider a Roth IRA-owned IC-DISC.
IC-DISCs & Roth IRAs
An Interest-Charge Domestic International Sales Corporation (IC-DISC) is a specialized entity used by U.S.-based export companies to reduce income taxes by paying tax-deductible commissions to an IC-DISC, which is exempt from federal income tax. In this specific structure, the IC-DISC is owned by one or more Roth-IRAs. A related exporter makes deductible commission payments to the IC-DISC that are then distributed as dividends to the Roth-IRA(s). The amounts are generally subjected to federal income tax, but the structure allows taxpayers to effectively bypass the Roth IRA contribution limits that would normally apply to individual owners.
Form over substance
Over the years, the IRS has argued that the form of a transaction should be disregarded if the transaction lacked substance, or the substance was contrary to the form. Courts have often accepted this substance-over-form argument in other corporate structures, but the latest case continues a trend at the federal appellate level of recognizing form over substance when the form is specifically created by law. In these cases, the IRS argued that structures like the Roth IRA-owned IC-DISC amount to a legal shell that exists only to reduce taxes and that the relationship between the IC-DISC and its owners should be taxed based on the economic substance of the end result.
The 2021 Ninth Circuit case actually involves an entity known as a Foreign Sales Corporation (FSC), not a DISC. However, the Ninth Circuit makes clear that the same logic applies to “the Congressionally authorized separation of substance and form that is involved in an entity similar to the FSC at issue here.”
Previous decisions that focused on Roth IRA-owned IC-DISCs seemed to be written with an eye toward limiting their application to the facts of the structure being challenged and the particular argument that the IRS used to challenge it. In this case, the court seemed willing to consider and dismiss other potential challenges that the IRS might raise against congressionally authorized entities. The ruling dismissed these and summarized its conclusion noting, “when Congress expressly departs from substance-over-form principles, the Commissioner may not invoke those principles in a way that would directly reverse that congressional judgment.”
In short, the Ninth Circuit allowed that failures to follow the form set forth in the statute could always be challenged, but that economic substance arguments wouldn’t be considered when Congress creates the form without also requiring any elements of substance. “It may have been unwise for Congress to allow taxpayers to pay reduced taxes and pay out dividends, ‘through a structure that might otherwise run afoul of the [Internal Revenue] Code,’” the court said, quoting one of the previous decisions on IC-DISCs. “But it is not our role to save the Commissioner from the inescapable logical consequence of what Congress has plainly authorized.”
IC-DISC-eligible export businesses
While this structure provides significant tax advantages, it’s only available for those that meet certain requirements. The IC-DISC structure is only an option for businesses that export products out of the United States. The majority of businesses that qualify will be in the manufacturing and distribution sector. Professional service businesses that might qualify include architectural engineering services or software companies, but this sector typically has a narrower path to meet the qualified export requirements.
This 2021 court ruling stresses the importance of proper tax planning and execution when creating these entities. The courts have shown a willingness to accept these legislative forms over substance only when the entities are created exactly as specified in the law. To learn more about whether or not your business may qualify and the steps necessary to create a Roth IRA-owned IC-DISC structure, please contact us.