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IRS Gets Its Wings Clipped on Roth IRA’s and “Substance Over Form” Doctrine

John Hyre udirect ira services llc

By Guest Contributor By Attorney John Hyre –

 The 6th Circuit recently released a case that is good news for taxpayers on several levels.  In Summa Holdings, the Court ruled that a Roth-IRA-owned Corporation to which the Roth owner fed business and used to stuff his Roth IRA with around $5 million was legitimate.  Bear in mind that no income taxes will ever be paid on the $5M or the income it generates.

What Happened, Simplified Version:

Summa Holdings is the parent company of a number of large manufacturing companies.  The Benesons own Summa.  While several Benesons were involved in the case, let’s simply this discussion and pretend that only one Beneson was involved.

Beneson established a small Roth IRA and made about $7,000 in total contributions.  Beneson then formed a special kind of C-Corporation, known as a DISC.  DISC’s get special tax breaks for exporting goods.  The Roth paid $3,500 for the DISC’s shares.  The DISC was named JC Export.[1]

Summa then paid commissions to JC Export.[2]  Summa took a tax deduction for the commissions, probably at about a 35% rate.  JC Export paid taxes on the commissions at about a 33% rate, so these taxes netted out against the deductions Summa took, making the transfer from Summa to JC functionally tax-free.  JC’s remaining cash was distributed to the Roth IRA.  Beneson funneled about $5M to the Roth IRA in this fashion, tax-free.  Clever.

The IRS audited and thought Beneson had been very naughty.  They argued that the true substance of the transaction (which is distinct from its “form”, or what was done on paper) was that the tax-deductible “commissions” were really non-deductible “dividends” from Summa to Beneson and a taxable “over-contribution” by Beneson to his Roth IRA.  Net result:  The 33% tax paid by JC was no longer offset by the 35% deduction by Summa, and the $5M was subject to an annual 6% “over-contribution” tax, plus various rather steep penalties.

Beneson sued in Tax Court and lost.  In other words, the Tax Court agreed that the transaction really should be treated as a non-deductible dividend distribution from Summa to Beneson and a taxable over-contribution by Beneson to his Roth.

Beneson appealed the decision to the 6th Circuit Court of Appeals.  And to my personal surprise, Beneson won.  The 6th Circuit said “No, no, no, this really was a set of commissions paid by Summa to JC and the result is that Beneson converted $5M or so of taxable income into tax-free income and pumped up his Roth by the same amount, all legal and legit.  The IRS is entitled to not like the law, but it is not entitled to change the law.  That is Congress’ job”.

In other words, Beneson managed to get $5M+ into his Roth IRA tax-free.  That money and the earnings on that money will never be taxed.  In addition, under present law, a baby-Beneson could inherit part or all of the huge Roth and not pay taxes on distributions from the Roth.[3] 

The decision has major implications that go far beyond DISCS, IRA’s, tax law, or the “substance over form” doctrine, important as it is to all of those areas of the law.  This case goes to the heart of “who makes the law in our Republic?”  In this case, the Court’s answer is Congress – as it should be, but often is not.  Here are my fairly simplified conclusions on this very important case:

1)  Roth IRA transactions that are “grey” and “do not clearly cross the line” will be easier to defend.  Remember, bureaucrats are not normally rewarded for producing excellent results.[4]  Rather, they tend to advance on schedule if they do not foul up, or at least can blame foul ups on someone else.  I am convinced that this is one major reason behind why IRS attorneys are reluctant to take grey cases to court.[5]  They do not want to risk a loss, and so tend to take only “black & white” cases to court.  This case took some of the edge off of a major IRS weapon, and makes grey cases riskier for the government.  Risky cases tend to get settled, often in the taxpayer’s favor.  I have provided some beautiful “Roth IRA quotes” (towards the end of the article) from the case that will be useful in future spats with the IRS, be it in an audit, with Appeals, or in Tax Court.

Bottom line:  If you have some Roth transactions that were “close to the line, not sure which side of the line”, you should be able to sleep a bit better.  Skip to the Section entitled “Great Roth IRA Quotes from the Case” for more on this topic. 

2)  Let’s Not Get Stupid, the IRS does learn.  Granted, they learn at the speed of government, which is to say quite slowly – but they do learn.  While they lost this case, their approach was much more sophisticated than a very similar case from 1996, the famous Swanson case often cited by “checkbook LLC” promotors.  Further, I think there are some arguments that the IRS missed in this case that could have changed the result.  I will not list those arguments, I see no need to do their homework for them.  This case is reason for celebration, but also for humility and care, for they shall adapt and improve their approach.  We must be ready, anticipate their next evolution, and structure our transactions accordingly.

 3)  Substance over form doctrine is still alive, well & relevant to all federal income tax transactions.  It was cut down to an appropriate size, at least in the 6th Circuit.  To receive tax benefits, relevant transactions have to be “real”.  The underlying “economic substance” of a transaction much match what is “on paper”.  Transactions entered into purely “on paper” can be re-characterized to match reality by the IRS.  But the IRS cannot (at least in the 6th Circuit, and likely other conservative-leaning Circuits) simply disregard a set of transactions because it does not like the result.  Words once again mean things, and if Congress permits a thing, then the bureaucrats cannot simply “un-permit” it because they do not like it.[6]  What a novel concept – and one that is deeply offensive and threatening to progressives.  Here’s a quote from the case that nicely explains the “substance over form” doctrine:

“Professor Joseph Isenbergh put the point well:  “When someone calls a dog a cow and then seeks a subsidy provided by statute for cows, the obvious response is that this is not what the statute means.  It may also happen that rich people who would not otherwise have cows buy them to gain cow subsidies.  Here, when people say (as they do) that this is not what the statute means, they are in fact saying something quite different.”  Musings on Form and Substance in Taxation: Federal Taxation of Incomes, Estates, and Gifts, 49 U. Chi. L. Rev. 859, 865 (1982).”

Excellent way to put it.  To avoid issues with “substance over form”, do not call a dog a cow.  Do not paint the dog black and white & attach a milk bottle to its belly.  Instead, to get the cow subsidy (no matter how stupid the reasoning behind the subsidy), be sure to acquire a real cow.  Or a thousand of them.

Here’s an example from fairly recent case law:  An MD set up a C-Corporation to provide admin services to his medical practice.  The practice paid for the “services” and deducted them from its tax return.  The C-Corporation included the “services” in its income, which was taxed at a much lower tax rate (15%) than the MD’s income (40%).[7]  The problem was that the C-Corporation never actually provided any services.  There was no consulting contract.  The employees who performed the services were employed by the practice, and not the C-Corporation.  In other words, the “corporate services” existed only on paper or “in form”, and not in fact or “in substance”.  As such, the “services” deductions taken by the practice were disallowed and the tax was paid at the higher 40% rate and not the lower 15% rate.  Penalties were also imposed.  Had the C-Corporation actually provided the services in question, the substance of the case and its outcome would have likely been different.

4)  Supreme Court.  I do not think the IRS will appeal this particular case.  That is contrary to my initial reaction.  Going to the Supreme Court risks the “substance over form” doctrine being limited nationwide in a clear manner.  Here, the IRS can (and will) argue that the Summa decision only applies to Roth IRA’s that use DISC’s (rare, so it would not apply in many cases) and only in the 6th Circuit (OH, MI, TN, KY).  That’ll be their “public face”.  Privately (for example, when negotiating settlements to other “grey IRA” audits), they will be quite aware that other courts may mimic the Summa decision (especially the more conservative Circuits) and will take the Summa decision into account when deciding whether to litigate or settle, and how much they are willing to settle for.  That is good news for taxpayers.

Great Roth IRA Language from this Case, Worth Reading

Act now.  Use Roth IRA’s (and especially) Roth 401k’s before Congress changes the law.  As this case illustrates, Roth’s are one of the premier means of legal tax reduction – in my subjective but informed opinion, Roth’s are the single best tax-avoidance tool in existence.  Do not delay, ACT!  This is not the time for delay.  Some of the better language from the case that touches on Roth IRA’s:

“The Code authorizes companies to create DISCs as shell corporations that can receive commissions and pay dividends that have no economic substance at all.  By congressional design, DISCs are all form and no substance, making it inappropriate to tag Summa Holdings with a substance-over-form complaint with respect to its use of DISCs.  The same is true for the Roth IRAs.  They, too, are designed for tax-reduction purposes.  And that’s just how the Benensons used them.”

All IRAs are permitted to hold shares of stock, some of which may increase markedly in value over time and some of which may generate considerable dividends over time. Whether Congress’s decision to permit Roth IRAs to own DISCs was an oversight makes no difference.  It’s what the law allowed.”

When the Commissioner says that the transaction amounted in substance to a Roth IRA contribution, all he means is that the purpose of the transaction was to funnel money into the Roth IRAs without triggering the contribution limits.  True enough.   But the substance-over-form doctrine does not authorize the Commissioner to undo a transaction just because taxpayers undertook it to reduce their tax bills.”

And the Code authorizes investors to avoid significant taxes on capital gains and dividends by using their Roth IRAs in all manner of tax-avoiding ways, including by buying shares in promising new companies whose share prices may rise considerably over time or which may pay out large dividends over time.  The point of these entities is tax avoidance.  The Commissioner cannot place ad hoc limits on them by invoking a statutory purpose (maximizing revenue) that has little relevance to the text-driven function of these portions of the Code (minimizing revenue).”

The Commissioner cannot fault taxpayers for making the most of the tax-minimizing opportunities Congress created.”

“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.

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.”  John adds:  Roth’s represent one of those complex gaps in taxation created by Congress.  Use them!

Quotes as to the substance-over-form doctrine:

“As he sees it, the doctrine allows him to nullify the DISC commissions and dividends to the Roth IRAs on the ground that the purpose of the transactions was to sidestep the contribution limits on Roth IRAs and lower the tax obligations of the Beneson sons in the process.  That is a step too far.  It’s one thing to permit the Commissioner to re-characterize the economic substance of a transaction—to honor the fiscal realities of what taxpayers have done over the form in which they have done it.  But it’s quite another to permit the Commissioner to re-characterize the meaning of statutes—to ignore their form, their words, in favor of his perception of their substance.

“That leaves the Commissioner to invoke another, distinct version of the substance-over-form doctrine.  When two potential options for structuring a transaction lead to the same end and the taxpayers choose the lower-tax path, the Commissioner claims the power to re-characterize the transactions as the higher-taxed equivalents.  It’s not that the transactions don’t have economic substance (they do) or that the Code forbids them (it doesn’t).  Instead, the Commissioner simply stipulates that the “real” transaction is the higher-taxed one, and that the lower-taxed route, often the more complex of the two, is a mere “formality” he can freely disregard.

“But it’s odd to reject a Code-compliant transaction in the service of general concerns about tax avoidance.  Before long, allegations of tax avoidance begin to look like efforts at text avoidance.  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.”  John adds:  Yes!  Yes!  Yes!

“The Commissioner adds that the “critical point” of his argument is that the tax benefits Summa Holdings has enjoyed were “unintended by both the Roth IRA and DISC provisions.”  He may be right.  And he may be right that permitting these DISC–Roth IRA arrangements amounts to dubious tax policy.  But the substance-over-form doctrine does not give the Commissioner a warrant to search through the Internal Revenue Code and correct whatever oversights Congress happens to make or redo any policy missteps the legislature happens to take.

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.

John Hyre is a tax attorney, accountant and real estate investor with over 22 years of experience with direct experience in IRS audits and in Tax Court with SDIRA and REI issues.  He consults with real estate investors of all sizes, small business owners and self-directed IRA/401k owners nationwide.  He also represents taxpayers in audits and in Tax Court nationwide.  He frequently speaks nationally on the topic of taxation of self-directed IRA’s/401k’s, taxation of real estate & small businesses, and asset protection.   He can be found at and  He serves clients nationwide.

[1] The structure was a bit more complicated than I have described it.  I have simplified my description of it to make this article easier to read and grasp for people who do not specialize in the field.

[2] Sounds incestuous as heck.  Cause it is.  And opened Summa up to attacks that the IRS was not sophisticated enough to make….this time around.

[3] Google “stretch Roth IRA” for more info on inheriting IRA’s.

[4] Whereas entrepreneurs get rewarded for good results and punished for bad ones, excuses/”reasons” notwithstanding.

[5] Another reason is that they are assigned far more cases than they can really litigate.  Sheer numbers dictate large numbers of settlements.  My direct experience in audits and Tax Court in both SDIRA and non-SDIRA cases reflects these patterns:  lots of good settlements for taxpayers, and for the most part, only “slam dunk for the IRS” cases go to trial.

[6] For example:  The President cannot use executive orders to subvert the law, ala Obama and immigration law, to name but one example.

[7] This is a very common tax planning technique.  We assist clients with it frequently.  But for it to work, it has to be done correctly.

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