There are two ways to structure a transaction. One carries a lower tax burden. You decide to use that one. The IRS cannot later force you to use the other one. In the recent case, two brothers combined two tax incentives – one common and one obscure – to limit their taxes.
In protracted tax litigation, the IRS argued that even if the brothers hadn’t necessarily broken the letter of the law, they had violated the spirit of the law. The Tax Court sided with the IRS, but the Sixth Circuit Court of Appeals reversed the decision. We’ll summarize how the incentives worked together and the broader application of the ruling.
DISC commissions + Roth IRAs
Not just everyone can set up a Domestic International Sales Corporation (DISC). This tax-favored type of entity is used to promote exports made by closely-held firms. By combining this obscure incentive with common Roth IRAs, the brothers were able to increase their Roth balances without tax consequences.
The Wall Street Journal reported on the facts of the case. Each brother created a Roth IRA in 2001 with $3,500. Then each purchased a 50 percent ownership interest in a family company DISC. A transfer of DISC shares to a third corporation, JC Holdings, avoided tax issues that could arise if their Roth IRAs had owned the DISC.
By a complicated series of transaction DISC commission payments were routed into the Roth IRAs. Between 2002 and 2008, $5.2 million was transferred into their Roth accounts. Eventually, each account contained more that $3 million.
The IRS argument was that the transactions circumvented various rules and the family company owed income tax and the brothers owed penalties for overfunding Roth IRAs. The appellate court disagreed stating, “The Commissioner cannot fault taxpayers for making the most of tax-minimizing opportunities Congress created.”
The decision could directly benefit exporters who may have been using Roth IRAs in coordination with DISC commissions. The impact could be broader than solely in the DISC context, because it goes to what the court viewed as IRS overreaching.