The Tax Court took a different approach in their attempt to dismantle a Roth IRA based tax shelter in the case of Mazzei v. Commissioner, 150 TC No. 7 than the approach the Sixth Circuit turned thumbs down on in the case of Summa Holdings Inc. v. Commissioner, 848 F.3d 779 (6th Cir. 2017).

In this case the taxpayers’ Roth IRAs had formed a Foreign Sales Corporation (FSC), a mechanism that Congress created for a period of time to attempt to give a tax break to taxpayers selling products overseas. Under the provisions of the law applicable to FSCs, it could receive commissions from a manufacturer exporting goods even if it performed no services. These commissions were subject to a significantly lower rate of tax than applied on regular corporations.

In this case the FSC received commission payments from a corporation controlled by the owners of the Roth IRAs and incurred no expenses related to those commissions. The FSC then paid out the amounts as dividends to the Roth IRAs. From 1998 to 2002 $533,057 was transferred to the Roth IRAs using this vehicle.

The Summa Holdings case had involved a similar structure, though using a Domestic International Sales Corporation (DISC). In that case the Tax Court had initially ruled the transaction as a sham and denied the deductions to the paying corporation, as well as treating the eventual money going to the Roth IRAs as excess contribution. The corporation’s appeal (but not that of the shareholders) was heard by the Sixth Circuit.

The Sixth Circuit noted that, effectively, Congress intended the DISC to be an entity that received payments without holding the organization strictly to the provisions of Section 482, where the IRS could reallocate income to a related corporation. So even if the transaction did not reflect economic reality, it was working exactly as Congress intended. Thus, the Court concluded, the Tax Court erred in disallowing the deductions as a sham.

In this case an appeal would be heard by the Ninth Circuit Court of Appeals, so the Tax Court could have opted to simply ignore the Sixth Circuit analysis and again ruled the entire operation a sham. But the majority of the Court this time decided to take a different approach.

In this case the Court decided to look at who was the actual owner of the FSC corporation. While the Roth IRAs were the nominal owners, the Court found that they were owned for all practical purposes by the Roth IRA beneficiaries.

The Court’s analysis begins as follows:

Petitioners suggest that when their Roth IRAs formally purchased the FSC, the Roth IRAs thereby acquired the right (represented by the FSC stock) to receive income from the FSC. But a formal purchase does not necessarily mean that for tax purposes the Roth IRAs should be treated as the recipients of income from the FSC; the question is who had power and control over the FSC or over receipt of the dividend income. As the Supreme Court has stated: “The crucial question remains whether the assignor retains sufficient power and control over the assigned property or over receipt of the income to make it reasonable to treat him as the recipient of the income for tax purposes.” Commissioner v. Sunnen, 333 U.S. 591, 604 (1948). “[T]axation is not so much concerned with the refinements of title as it is with actual command over the property taxed — the actual benefit for which the tax is paid.” Corliss v. Bowers, 281 U.S. 376, 378 (1930).

The Court, looking at Ninth Circuit precedent and the Supreme Court’s ruling in Frank Lyon Co. v. United States, 435 U.S. 561 (1978), determined that the key issue was whether the Roth IRA owners were “exposed to any downside risk or could have expected any upside benefits from their claimed ownership of the FSC.”

The Court found no real downside risk existed to the Roth IRA. The IRAs never paid any costs or fees beyond the $500 they exchanged with the corporation to buy their stock and the corporate entity meant that they were not exposed to any risk in the investment itself. The Court noted that the $500 investment itself was so small as to be worth ignoring—but then noted even that was overstating the real risk. The Court noted:

In any event, petitioners have failed to show that the negligible $500 “purchase price” of the FSC stock amounted to anything more than a fee paid to WGA to set up a new and empty FSC. Nothing in the record suggests that the prearranged $500 “price” bore any relationship to the actual value of what was purportedly purchased, i.e., the FSC stock. At trial the parties agreed that the stock in the FSC was worth only $100 when it was purchased. We note, however, that whether the value of the stock was $500 or $100 at the moment of purchase, the shareholders' agreement (which was entered into simultaneously with the purchase) specifies that, if the Roth IRAs were to sell their FSC stock, the total sale price for all 100 shares was to be $1, rather than $500 or $100. The fixed discrepancy between the predetermined $500 purchase price and the immutable $1 sale price strongly suggests that all but the nominal amount of $1 was a fee for access to the FSC rather than a payment for property. Cf. Hewlett-Packard Co. v. Commissioner, 875 F.3d 494 (9th Cir. 2017) (differentiating between fees and bona fide losses), aff'g T.C. Memo. 2012-135. Consequently, considering the FSC stock in the light of the shareholders' agreement, we conclude that the Roth IRAs paid only $1 for the FSC stock. The rest was a fee. Petitioners have not cited, nor are we aware of, any authority for the proposition that such a fee is capable of lending substance to a series of transactions.

The Court also rejected the taxpayers’ argument that the Roth IRAs were exposed to risk when they reinvested the dividends they received. The Court noted that any contribution is exposed to risk when the Roth IRA invested it, so it did not somehow imbue the FSC stock investment with risk.

The Roth IRA also had no real upside. The Court found that the corporation controlled by the Roth IRA beneficiaries had absolute and unfettered control over the benefits (if any) that the Roth IRAs received, and, absent the ownership relationship, it would make no sense for any commissions to be paid to this organization. Thus, a truly independent owner could not have expected to receive any benefits.

As the Court explained:

Injector Co. retained complete control over whether any of its export receipts would flow to the FSC in any year. The commission agreement between petitioners' business and the FSC states: “At all times * * * [petitioners' business] shall have the discretion as to when and how much it wishes to pay FSC and no account receivable shall ever exist between FSC and * * * [petitioners' business].” Consequently, no independent holder of the FSC stock would have been entitled to, or would have expected, any upside; Injector Co. retained complete control over whether any payments would ever be made.

Furthermore, Injector Co.'s control over upside profits extended beyond the discretion to direct commission payments to the FSC. The commission agreement also allowed Injector Co. to reach into the FSC and take back any payments that had already been made — i.e., under the commission agreement, petitioners' business controlled any profits even after those profits had been paid to the FSC.38

On these facts, no independent holder of the FSC stock could realistically have expected to receive any benefits (before or after tax) due to its formal ownership of the FSC stock; Injector Co. retained control over any benefits at all relevant times.

The Court concludes that the Roth IRA beneficiaries, and not the Roth IRAs, were the true owners of the FSC. The Court continues:

…[B]ecause petitioners (through various passthrough entities) controlled every aspect of the transactions in question, we conclude that they, and not their Roth IRAs, were the owners of the FSC stock for Federal tax purposes at all relevant times. The dividends from the FSC are therefore properly recharacterized as dividends from the FSC to petitioners, followed by petitioners' contributions of these amounts to their respective Roth IRAs. All of these payments exceeded the applicable contribution limits and were therefore excess contributions. We therefore uphold respondent's determination of excise taxes under section 4973.

The majority then presents their argument regarding why this ruling is not contrary to the Sixth Circuit’s holdings in Summa Holdings.

The taxpayers before this Court in Summa Holdings I were individual taxpayers (who resided in the First and Second Circuits) and their C corporation (which had its principal place of business in the Sixth Circuit). All of these taxpayers appealed. The only taxpayer before the Court of Appeals for the Sixth Circuit in Summa Holdings II was the C corporation; consequently the issue before that court was limited to whether the commissions paid to the DISC were deductible by the taxpayers' business, i.e., the C corporation. The Court of Appeals for the Sixth Circuit decided that the commissions were deductible but appropriately did not consider the issue of whether the payments to the Roth IRAs were contributions. That shareholder-level issue is among the issues currently before the Courts of Appeals for the First and Second Circuits, to which the individual taxpayers in Summa Holdings I have appealed (under the names Benenson v. Commissioner, Nos. 16-2066 and 16-2067, and Benenson v. Commissioner, No. 16-2953, respectively). Accordingly, as the case presently before us involves only the shareholder-level issue (any corporate-level issues are barred by the statute of limitations), the holding in Summa Holdings II is not directly on point; that opinion did not analyze the payments to the Roth IRAs, the facts specifically relating to those payments, or the ownership of the DISC stock for tax purposes.