Benensen vs. Commissioner: The Benefits of Advanced Tax Planning
By Joe Nagel, Esq., LLM, CPA
The recent case of Benenson v. Commissioner, 887 F.3d 51 (1st Cir. 2018), illustrates how tax planning utilizing the combination of DISCs and Roth IRAs have the potential to funnel significant amounts of income related to international sales into tax free retirement accounts.
As background, Domestic International Sales Corporations (“DISCs”) were designed by Congress as an export incentive for U.S. domestic companies. Operating companies can pay commissions on international sales to a DISC, normally owned by some or all of the operating company’s shareholders. The commissions are deductible to the operating companies and results in a net profit to the DISC. The net profit is not subject to federal income tax. The DISC then distributes the net profit to it’s shareholders as qualified dividends, subject to capital gains tax rates. DISCs thereby allow income from international sales to be taxed at the lower capital gain rate of 20% (23.8% including net investment income tax) rather than ordinary income tax rates.
Note, under the 2018 Tax Cuts and Jobs Act, ordinary income tax rates have been reduced to 37.0% (for individual owners of flow-through entities) or 21% (C corporations). Owners of flow through entities may also be able to take advantage of a 199-A deduction, which may further reduce the effective rate of tax for flow through business entity income. However, that deduction and the lower 37% tax rates on individuals are scheduled to sunset in 2025.
IRAs are retirement savings plans that allow individuals to benefit from tax advantaged growth. Roth IRAs require investors to contribute after tax income (i.e. there is no tax deduction for Roth IRA contributions), but allow growth to accumulate tax free and allow distributions from the Roth IRA account to be made tax free. In addition, unlike traditional IRAs, Roth IRAs are not subject to the required minimum distribution rules, allowing Roth IRA assets to grow tax free for a longer period of time.
Utilizing a structure combining Roth IRAs and DISCs, James III and Clemet Benenson endeavored to direct DISC income to Roth IRAs. In 2002, James III and Clement, who are shareholders of Summa Holdings, Inc., an operating C corporation, set up and funded Roth IRAs with contributions of $3,500 each. The Roth IRAs then invested those funds into JC Export, a newly formed DISC in return for ownership of the entity. They then sold their JC Export shares in return for stock in JC Holding, a C corporation holding company, with each Roth IRA owning a 50% interest in the C corporation holding company.
The DISC entered into agreements with subsidiaries of Summa Holdings, Inc. whereby it would pay commission it received from Summa Holdings’ subsidiaries to the C corporation holding company, which then (after tax withholding) paid dividends to the Roth IRAs. By 2008, the Roth IRAs were each worth $3 million dollars.
In 2012, the IRS issued a notice of deficiency for the 2008 tax year, arguing that commissions paid to JC Export (the DISC) were in substance dividends to Summa Holdings’ shareholders rather than DISC commissions. The IRS viewed the resulting payments from JC Holding to the Roth IRAs not as dividends from a holding company to its C corporation shareholders, but as contributions to an IRA in excess of statutory limits.
The First Circuit sided with the taxpayers, finding that Congress contemplated that DISCs may be owned by tax exempt IRAs and that it should be up to Congress to change the law if it does not like the outcome.
Notably, JC Holdings, the C corporation holding company, paid income taxes on DISC distributions of $2,161,965 at the corporate income tax rate. The true benefit to the structure was the funneling of huge amounts of after tax dollars to Roth IRAs, where distributions from the holding company may grow tax free in the future free of the required minimum distribution rules and future IRA distributions may be made without additional income tax.
If you have any questions about Benenson, or DISCs or Roth IRAs in general, please contact us (404) 255-7400.
