June 23, 2021
The Court of Appeals for the Ninth Circuit recently held that the IRS could not assert the substance over form doctrine to prevent a taxpayer from using a transaction involving a Foreign Sales Corporation ("FSC") to contribute more to a Roth IRA than the contribution limit would otherwise allow. While the FSC provisions were repealed in 2000, a similar result could be utilized through the use of a Domestic International Sales Corporation ("DISC").
I. Basic DISC Structure
Under the Internal Revenue Code, DISCs can provide domestic exporters with special tax exemptions so long as certain "receipts" and "asset" tests are met. Once a DISC has been established in a qualifying foreign jurisdiction, the domestic exporter passes a portion of export sales to the DISC in the form of a sales commission. This expense is deductible by the domestic exporter and, through special provisions in the Internal Revenue Code (IRC), is not taxed to the DISC. The DISC then pays the commission back to its U.S. shareholders in the form of a dividend. The result is that a Corporation has effectively deducted a dividend payment to shareholders. With the proposed increase of the Corporate Tax rate to 28%, the use of a DISC is likely to become more common.
II. Use of a DISC to Maximize Tax Savings in a Roth IRA
In order to maximize tax savings, a DISC can be created in which the shareholders are one or more Roth IRAs. In essence, the domestic exporter pays deductible sales commissions to the DISC, and the DISC redistributes this commission to the Roth IRA in the form of a dividend. While the distributions to the Roth IRA would be subject to corporate tax under § 995(g) as unrelated business income, this structure would allow taxpayers to exceed current IRA contribution limits.
III. Effect of Recent Ninth Circuit Holding
In Mazzei v. Commissioner, the Ninth Circuit negated the IRS's substance over form argument by referencing statutory language in repealed IRC § 925(a) which provided that FSCs could engage in transactions with commonly controlled entities "regardless of sales price actually charged." The court held that this language indicated that Congress had expressly directed that FSCs could engage in conduct that lack economic substance. As a result, the court held that the express language in the repealed IRC provision prohibited the IRS from making any substance over form arguments with respect to the FSC.
The holding in Mazzei is consistent with several holdings across various districts regarding a similar structure involving the use of DISCs. Under IRC § 994(a), congress uses the identical "regardless of sales price actually charged" language as was seen in the related FSC provision. As a result, based on the Ninth Circuit holding, the IRS would not succeed on a similar "substance over form" argument with respect to the use of a DISC to exceed Roth IRA contribution limits. As a result, a DISC could likely be used to exceed Roth IRA contribution limits. The contributions would then be eligible for tax-free accumulation.