The February 2016 ruling in favor of the taxpayer by the U.S Court of Appeals in Summa Holdings, Inc. v. Commissioner has validated a new dimension in the use of the IC-DISC vehicle for long-term tax planning and wealth building. In summary, the Summa Holdings verdict allows the use of Roth IRAs to accumulate IC-DISC dividends without limitation after those dividends are received by a Roth IRA on an after-tax basis.
In this case, the financial benefit of adding shares of an IC-DISC to a Roth IRA worked as follows: The owner of a family-held exporting company transferred money from the exporter to an IC-DISC as a deductible commission payment, which in turn paid those funds as a dividend to the IC-DISC’s shareholder, a simple holding company. Pursuant to Internal Revenue Code §408(e)(1) the Roth IRA account holder did ultimately incur the high unrelated business income tax — 33% in this instance — when the IC-DISC dividends were paid into the holding company, but once the Roth IRAs received the after-tax money as a dividend from the holding company the Roth account holder could invest it freely without having to pay capital gains taxes on increases in the value of each share, or income taxes on the dividends received—just like other Roth IRA owners who buy shares in companies that generate large dividends and/or experience quick growth in share value. Moreover, as with all Roth IRAs, the owner would not have to pay any individual income or capital gains taxes when the assets leave the Roth account after he reaches the required retirement age.
IC-DISCs and Roth IRAs were both designed by Congress to reduce taxes. The Sixth Circuit U.S. Court of Appeals reversed a U.S. Tax Court decision holding that the transaction in Summa is to be respected because it applied the IC-DISC and Roth IRA rules for their Congressionally-sanctioned purpose, which is to facilitate tax reduction. That is exactly how the Benenson family in Summa used these entities: Summa Holdings paid deductible commissions to JC Export IC-DISC, who then distributed the money as a dividend to JC Holding, the IC-DISC’s sole shareholder. JC Holding paid the 33% unrelated business income tax on those dividends, and then distributed the net balance as dividends to its shareholders, the Benenson family’s two Roth IRAs. This strategy began in 2002 and by 2008 each Roth IRA had accumulated over $3 million, well above the standard Roth IRA annual contribution limits.
At the time that this strategy was put in place – just as now – §995(g) of the Internal Revenue Code permitted traditional and Roth IRAs to own tax-exempt entities such as IC-DISCs. Congress further affirmed in §408A(a) that both types of IRAs (traditional and Roths) should be treated the same, allowing the structure in Summa to be implemented. Permitting taxpayers to circumvent the Roth IRA contribution limits may be an unintended result of Congressional legislation, but it is definitely a taxpayer-friendly result that is now approved by the U.S. Court of Appeals.