DISC Commissions not subject to IRS Recharacterization

On February16th, the Sixth Circuit Court of Appeals reversed the Tax Court Summa Holding, Inc. (Summa) decision which disallowed the payment of commissions to Domestic International Sales Corporation (DISC) owned by Roth IRAs. The Tax Court improperly held that the DISC payments paid by the parent of a closely held manufacturing company were not commissions and that the dividends the DISC paid to its Roth IRA shareholders were excess contributions.

Congress designed DISCs to enable exporters to defer corporate income tax. The exporter avoids corporate income taxes by paying the DISC commissions up to 4% of gross receipts or 50% of net income from qualified exports. The DISC pays no tax on its commission income (up to 10 million) and may hold the money indefinitely. However, the DISC shareholders must pay annual interest on their shares of the deferred tax liability. The money and other assets in the DISC can be distributed as dividends to its shareholders. The dividends that are paid to individuals are eligible for the qualified dividend tax rate.

In the Summa case, the taxpayer paid commissions to the DISC, which then distributed the money as a dividend to the holding company. The holding company paid income tax on the dividends and then distributed the balance to its Roth IRA shareholders. The owner of a Roth IRA can add shares of a DISC to their account and invest freely without having to pay capital gains taxes on the increases in the value of the shares of stock in companies that generate considerable dividends. As with all Roth IRA’s account holders, the owner does not pay any individual income or capital gains taxes when assets are distributed from the account at retirement age. While Congress’s decision to permit Roth IRAs to own DISCs might have been an oversight, it is still the law. 

 The Sixth Circuit ruled that the Internal Revenue Service (IRS) had no basis for the disallowance and held that the use of a DISC indirectly owned by a Roth IRA’s is expressly authorized by Congress and not subject to any type of recharacterization. The substance-over-form doctrine did not authorize the IRS to prohibit a transaction just because taxpayers undertook the strategy to reduce their individual tax liability. Therefore, the Court held that the language of the DISC statutes must be respected and that the DISC commissions were not subject to substance-over-form recharacterization. 

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