In a recent, well-reasoned case, the Sixth Circuit upheld a taxpayer’s use of an IC-DISC as a Roth IRA investment to accumulate earnings tax-free. The investment was established by the following steps:

  • Roth IRA owns shares of Holding Company (Holdco);
  • Holdco owns shares in IC-DISC, a tax-exempt entity for export sales
  • Dividends from IC-DISC to Holdco are taxed to Holdco;
  • Dividends from Holdco to the Roth IRA are taxed, but then grow tax-free and are later not taxed when distributed to the Roth IRA owners;

The IRS recast the dividends to the Roth IRA as contributions, rather than IRA investment earnings. Since the dividends exceeded the contribution limits ($5,500 each year, $6,500 for owners over 50), the IRS assessed penalties. The IRS argued that the “substance-over-form doctrine” allowed them to recast these transactions into to a higher-tax alternative. The court rejected this argument.

Critical to the 6th Circuit’s rejection of the IRS’s argument was that the IRS agreed that the taxpayer was fully compliant with the literal requirements of the Tax Code. The IRS simply didn’t like that this arrangement led to so much tax savings. The IRS protested that the taxpayer was only using the IC-DISC and the Roth IRAs to avoid tax. In response, the court noted that, “the point of these entities is tax avoidance.”

This is not a complete rejection of the substance-over-form doctrine. Taxpayers still need to seek advice and exercise caution in implementing tax strategies involving IC-DISC’s and IRA’s.

IC-DISC’s can be very effective tax strategies, filled with significant tax-saving opportunities, but also with compliance risks and pitfalls. This Sixth Circuit decision could represent a major opportunity to super-charge Roth IRA’s.

If you have any questions about whether this tax strategy might be right for you, please contact a Barnes Dennig representative here.