Sixth Circuit Upholds Tax Loophole for the Rich

(CN) – The Sixth Circuit ruled the IRS cannot prosecute a wealthy family for using a complex, but legal, tax strategy to avoid limitations on Roth IRA contributions and funnel $6 million into tax-free investment accounts.

“[The Roman Emperor] Caligula posted the tax laws in such fine print and so high that his subjects could not read them,” Judge Jeffrey Sutton begins his 15-page opinion. “That’s not a good idea, we can all agree.”

Fortunately, the IRS prints its tax code legibly for all Americans with the time, and patience to read it – or with the money to pay others to read it on their behalf.

The Benenson family, owner of Summa Holdings Inc., paid its tax attorneys to do just that, and, on their attorneys’ advice, transferred money from the family-owned company to their sons’ Roth Individual Retirement Accounts via a domestic international sales corporation.

Through this complicated arraignment, the Benensons transferred a total of $6 million in corporate dividends to their two sons’ Roth IRAs in just six years, although the annual individual contribution limit of a Roth IRA is just $5,000.

The company paid a 33 percent tax on the money before it went into the Roth IRA accounts, but once invested, the money can grow completely tax-free and the sons can withdraw the money when they hit retirement age.

The IRS acknowledges that the tax code authorizes this tax avoidance strategy, but nevertheless characterized the transactions as a form of tax evasion that comply with the letter but not the spirit of the law.

The U.S. Tax Court upheld the IRS’s determination, applying the “substance-over-form doctrine,” and finding that the strategy intended to evade the contribution limits on Roth IRAs.

But the Sixth Circuit rejected this reasoning Thursday.

“Each word of the ‘substance-over-form doctrine,’ at least as the Commissioner has used it here, should give pause,” Sutton wrote for a three-judge panel. “‘Form’ is ‘substance’ when it comes to law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence – to allow him to determine the substance of a law and to make it govern ‘over’ the written form of the law – and to call it a ‘doctrine’ no less.” (Parentheses and emphasis in original.)

The unanimous three-judge panel said the IRS cannot prosecute the Benensons or their company for following the law, even if their motive was to avoid taxes.

“It’s one thing to permit the Commissioner to recharacterize the economic substance of a transaction – to honor the fiscal realities of what taxpayers have done over the form in which they have done it,” the opinion states. “But it’s quite another to permit the Commissioner to recharacterize the meaning of statutes – to ignore their form, their words, in favor of his perception of their substance.”

Sutton said that federal courts should not step in to close loopholes written into the federal tax code, when that would just “reward[] Congress’s creation of an intricate and complicated Internal Revenue Code by closing gaps in taxation whenever that complexity creates them.”

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