Benenson v. Comm'r

• Decision Date: 14 December 2018
• Docket Number: August Term 2017,No. 16-2953-ag,16-2953-ag
• Citation: 910 F.3d 690
• Parties: James BENENSON, Jr. and Sharen Benenson, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Second Circuit

910 F.3d 690

James BENENSON, Jr. and Sharen Benenson, Petitioners-Appellants,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 16-2953-ag

August Term 2017

United States Court of Appeals, Second Circuit.

Argued: April 10, 2018

Decided: December 14, 2018

Neal J. Block (Robert S. Walton, on the brief ), Baker & McKenzie LLP, Chicago, Illinois, for Petitioners-Appellants.

Ellen Page DelSole, Attorney, Tax Division (Gilbert S. Rothenberg, Teresa E. McLaughlin, Attorneys, Tax Division, on the brief ), for Richard E. Zuckerman, Deputy Assistant Attorney General, Washington D.C., for Respondent-Appellee.

Before: Parker, Raggi, Livingston, Circuit Judges.

Reena Raggi, Circuit Judge:

At issue on this appeal is a decision of the United States Tax Court (Kathleen Kerrigan, Judge ), upholding tax deficiencies noticed by respondent Commissioner for tax year 2008 against (1) petitioners, James Benenson, Jr. ("Benenson, Jr.") and his wife Sharen Benenson; (2) petitioners' adult sons, James Benenson III and Clement Benenson ("Benenson sons" or "sons"); and (3) Summa Holdings, Inc. ("Summa"), a C corporation founded and, in 2008, still controlled by Benenson, Jr. See Summa Holdings, Inc. v. Comm'r, 109 T.C.M. (CCH) 1612 (2015). The Commissioner identified these deficiencies by applying the substance-over-form doctrine to recharacterize a series of concededly lawful tax-avoiding transactions as tax-generating events.

These transactions included (1) Summa's payments, totaling $2.2 million, in genuine export income as tax-deductible commissions to a qualified domestic international sales corporation ("DISC"); (2) the DISC's payment of $2.2 million in taxable dividends to its sole shareholder, a holding company owned by the Benenson sons' individual retirement accounts ("IRA"); (3) the holding company's after-tax payment of $1.477 million in non-taxable dividends to the Benenson sons' IRAs. There is no question that the "sole reason" for the taxpayers to enter into these aforementioned transactions "was to transfer money into the [sons'] IRAs so that income on assets in the Roth IRAs could accumulate and be distributed on a tax-free basis." App'x 102. They stipulated as much in the Tax Court. The Commissioner concedes that, in form, the money transfers present as lawful, non-taxable returns on IRA investments. Nevertheless, he maintains that, in substance, the transfers effect excess IRA contributions subject to excise taxes. Accordingly, he noticed deficiencies against the sons for such taxes. Further, concluding that the excess contributions derived from the $2.2 million that Summa had treated as deductible DISC commissions, the Commissioner recharacterized those commissions as non-deductible constructive dividends to Summa shareholders, specifically, Benenson, Jr. and a Benenson family trust, thereby triggering income tax deficiencies for Summa, petitioners, and the trust.¹

Consistent with their diverse residences in Massachusetts (Benenson sons), New York (petitioners), and Ohio (Summa), the taxpayers appealed the Tax Court's judgment to the First, Second, and Sixth Circuits respectively. See 26 U.S.C. § 7482(b) (establishing taxpayer residence as appropriate venue for appeals from Tax Court). The First and Sixth Circuits have now reversed the judgment as it pertains to the Benenson sons and Summa, concluding that the substance-over-form doctrine does not support the Commissioner's recharacterization either of Summa's deductible DISC commission payments as non-deductible constructive dividends to its shareholders, see Summa Holdings, Inc. v. Comm'r ("Summa v. Comm'r "), 848 F.3d 779 (6th Cir. 2017) ; or of the holding company's dividend payments to the sons' IRAs as excess contributions, see Benenson v. Comm'r , 887 F.3d 511 (1st Cir. 2018). On this appeal, we consider petitioners' challenge to the same Tax Court decision as it pertains to them and also reverse.

BACKGROUND

We assume readers' familiarity with the First and Sixth Circuits' opinions, particularly their detailed discussions of the transactions at issue and the tax code provisions relevant to those transactions. We, therefore, only briefly summarize these matters as pertinent to petitioners' appeal.

I. DISCs and IRAs

The transactions at issue sought to take advantage of the tax-minimizing features of two creatures of federal law, DISCs and IRAs.

Congress created DISCs to provide domestic companies with tax incentives to increase exports. See LeCroy Research Sys. Corp. v. Comm'r , 751 F.2d 123, 124 (2d Cir. 1984) ; see also Benenson v. Comm'r , 887 F.3d at 514 ; Summa v. Comm'r , 848 F.3d at 782. Toward that end, the tax code allows companies to avoid corporate tax on export income up to 4% of gross export receipts (or 50% of net export income), by paying that amount as tax-deductible "commissions" to a DISC. See 26 U.S.C. §§ 993(a)(1), (f) ; 994(a). The DISC itself pays no tax on the commission income. See id. § 991. Rather, tax obligations arise only for DISC shareholders when the DISC distributes dividends to them. See id. § 995(a), (b)(1)(E). Thus, tax liability on export income, when channeled through a DISC, can not only be deferred until such distribution, but also can be reduced by application of the dividend tax rate rather than the higher corporate rate that would otherwise apply to export revenues. See Summa v. Comm'r , 848 F.3d at 782 (citing relevant statutory provisions in observing that "net effect" of DISC is "to transfer export revenue to the export company's shareholders as a dividend without taxing it first as corporate income"). These benefits obtain even if, as is frequently the case, the exporter and the DISC are related entities and commission transactions between them are not conducted at arms-length. See 26 C.F.R. § 1.994–1(a)(1). They obtain even if the DISC is a mere shell entity, as is likely because a DISC "need not have employees or perform any specific function" for its commissions to be immunized from challenge by the Commissioner for tax purposes. Id. § 1.993–1(l); see id. example 2; id. § 1.994–1(a)(2) (providing that DISC tax benefits do "not depend on the extent to which the DISC performs substantial economic functions"). Indeed, as the Commissioner himself acknowledges, as long as a company complies with DISC statutory requirements, its commission payments to a DISC cannot be challenged. See id. § 1.992–1(a) (noting that regulations governing DISCs "constitute a relaxation of the general rules of corporate substance otherwise applicable under the Code").

As for IRAs, the law provides for two types: traditional and Roth. Traditional IRAs encourage retirement savings by allowing taxpayers to make tax-deductible contributions to such accounts up to specified limits ($5,000 in 2008). See 26 U.S.C. § 219(b)(5) (2008). Contributions to a traditional IRA, as well as earnings on such contributions, are taxed only upon withdrawal. See id. § 408(d)(1).

Roth IRAs offer inverse tax incentives. While contributions to such accounts (also limited to $5,000 in 2008) are not deductible from current income, withdrawals from Roth IRAs are not taxed. See id. § 408A(c)(2)–(3), (d)(1)–(2). Thus, contributions to Roth IRAs grow tax-free. Income limits restrict participation in Roth IRAs. In 2008, a person filing singly with income over $116,000, or jointly with income over $169,000, could not contribute to a Roth IRA. See id. § 408A(c)(3). Excess contributions to either traditional or Roth IRAs are subject to an annual six-percent excise tax until eliminated. See id. § 4973(a), (f).

The tax code permits both traditional and Roth IRAs to invest in various legal entities, including, as relevant here, C corporations and DISCs. See Benenson v. Comm'r , 887 F.3d at 520 (discussing how various code provisions, read together, lead to that conclusion); Summa v. Comm'r , 848 F.3d at 784 (same). But whereas an individual DISC owner is taxed at the dividend rate on DISC dividends, a corporate owner is taxed at the higher corporate rate, and an IRA owner is taxed at the unrelated business income rate, which is equal to the corporate rate. See 26 U.S.C. §§ 246(d), 511, 995(g). This makes DISC ownership less attractive for traditional IRAs. See Summa v. Comm'r , 848 F.3d at 783 (explaining that DISC dividends are subject to high unrelated business income tax when they go into traditional IRA and, like all withdrawals from traditional IRA, are subject to personal income tax when taken out). Not so for Roth IRAs. While a Roth IRA must also pay unrelated business income tax on any DISC dividends that it receives, ensuing investment gains on those dividends are tax-free because, as with all Roth IRA assets, DISC dividends and gains thereon are not subject to individual income or capital gains taxes when withdrawn. See id. (summarizing advantageous interaction between Roth IRAs and DISCs and noting that "one can begin to see why the owner of a Roth IRA might add shares of a DISC to his account").

II. The Transactions at Issue

Summa is the parent company of several industrial manufacturing subsidiaries with significant export income. During the 2008 tax year, Summa was 99% owned by its founder, Benenson, Jr. (23.18%), and a family trust benefitting the Benenson sons for which petitioners served as trustees (76.05%). Benenson, Jr. then controlled Summa through his majority ownership of the company's voting shares.

From 2002 through 2008, Benenson, Jr., his sons, and Summa engaged in various transactions that they acknowledge had as their sole purpose the transfer of money into the sons' Roth IRAs "so that income on assets in the Roth IRAs could accumulate and be distributed on a tax-free basis." App’x 102. Each Benenson son had established a Roth IRA in 2001, contributing $3,500. Neither made any further contributions to these accounts and, indeed, by 2008, each son's income was too high to allow him to do so. Nevertheless, by 2008, each son's Roth IRA held $3.1 million...