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Commission Payments to IC-DISC Recharacterized as Non-Deductible Dividends

In Summa Holdings, Inc. v. Commissioner, T.C. Memo 2015-119, the Tax Court recharacterized an exporter’s deductible commission payments made to an IC-DISC as non-deductible dividend payments to the exporter’s shareholders followed by contributions by those shareholders to certain Roth IRAs. The Tax Court mentioned that there was “no nontax business purpose or economic purpose for establishing” the DISC (and certain related entities). This comment is surprising because the Tax Court has consistently held that “[a] DISC may be no more than a shell corporation, which performs no functions other than to receive commissions on foreign sales….” A DISC thus requires no nontax business purpose, and almost by definition (a definition crafted by Congress and acknowledged by Treasury) exists only for tax reasons. In any event, based on the holding in this case, it is questionable whether ownership of a DISC by any person that is not subject to full U.S. taxation (for example, a foreign entity that is not engaged in U.S. trade or business and is resident in a treaty country) remains viable.


An “interest charge domestic international sales corporation” (“IC-DISC” or “DISC”) is a tax-exempt U.S. corporation formed by an exporter company to receive commissions on the exporter’s sales. In a DISC structure, an exporter company typically sets up a DISC owned either by the exporter company itself (if the exporter is a flow-through entity) or by the shareholders of the exporter company (if a corporation).  The exporter pays deductible commissions to the DISC equal to the greater of: (i) 4% of gross receipts from qualified exports, or (ii) 50% of net income from qualified exports.  The DISC, as a tax-exempt entity, pays no tax on the commission income.  The DISC can then either hold the commission income (up to $10,000,000) or distribute the income to its shareholders.  If the income is held in the DISC, the DISC shareholders pay a nominal interest charge.  If the DISC distributes the commission income to its shareholders, it is classified as a dividend.  For individual U.S. and foreign taxpayers, the use of a DISC can thus reduce U.S. tax by converting a portion of the export income, normally taxable to the exporter at ordinary federal rates of up to 39.6%, into qualified dividend income, which generally is taxable to individual shareholders at rates of up to 23.8%.

Roth IRAs

A Roth IRA is a type of tax-favored retirement account, under which contributions to the Roth IRA are not tax deductible like contributions to a traditional IRA would be, but all earnings accumulate free of U.S. tax and there is no future tax on qualified distributions from the plan. Once funds are placed in a Roth IRA, in other words, those funds generally are not taxed again. As with traditional IRAs, the valuable benefits of Roth IRAs are restricted to certain taxpayers who fall below certain modified adjusted gross income thresholds, and even then, such persons are limited in the amounts that can be contributed each year. Any “excess contributions” beyond the stated limitations trigger an annual 6 percent excise tax until the excess contributions are eliminated. Dividends paid on stock held by a Roth IRA are not considered contributions and do not count toward the limitation, but rather are viewed as earnings of the IRA itself.

Notice 2004-8, 2004-1 C.B. 333

The IRS issued Notice 2004-8 to address a type of transaction that taxpayers were using to avoid Roth IRA contribution limits. The Notice says that where a taxpayer’s preexisting business enters into transactions with a corporation owned by the taxpayer’s Roth IRA, in certain cases “the acquisition of shares, the transactions, or both are not fairly valued and thus have the effect of shifting value into the Roth IRA.” The Notice identified three ways the IRS would seek to challenge such transactions:

  1. Under Section 482, by seeking to allocate income from the corporation to the taxpayer, the preexisting business, or other entities under the control of the taxpayer;
  2. Under Section 408(e)(2)(A), on the basis that the transaction gives rise to one or more prohibited transactions between a Roth IRA and a “disqualified person”; and
  3. By asserting that the substance of the transaction is that the amount of the value shifted from the preexisting business to the DISC is a dividend to the taxpayer, followed by a contribution by the taxpayer to the Roth IRA and a contribution by the Roth IRA to the corporation.


In 2011, the Tax Court ruled in the taxpayers’ favor in a case involving a DISC indirectly owned by Roth IRAs when the IRS sought to impose excise taxes and penalties on the taxpayers in Hellweg v. Commissioner, T.C. Memo 2011-58. In that case, four individual taxpayers owned and controlled an S corporation that manufactured certain pet food ingredients (“ADF”). The taxpayers each established a Roth IRA and funded those IRAs with a small amount of money. The IRAs then used part of this money to purchase the previously unissued stock of a DISC. Subsequently, each of the IRAs dropped its DISC stock into a separate domestic C corporation holding company (the “Holdcos”). In the tax years 2004-2006, ADF paid deductible commissions to the DISC. These amounts were in turn paid by the DISC to the Holdcos, which reported and paid tax on such amounts. Each of the Holdcos then distributed the net after-tax balance as dividends to the IRAs.

The IRS audited ADF and its individual owners, issuing ADF no-change letters for each year, but issuing the individual taxpayers each a notice of deficiency. The IRS asserted that payments from ADF to the DISC and ultimately to the IRAs improperly shifted value to the IRAs in excess of the IRA contributions limitations, and that therefore excise tax should apply to the excess contributions. To address this, the IRS sought to recharacterize the transactions as distributions from ADF to the individual taxpayers, followed by contributions from the taxpayers to their respective IRAs. The taxpayers, on the other hand, argued that the payment of DISC dividends to a Roth IRA cannot be treated as excess contributions because Congress specifically addressed the ownership of a DISC by an IRA, acknowledging that such ownership was possible and permissible, when it enacted Section 995(g) (deeming tax-exempt entities to realize unrelated business taxable income (UBTI) from certain transactions with DISCs).

The court held for the taxpayers in Hellweg, noting that the IRS could have attacked the transaction using Notice 2004-8, reallocating income or recharacterizing the transaction, but instead had made no adjustments with respect to ADF and issued ADF no-change letters. The court stated that it had “not been asked to and d[id] not decide what the proper treatment of the [t]ransaction [was] for income tax purposes.” Rather, the IRS framed the case in a way that asked the court to rule that the IRS can characterize a transaction differently for income tax purposes and excise tax purposes. The court was not willing to do this. Toward the end of the opinion, the court clarified that:

“[Our] decision does not prevent the IRS from recharacterizing the [t]ransaction consistently for income tax and excise tax purposes.”


The facts in Summa were very similar to the facts in Hellweg. The Benenson family owned a company called Summa, a Delaware C corporation. Summa was founded by James Jr., the patriarch, in 1983, and it owned a consolidated group of several manufacturing companies. In 2001, the children of James Jr., James III and Clement, each formed a Roth IRA and funded it with $3,500. As of January 1, 2002, a new Delaware corporation made a DISC election, and on January 31, 2002, the children’s IRAs each purchased 1,500 shares of the DISC for $1,500 ($1 per share). That same day, the IRAs transferred their respective 1,500 shares of the DISC into a holding company, another Delaware C corporation (“Holdco”). As in the Hellweg case, the Holdco was used to avoid UBTI, as well as being helpful to the IRA custodians.

The Summa subsidiaries and the DISC then entered into commission agreements under which the subsidiaries began making commission payments to the DISC. The DISC in turn made distributions to the Holdco. Holdco then estimated the US tax due on such payments (since Holdco was a corporation and not a DISC, it had to pay regular US federal income tax on its receipts), and immediately remitted the remaining funds to the IRAs. By the end of 2008, each IRA held assets with a fair market value of more than $3 million.

In 2012, the IRS issued notices of deficiency to each of Summa (disallowing its deductions for the commission payments made by the subs that formed its consolidated group), James Jr., James III, and Clement. The IRS, perhaps having learned from its prior experience in Hellweg, attacked the transactions from both an income and excise tax perspective, arguing that the taxpayers had improperly shifted value to the IRAs in excess of the contribution limits, and that based on the substance over form doctrine, the transactions and payments could be recharacterized. The IRS thus sought to recharacterize the commission payments as dividend distributions to the shareholders of Summa, followed by [excessive] contributions to the IRAs. The taxpayers countered that, based on Hellweg, the three ways that the IRS may attack such transactions per the Notice could not be applied to them. They also made a backup argument that reclassification of the transaction based on substance over form was improper because it would result in disregarding a DISC or DISC transactions, contrary to Congressional intent (citing Addison Int’l, Inc. and Jet Research, Inc.)

This time, the court (same court, but different judge) ruled in favor of the IRS. The court clarified that this ruling was not inconsistent with Hellweg, because in that case the court had simply held that a transaction cannot be treated differently for income and excise tax purposes, and here the IRS was arguing that the transactions were invalid for both income and excise tax purposes. The court also noted that the IRS was not seeking to disregard the DISC itself, but rather arguing that a transaction involving a DISC should be recharacterized. The court did not see this as contrary to Congressional intent behind the DISC provisions. But the court did agree that the taxpayers had improperly shifted excess value into the IRAs contrary to the contribution limits, and that recharacterizing the transactions on a substance over form basis was therefore appropriate.


As noted above, the Tax Court has consistently held for decades that “[a] DISC may be no more than a shell corporation, which performs no functions other than to receive commissions on foreign sales….” The regulations also provide that the DISC rules “constitute a relaxation of the general rules of corporate substance otherwise applicable under the Code.” The court’s repeated statements regarding the taxpayers’ lack of nontax business purpose and economic purpose for establishing the DISC are for this reason a bit misplaced. This DISC, like other DISCs, existed only for tax reasons. But that really does not matter. The Summa case is not about the substance of the DISC, but rather, the substance of the payments made to and from the DISC and related parties (including, in this case, the two Roth IRAs).

The holding of the case is perhaps not that surprising, and for many readers may not be particularly offensive. However, the case does raise some other potential questions. For example, if the DISC in this case was valid (which no one disputes), but this transaction was objectionable and therefore recast because the recipient of the DISC dividends was a Roth IRA that therefore would never pay additional tax on these amounts, what other classes of owners of DISCs might the IRS find objectionable? In a situation involving US individual shareholders of a DISC, the real benefit of the DISC is the ability to convert a portion of the exporter’s income from ordinary income (taxable at 35% or 39.6%) into lower-taxed qualified dividends realized by the DISC shareholders.

The taxpayers in Summa received no significant income tax benefits compared to typical individual DISC owners, other than eventual benefits provided through the Roth IRAs. The commissions paid by the Summa subs to the DISC were deductible by Summa, but when the DISC paid those same amounts to Holdco, Holdco (not being eligible for the dividends received deduction under Section 246(d)) was subject to tax at corporate rates of 35%. These taxes thus fully offset the deduction claimed by Summa. In this sense, the taxpayers in Summa were initially less tax-advantaged than the individual taxpayers in the more typical DISC structure described above, who were able to convert 35% or 39.6% income into 23.8% income. In Summa’s case, the dividends paid by Holdco were not taxable to the IRAs, and the IRAs could continue to accumulate such amounts free of tax, but again, a 35% tax had already been paid by Holdco, so there was no tax loss due to the exemption on the dividends paid from the DISC to the IRAs. Rather, the only significant difference was that the IRAs could continue to grow the amounts indefinitely and distribute them tax-free, whereas a taxable U.S. shareholder who receives distributions from a DISC generally would be taxable on any income and gains later generated by the money received.

What if the owner(s) of the DISC are non-US persons resident in a treaty country that do not have a permanent establishment (PE) in the US, and the relevant treaty provides for a reduced withholding tax rate of 0%, 5%, or 15% on the dividends? Will the IRS attack the commission payments made to the DISC in that case because the ultimate effective US tax rate is reduced? Section 996(g) provides that in the case of a foreign shareholder, all DISC distributions are treated as effectively connected income (ECI) earned through a PE and derived from US sources. As a result, dividends received by foreign shareholders from a DISC generally are subject to US tax at rates of up to 20%. Income tax treaty provisions can alter this result. There is nothing in the DISC provisions or the legislative history specifically stating that the DISC rules are intended to override subsequent federal income tax treaties. A number of treaties have been ratified subsequent to the enactment of the DISC rules, and most or all of those treaties contain provisions that are inconsistent with the DISC concept of deemed PE, as they require an actual physical presence in the United States. In these cases, the treaty provisions may override Section 996(g). If so, the foreign DISC shareholder should be eligible for the reduced withholding tax rates on dividends provided for under the treaty. Would such a structure be challenged under the Tax Court reasoning in Summa? It remains to be seen.

© 2020 Bilzin Sumberg Baena Price & Axelrod LLPNational Law Review, Volume V, Number 191


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