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Payments from Foreign Sales Corporation Reclassified as Excess Roth IRA Contributions
(Parker Tax Publishing March 2018)
The Tax Court held that a plan to save taxes by routing income from a family business through a Bermuda based foreign sales corporation (FSC) and then into Roth IRAs was properly characterized as contributions from the taxpayers to their Roth IRAs in excess of the contribution limits and thus subject to excise taxes. The Tax Court distinguished Summa Holdings, Inc. v. Comm'r, 2017 PTC 58 (6th Cir. 2017), where the Sixth Circuit reversed in part a Tax Court decision to recharacterize payments in a similar plan involving domestic international sales corporations. Mazzei v. Comm'r, 150 T.C. No. 7 (2018).
Background
Angelo Mazzei invented an injector that mixes chemicals with water for use primarily in agriculture. He received a patent for his invention in 1978 and he and his wife, Mary, formed the Mazzei Injector Corp. (Injector Corp.) as an S corporation. The Mazzeis' daughter, Cecelia, later joined the company as a vice president and acquired 10 percent of the company. Injector Corp. expanded its business overseas and by 1998, export sales were a reliable stream of income.
Mr. Mazzei was a member of the Western Growers Association (WGA), a trade association for farmers. In the 1990s, WGA began selling interests in foreign sales corporations (FSCs) to its members. FSCs were foreign corporations which elected to be taxed under now-repealed Code Sections 921-927. WGA's FSCs were located in Bermuda and managed by a company called Quail Street Management.
To participate in the FSC program, Angelo, Mary and Cecelia Mazzei each opened a self-directed Roth IRA and contributed $2,000. Each then directed their Roth IRA to buy one third of a new account inside one of WGA's FSCs (each FSC was a separate corporation under former Code Section 925). Altogether, the Roth IRAs paid $500 for 100 shares.
The FSC agreed to perform various export-related activities for Injector Co. in exchange for a commission payment. All of the activities contracted to the FSC had to be delegated back to Injector Co. in exchange for a fee, which could not exceed the commission. Injector Co. also paid a fee to Quail Street to administer the program. The management fee was a percentage of the FSC's foreign trading gross receipts. Under a shareholder agreement, the $500 purchase price for 100 shares of FSC stock included $1 of paid-in-capital and $499 of paid-in-surplus. Sale of FSC stock required approval of the FSC's directors, and the sale price of the FSC stock was set as the $1 paid-in-capital amount. The FSC was not required to perform any export related activities for Injector Co., and Injector Co. at all times retained the right not to make commission payments to the FSC.
In summary, there were three parts to the transactions: (1) the Mazzeis created self-directed Roth IRAs, which nominally purchased stock in an FSC, and Injector Co. simultaneously executed a series of agreements with the FSC; (2) Injector Co. made a series of commission payments to the FSC; and (3) after withholding taxes, the FSC paid the balance of the payments to the Mazzeis' Roth IRAs. Between 1998 and 2002, the FSC paid approximately $533,000 to the Mazzeis' Roth IRAs.
Before entering the transactions, the Mazzeis consulted with their accountant, Mr. Bedke, who advised that it was not prohibited for a Roth IRA to invest in an FSC. However, in 2003, the IRS issued Notice 2004-8 to advise the public that it considered some Roth IRA transactions to be abusive tax avoidance transactions.
The Mazzeis began filing protective disclosures on Form 8886, Reportable Transaction Disclosure Statement, disclosing that they participated in a program potentially covered by Notice 2004-8. The Mazzeis did not, however, file Forms 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts.
The IRS determined excise tax deficiencies for the Mazzeis for 2002-2007 and added penalties for each of the years at issue. The IRS recharacterized the transfers to the Roth IRAs under the substance over form doctrine as contributions by the Mazzeis that exceeded their annual contribution limits under Code Sec. 4973. The income tax treatment of the payments was not an issue because the statute limitations had run. However, because none of the Mazzeis filed Forms 5329, the limitations period never began to run with respect to the excise tax deficiencies. It was undisputed that the $533,000 that was deposited into the Mazzeis' Roth IRAs would be excess contributions and subject to excise tax if they constituted Roth IRA contributions.
The Mazzeis petitioned the Tax Court to review the deficiencies. They argued that the substance over form doctrine did not apply because the FSC/IRA arrangement was permitted under former Code Sec. 925. According to the Mazzeis, Roth IRAs were permitted to own FSC stock, so the form of the transactions should have been respected and the IRS's attempt to recharacterize the transactions frustrated Congress's intent. The Mazzeis also pointed out that under Reg. Sec. 1.926(a)-1T(a), any distribution by an FSC to its shareholder with respect to its stock is dividend income. The Mazzeis further claimed that the Sixth Circuit's reasoning in Summa Holdings, Inc. v. Comm'r, 2017 PTC 58 (6th Cir. 2017) (Summa Holdings II), which reversed in part Summa Holdings, Inc. v. Comm'r, T.C. Memo. 2015-119 (Summa Holdings I), precluded application of the substance over form doctrine. In that case, the Sixth Circuit upheld a similar arrangement that used a domestic international sales corporation (DISC).
Analysis
The Tax Court held that the IRS properly recharacterized the scheme as contributions to the Roth IRAs directly from the Mazzeis because the Mazzeis, not the Roth IRAs, were the substantive owners of the FSC stock. In the Tax Court's view, the FSC's payments were in substance income to the Mazzeis rather than to their Roth IRAs and then excess contributions by the Mazzeis to their Roth IRAs.
The Tax Court reasoned that the Roth IRAs were not the economic owners of the FSC because they were exposed to no risk and could expect no upside benefits. The Tax Court found that the initial $500 payment was at most a de minimis risk which was insufficient to give substance to the Roth IRAs' purported ownership of the FSC stock. Moreover, the FSC was a separate corporate entity and the Roth IRAs were protected from liability by its corporate shield; the Tax Court saw no reason to believe that creditors would have been likely to pierce the corporate veil, nor was there evidence that the FSC had any creditors other than possibly Injector Co. In the Tax Court's view, the $500 was a fee paid to WGA to set up the FSC. The payment was unrelated to any actual value of the FSC stock.
The Tax Court further reasoned that no independent holder of the FSC stock could have expected any upside benefit, given that Injector Co. retained complete control over whether any of its export receipts would flow to the FSC and could reach into the FSC and take back any payments that had already been made. The Tax Court concluded that in reality, the Roth IRAs effectively paid nothing for the FSC stock, put nothing at risk, and could not have objectively expected any benefits.
Addressing the Mazzeis' argument that Roth IRAs were permitted to hold FSC stock, the Tax Court explained that the cases cited by the Mazzeis in support of this position did not specifically address whether related party transactions which do not in substance transfer any investment to a Roth IRA could give rise to income for the Roth IRA. The Tax Court rejected the Mazzeis' congressional purpose argument because it found that nothing in the FSC provisions was intended to allow taxpayers to use FSCs to defeat the contribution limits for Roth IRAs. The Tax Court determined that Reg. Sec. 1.926(a)-1T(a) did not preclude the court from applying well established principles to decide, in substance, who the FSC owners really were by considering the practical economic realities of the transactions and taking into account the actual benefits and risks of ownership.
The Tax Court also found that the Sixth Circuit's decision in Summa Holdings II was not controlling. First, the Tax Court pointed out that its decision would be appealable not to the Sixth Circuit but to the Ninth. The Tax Court reasoned that Summa Holdings II was not on point because the issue before the Sixth Circuit was whether commissions paid to the DISC were deductible by the taxpayer's C corporation, not whether payments to the Roth IRAs were contributions. The Tax Court also noted the dissimilarities between DISCs and FSCs that differentiated the case before it from Summa Holdings II.
The Tax Court found that the Mazzeis were not liable for failure to file or failure to pay tax penalties under Code Sec. 6651 because they reasonably relied on their accountant who was a competent professional and not a promoter of the transaction.
Observation: In a dissenting opinion, one judge reasoned that the Mazzeis' arrangement was consistent with the FSC provisions in the Code, and asserted that under Summa Holdings II, the substance over form analysis cannot be used to override a Code provision whose only function is to enable tax savings. The point of a DISC, the judge noted, is tax avoidance.
For a discussion of abusive Roth IRA transactions, see Parker Tax ¶135,160.
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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