By Laura Saunders 

In less than a decade, two brothers turned a $3,000 investment into $6 million. Thanks to a federal appeals court, they won't owe income taxes on this monster return.

To lower their taxes, the brothers paired a common retirement account with an obscure export incentive. The Internal Revenue Service challenged these moves in court, arguing that even if the transactions didn't break the letter of tax law, they violated the spirit of it.

But the transactions were upheld by the U.S. Sixth Circuit Court of Appeals. The decision, Summa Holdings Inc. v. Commissioner, provides new ballast for taxpayers who use legal techniques in ways the Internal Revenue Service objects to.

"It says that if there are two ways to structure a transaction and one incurs less tax, then the IRS can't force the taxpayer into the other one," says Robert Willens, an independent tax expert based in New York.

Both the IRS and the U.S. Department of Justice declined to say whether the ruling would be appealed. Two related cases are pending before the First Circuit and the Second Circuit appeals courts and likely won't be decided until this case's outcome is clear, according to Neal Block, a lawyer with Baker McKenzie, who argued the case.

Here's how the brothers did it.

Summa Holdings Inc. is controlled and largely owned by the Benenson family, including two sons. The Cleveland-based company is the parent corporation of a group of companies that manufacture industrial products that are sometimes exported.

To promote exports by closely held firms like Summa that lack vast foreign outposts, Congress has authorized a tax-favored entity called the Domestic International Sales Corporation, or DISC. The tax break is that the parent firm doesn't owe corporate-level income tax on "commissions" paid to the DISC on its qualified exports.

These commissions can generally be as high as 4% of gross sales or 50% of net export income, says Mr. Block. Dividends from the DISC to its shareholders -- who are often the owners of the parent firm -- are taxable to the recipient.

The two Benenson sons didn't take direct payouts of DISC dividends, which would have been taxed at a top rate of 15% during most of the time referred to in the case. Instead, they opted for a series of transactions that routed DISC payments into their Roth individual retirement accounts.

In Roth IRAs, contributions are made with after-tax dollars, but asset growth and withdrawals can be tax-free. Like traditional IRAs, they're allowed to invest in assets other than traded securities, including real estate, private placements, timber -- and DISCs.

Each Benenson brother set up a Roth IRA in 2001, funded it with $3,500, and used $1,500 of the funds to buy 50% of a DISC related to the family company. To forestall a tax issue that can arise when an IRA owns a DISC, they transferred the DISC shares to a third corporation owned by the Roth IRAs known as JC Holding.

The upshot: Summa Holdings paid commissions on exports that skipped corporate income tax and flowed into the DISC. The DISC then paid the money to JC Holding as a taxable dividend, and JC Holding paid a 33% corporate levy on it. What was left became a tax-free dividend paid to the brothers' Roth IRAs.

According to the decision, the Benenson brothers were able to transfer $5.2 million from Summa Holdings to their Roth IRAs from 2002 through 2008 in this way. By 2008, each Roth IRA had more than $3 million in it.

The IRS objected. It argued that the transactions improperly circumvented the Roth IRA rules because the brothers' high income precluded a contribution and that the annual contribution was only a few thousand dollars at the time. Therefore, Summa owed income tax on the DISC commissions and the brothers owed penalties for overfunding their Roth IRAs.

The Tax Court sided with the IRS, but the Sixth Circuit appeals court reversed the decision. It reasoned that lawmakers awarded tax breaks to DISCs and Roth IRAs to promote certain activities, so "the Commissioner cannot fault taxpayers for making the most of the tax-minimizing opportunities Congress created."

This decision will benefit many exporters, large and small, who use Roth IRAs for DISC commissions or would like to. But its impact is likely to go far beyond the DISC area, says Mr. Willens, because it "puts a damper on what the court saw as IRS overreaching."

Write to Laura Saunders at laura.saunders@wsj.com

(END) Dow Jones Newswires

February 24, 2017 05:44 ET (10:44 GMT)

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