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Tax Loophole Upheld by 6th Circuit

By William Vogeler, Esq. | Last updated on

Caligula, the notorious Roman emperor, posted the tax laws in fine print and so high that citizens could not read them.

"How can citizens comply with what they can't see?" the U.S. Sixth Circuit Court of Appeal said in comparing the short-lived emperor to the commissioner of the Internal Revenue Service. "And how can anyone assess the tax collector's exercise of power in that setting?"

Reversing a tax court decision, the federal appeals court upbraided the IRS commissioner for penalizing taxpayers for their contributions to Roth IRA's. The contributions were designed to avoid taxes within the scope of the law at the time, but the commissioner "recharacterized" the transactions to extract more tax dollars.

"As it turns out, the Commissioner does not have such sweeping authority," Judge Jeffrey Sutton wrote for the unanimous court. "And neither do we."

Deferred Taxes

The case arose from a dispute over tax laws that allowed domestic international sales corporations (DISC) to defer corporate income taxes. Summa Holdings, Inc., used the DISC and Roth IRAs to reduce taxes for businesses owned by James Benenson, Jr. and his children's trust.

The Benensons transferred $5,182,314 from Summa Holdings to the Roth IRAs between 2002 and 2008. Over that time, each Roth IRA had accumulated over $3 million.

In 2012, however, the commissioner notified Summa that the IRS was recharacterizing the transfers and assessing new taxes and penalties. The tax court upheld the commissioner's decision, but the appeals court reversed.

Taxes Were Paid

"The Internal Revenue Code allowed Summa Holdings and the Benensons to do what they did," the court said. "Section 995(g) expressly contemplates that tax-exempt entities like traditional IRAs may own DISC shares. It just requires that they pay unrelated business income tax on any dividends. The Benensons paid those taxes."

The court said the law allowed the transactions and the IRS accepted the tax payments at the time. Noting that the IRS conceded the taxpayers had not broken the law, the judges took exception with the commissioner's attempt to enforce "substance-over-form" to collect more taxes.

Congress created the laws, the panel said, and the courts are charged with enforcing them. It is not their job to close gaps in the code.

"The last thing the federal courts should be doing is rewarding Congress's creation of an intricate and complicated Internal Revenue Code by closing gaps in taxation whenever that complexity creates them," the court said.

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