David Spray: Hi Neal.
Neal Block: Hi David.
David Spray: So how are you today?
Neal Block: Doing fine.
David Spray: Thank you for taking time to be on the IC-DISC show. Well, let's just get right to it. I'd like to start out by just reading your bio, and then we can... if there's anything that I left out from the bio that you think is relevant to add, please add.
David Spray: Neal Block received his BS with high honors from the University of Illinois in 1964, and passed the CPA exam in the same year, receiving an Illinois silver medal, and the Elijah Watt Sells honorable mention. He received his JD from the University of Chicago in 1967. He was admitted to practice law in the District of Columbia and Illinois in 1967. Upon graduation from law school he served as an attorney advisor on the U.S. tax court from 1967 to 1969. And I believe you joined Baker & McKenzie in 1969 then, is that correct?
Neal Block: That's correct.
David Spray: Mr. Block was also an adjunct professor of taxation in the Master's of tax law program at the Chicago-Kent School of Law from 1986 to 1990, where he taught a foreign taxation course. Neal is a frequent contributor of articles on the extraterritorial income exclusion, foreign sales corporations, and domestic international sales corporations, and he has had numerous publications. He's also published a book for Commerce Clearing House on extraterritorial income exclusion, and foreign sales corporations, and domestic sales corporations. So, is there anything else that we need to add, that you think is important about your background?
Neal Block: Well, I just published the B & M portfolio.
David Spray: Oh, that's right. So can you just talk a bit about that, before we get started?
Neal Block: Yeah, I think I was chosen by default. There was an export incentives portfolio, primarily devoted to foreign sales corporations for a while, for quite a while, and I was asked a number of years ago if I would update it. And as it turned out, the update for DISC reg and foreign sales corporations, and there's almost very little on that. So I got together all of my outlines from the speeches I gave and articles I wrote, and came out with the most recent version of the export incentives, just earlier this year. So it's hot off the press, 603, I believe it is.
David Spray: Okay, well thank you for the reminder of that. Anything else about your bio that we should mention, or can we go ahead and get started with some of the questions I have?
Neal Block: I'm sure that the questions are more important than my bio.
David Spray: Okay. So, I'd like to start off with... just to kind of set the stage, I believe that a law professor of yours encouraged you to specialize. Can you just share that story of who that was, and what his thoughts were on that?
Neal Block: Well, I wouldn't consider him encouraging me, it was a general comment that he made to the class.
David Spray: Okay.
Neal Block: Incorporations, and something. I don't know if he was looking at me, but he said something to the fact that you didn't have to be the sharpest tack in the shed in order to be successful. If you could specialize in an area that nobody else knew about and looking around, I had all these lawfully famous people. I had John Ashcroft in my class the Attorney General. I had a guy that became... had his own chair in California at Berkeley. I figured maybe I ought to start specializing, so when I got off of tax court, the DISC was just being introduced as a new tax regime, and I figured I might as well become a specialist in that area, and so that's how it started. I commented on proposed regulations, and tried to learn as much as I could about the area. And I'd say for a long time, no more than 5 or 10 percent of my practice was in the DISC area, but I sort of stuck with it until I got a name for myself. And eventually I had it as a major focus in my practice.
David Spray: Okay. And so from then, so basically from the time that you joined Baker & McKenzie in '69, was the DISC legislation then already... were they already starting to talk about it? Because I don't think it was actually enacted until 1971. Is that correct?
Neal Block: That's correct, but it was being introduced, and it was being talked about, and there was a predecessor called the western hemisphere trade corporation, which I wasn't aware of at the time, which was somewhat like the DISC. It provided an export incentive, and a bit of a different manner, more of an arm's length transaction nature, but it was within the code itself.
David Spray: Okay. And so you mentioned that you had the chance to have some input, or commentary on the proposed regs. What were your initial thoughts on the DISC when you first started to read about it?
Neal Block: Well, since I was pretty naïve, I had no idea of the fact that it was something I wanted to get interested in, and try to know as much about it as I could. I wasn't politically motivated as to whether or not it made any sense. I wasn't sure it did, because of the fact that I wasn't sure how much people were exporting, or how much more they would export because of the DISC provisions. And interestingly enough, I never really tried to devout the fact that my clients were adopting DISCS, so that they could have the incentives dashboard, because I didn't really know if they did or did not.
David Spray: Sure.
Neal Block: And as it turns out, even today when we just have these similar cases... I know we're jumping ahead, but with the DISC owned by ROTH IRA, we did not try to imply that the clients were incentivized to export because of the DISC provisions, because we just couldn't prove it.
David Spray: Sure. Okay, well that makes sense. And when this came online in 1971, could you have imagined that it would still be in existence 48 years later?
Neal Block: Well, of course the answer is no. As a matter of fact, it's interesting, because at the time there were a number of us younger associates who were told to try to learn about areas that were becoming popular in the code, so we could be up-to-date. And various cash persons came in and left, and the DISC was always on its way out, but never quite made it out. Just to let you know, the DISC was introduced by the Ford administration, as a Republican export benefit for the benefit of large and small businesses. A few years later, the Republicans decided to get rid of DISC, but the Democrats decided it was a good small business incentive, and so they decided they wanted to keep it in. And so every so often, the DISC provisions are looked and designed to be legislative out, and come right back in again. And most recently the tax reform act of 2016, the DISC was out, and in the senate report they were going to get rid of DISC, but some senators refused to vote for the bill, and DISC came back in again. It's still there.
David Spray: Yeah, and I think you had mentioned to me before, that one of the reasons that it seems like there's not a lot of people that have really specialized in the DISC to the extent you have, is because of this whole idea that quote, it's going away. And like you just mentioned, it's been quote going away for 48 years now, hasn't it?
Neal Block: I would say about every five years or something, it's been proposed to get rid of it, or change it dramatically. In fact, in 19... the big shift came in 1984, when the DISC was held to be in violation of the general agreement of the tariffs and trade, and that's when the foreign sales corporation provisions were adopted in order to meet the DISC objections. The DISC was kept in as an interest charge DISC designed to help the smaller exporters who didn't want to go offshore. So in 1984 there was a substantial shift in the DISC provisions, but they stayed in the code, whereas the foreign sales corporation came in, and then ultimately in 2000, was phased out again.
David Spray: Okay. Yeah, so one of the reasons I was really excited to have you on the show, is because you really had a ringside seat from the very beginning of DISC. And what I'd kind of like to do, is really just kind of go through and in chronological order, through the history of the DISC. And you had mentioned 1984 was a major year, because of the issues with the foreign sales corporation. Was there anything before '84 that comes to mind, any relevant things? Or was the DISC pretty quite from '71 to '84?
Neal Block: Well, actually from '71 on, there was a lot of litigation. Of course there were proposed regulations, final regulations. There were amendments to the regulations, and there was litigation. Interestingly enough, while the most recent cases were substance or reform cases, the service has always been trying to put more substance into the DISC. And for the most part, the regulations that the service came out with were held invalid by the tax court. Just about all the cases involving DISC were tax court cases, except for the Caterpillar Tractor case, which we'll talk about in a little bit. But basically, the DISC was required to have its own bank account, and that was held to be invalid, or decided it would be invalid. There were a number of requirements for DISCS to meet, that the taxpayers challenged when they were found to be invalid, so if you look at the history of the DISC litigation, a good portion of it involved validity of regulations. Some regulations were upheld, they weren't all generally attacked, but certainly some of the ones requiring more than a bare boned structure were struck down.
David Spray: Okay. And you're saying those happened over the course of several cases during those first 10 years or so?
Neal Block: I would say through the '70s, there were quite a bit of DISC litigation.
David Spray: Okay. And just to make sure I understand, so the service was trying to basically force more substance to the DISC, and that the litigation, that much of the time, the service got lost in that endeavor, but some of the times they were successful? Is that correct?
Neal Block: That is correct. In fact, one of the cases I tried, the Swanson Tool case, which was one that was in the IRA case, we went for attorney seize on the basis that there was no reasonable basis for the service to take its position, and we were upheld on that basis. And one of the points made by the court, was the plain language rule had to be strictly filed in the DISC area, because of the fact that it was totally statutory.
David Spray: Okay. That's interesting. You had mentioned the Caterpillar Tractor case. Was that also around 1984, about the same time as the DISC.
Neal Block: No, it was in the early '70s.
David Spray: Oh, it was that long ago? Okay, well why don't we jump into that. Why don't you tell us about that case, and kind of the significance of that.
Neal Block: Okay, I almost forgot about it when we tried the other cases. But the Caterpillar Tractor case involved a regulation, which basically said that a WHTC, which was the forerunner of the DISC, could not generate qualified export receipts to a DISC, with respect to its transactions with the DISC, on the basis that the DISC was intended to be a replacement for the WHTC, and not work in tandem with the WHTC. And the court of claims, claims court in the court of claims, held that the regulation was invalid, that there was nothing in the legislation, in the WHTC or the DISC, that prevented either one from using the other. And therefore, even though there was basically an assignment of income, that's the phrase that the claims court used, there was nothing to prevent it, so that if you're looking for a history of invalid regulations in terms of transactions between two taxed identities, you'll find that in Caterpillar Tractor case.
David Spray: And when did the western hemisphere trade corporation either cease to exist, or when did it fall out of favor?
Neal Block: Probably '72, '73. It was not too much longer after Caterpillar, I think that the WHTC went out. And in fact, it might have gone out before the case was decided. I can't remember now.
David Spray: Okay.
Neal Block: I haven't had a question involving the western hemisphere trade corporation for many years.
David Spray: Okay, yeah. Well, I always try to ask you novel questions as I'm able to. Okay, so we have the Caterpillar Tractor case. Were you involved in that case, or was that somebody else that was responsible for that?
Neal Block: I had nothing to do with the case itself, but I had a large taxpayer who had used the WHTC, and we were able to file amended returns going back to all the open years that we would qualify for, so that we were able to get all the benefits of the WHTC for that company. But I did not have the pleasure or responsibility for shepherding that case through.
David Spray: So, basically your client was able to benefit without having to pay any of the legal fees to get to that point? That sounds like a good outcome for your client.
Neal Block: Well, I think we charged them.
David Spray: Oh, understood. So, after the Caterpillar case, what's the next maybe case that comes to mind chronologically that had significance? Either a case, or change in rules?
Neal Block: Well, I think what came about, was in the late '70s, or maybe... whenever the IRA provisions came into effect, I don't take responsibility for it. There was one of our employee benefits people got together with [inaudible 00:16:15], they had lunch, and they sort of drafted out on a piece of paper, having DISC owned by an IRA. And that was in the '70s, or early '80s, that the concept came through. And ultimately, the service started challenging that after awhile. But I would say in terms of by-practice, that was the next big thing. I think it's important to note, that initially the DISC was the child of the large exporters, that was where the big money was, because the DISC was designed to be a deferral vehicle, but unlimited deferral, and it was based on creating exports. And initially, it was unlimited deferral, and then they put in deemed distributions to cut back the benefit.
Neal Block: But some of the biggest companies in the world, like Caterpillar tractor, and I know Pillsbury when the DISC got phased out, they were providing for income tax when the DISC provisions were forgiven in 1984. I think they organized about three or four dollar special income item per share, because they were forgiven all the tax. I think one of the other big things, was I think Caterpillar Tractor was responsible for the transaction by transaction rulings. Up to that point, almost everybody had grouped their transactions in category case. It wasn't a case, it was actually a revenue ruling that they got from the service, saying that they could do transaction by transaction, which in most cases, multiplied the DISC benefit exponentially.
David Spray: Sure.
Neal Block: Because of the fact that you could now pick the best pricing, the 4% versus 50/50, and do that on a transaction by transaction basis. Now, not every taxpayer got a billion dollar benefit, but it did have ripple down effects, so that most people could adopt it.
David Spray: Sure.
Neal Block: The big difference was the DISC, up until 1984... Well, we had started using it as a tax avoidance, permanent avoidance. Not to share hold their own DISC, but basically because of the big players, the publicly held companies, it was basically a deferral vehicle, and companies were using it for that. And by 1984, you had companies such as Caterpillar, and General Motors, and other... I think Microsoft. I think the biggest...
David Spray: Boeing maybe.
Neal Block: Yeah, they had maybe a billion dollars or more of deferred income in the DISC. So in 1984, when the DISC was held to be invalid under the gap provisions, the DISC replacement was widely promoted by all these companies, because under the DISC replacement, or the FISC, all the DISC deferred income got forgiven, so any accumulated DISC income in 1984, was to be distributed tax free, which is a big bonus, and as I mentioned before, Pillsbury recognized the huge dividend, or income shift, because they no longer had to provide for the tax.
David Spray: Yeah, that's really amazing that you think about it, that there was a benefit or ruling that resulted in billions of dollars of benefits to mostly fortune 500 companies, right?
Neal Block: Yeah, I remember going to a meeting where FISC was being discussed, and I forgot which one, one of these big companies said, "I don't really give a damn what's in the legislation, as long as we can get that money back tax free."
David Spray: Sure, yeah he'll worry about that later, but let's capture that deferred income tax-free. Okay, so then... so that was early '80s. And then what was the next kind of significant case, was that the Blue Bird case by now, or was there something else that comes to mind?
Neal Block: Well, I'd have to go back and search my memory as to what other significant DISC cases there were. I would have to go through the literature. My involvement was primarily through the IRA, and the offshore ownership of DISC, got to be more and more popular, although the offshore ownership of DISC, we had one case that we got back had been settled, but never really has percolated as anything the IRS has definitely attacked. So, the IRA cases have always been adverted to the idea of having a DISC owned by another tax infinity, similar to the Caterpillar Tractor case. So, I got involved with, basically the IRA structure, and that was challenged by the service constantly. And a Bluebird body case was in the late '80s, I guess it was. I'm trying to remember, '86, '87. And that was a case where we had a DISC owned by a qualified profit-sharing plan, and at that time, the DISC dividends could flaw the plan tax free, and what the service tried to do, is disallow the DISC commission on section 482 grounds, even though the court of regulations said now you applied 482 to DISC commissions. And then ultimately, they conceded that case in the tax court, but then legislation was introduced in section 995-G was implemented, which provided that DISC dividends were to be subject to UBT tax, or unrelated business tax, which had not existed before.
David Spray: So, when that happened, did you think that was going to be kind of the resolution to the IRA-owned DISC, so that as long as the IRA's were willing to pay the UBT tax, that it'd be kind of smooth sailing?
Neal Block: I did. And that lasted a couple of years, until the service decided that the DISC provisions, the 995G was now dispositive. I think it should be noted that the DISC, and the IRA structures were never intended to necessarily go together, they're just two pieces of legislation that happened to fit. But in executing the IRA structure, you had to make sure that you did not have prohibited transactions, or do things that you weren't allowed to do with qualified plans. And if you did them, you could disqualify the plan, and disqualify the DISC. So there's always the possibility of doing something wrong, and the next case that we had was the Swanson Tool case, and once the service took the position that while they couldn't make a 482 adjustment, they were going to treat the DISC transactions as prohibited transactions, therefore disqualify the IRA's on that basis.
David Spray: Okay.
Neal Block: The interesting thing about Swanson Tool, is similar to the Blue Bird body case, by the time the case came up to submit into the court, the service conceded the Blue Bird body case. The same thing happened in the Swanson Tool case, when it came time to submit the case for decision, the service conceded the case. But my client didn't want to pay any more fees unless we could recover attorney's fees, so I filed a motion for attorney's fees in that case, and we were fortunately able to meet the requirements for attorney's fees qualification. The Swanson Tool case came out, it was not a decision for the taxpayer, because we'd already won the case.
Neal Block: It was whether or not the service had a reasonable basis for its decision, and therefore we were awarded attorney's fees on the basis that the service did not have a reasonable basis for its position, and that there was a prohibited transaction. So that's how we won attorney's fees on that case, and the case itself, of course, has been sided for the proposition that you can't have prohibited transactions on the payment of DISC commissions, or receipt of DISC dividends. But the truth be known, it's not a case where we won the case, because the service conceded.
David Spray: So, is that, I can't imagine that it happens all the time, that you can get the service to pay attorney's fees. Is that somewhat unusual circumstance, or does it happen, or is it something that happens frequently?
Neal Block: It happens more against the taxpayer than against the government.
David Spray: Oh, really? Okay.
Neal Block: So, a lot of the frivolous cases, the tax protestor cases, what have you, are ones where attorney's fees get awarded against the taxpayer, to get them against the government it's a little bit more unusual.
David Spray: Yeah. And I'm just curious, when the taxpayer has to pay attorney's fees, how is that calculated? Because I would assume that most of those attorney's fees are just the in-house folks at the service.
Neal Block: There's a rate that they use.
David Spray: Okay.
Neal Block: In fact, the rate that was applied, recovered attorney's fees were substantially lower rate than our normal billing rate.
David Spray: Oh, I see, so it's like the same rate, regardless of which side wins? It's a formulaic calculation?
Neal Block: Right. Of course, we were more interested in the attorney's fees for the taxpayer, than what the government could recover. But basically, it's like a frivolous penalty provision, more for the taxpayers.
David Spray: Okay. And then so what comes to mind next? I think, was there a jet research for the commissioner case?
Neal Block: Well, those cases came down, basically the jet research... and I forgot the other one.
David Spray: Is that the Addison?
Neal Block: Addison, yeah. They were basically two sides of the same client. One, the taxpayer was contending for, and the other was the government. The question arose in those cases, is whether or not what you did with the DISC after it was disqualified, and the taxpayer, and I believe it was Addison one that was disregarded by the entire commission reversed, was the government said why don't you pay the commission, and we didn't make any 482 allocations, you're stuck with it. And then the court upheld that. So, the answer was that you have to be careful. If you pay a DISC commission and you don't reverse it timely, you could end up having to pay tax, and the company having no intention of using it for tax purposes. The jet research case was just the opposite. It was one where the taxpayer didn't qualify, and the government was trying to take the entire DISC commission and put it back into the supplier, but it was a buy-sell DISC, and the court held that even though it was disqualified, it's still a corporation, and held to the 482 pricing. So I think the court left 10% of the income in the company.
Neal Block: But basically, both cases said that you cannot apply substance over form to rewrite a qualified DISC, or a disqualified one.
David Spray: And those two cases, and I don't believe you were involved in either of those, is that correct?
Neal Block: That is correct.
David Spray: Okay. So kind of staying in the sequence, because I think those cases were in the '90s, is that right? For Addison? The late '80s?
Neal Block: Yes, they were. Of course we relied on them when the tax for the Roth IRA started. The Swanson Tool case was a traditional IRA, but the next case that came up was... what was interesting about Swanson, by the way, is there was a DISC and a FISC, and the FISC was also being used for IRA purposes. That sort of got lost in the shuffle. But initially, the IRA concept with the DISC, was with the foreign sales corporation, and with the DISC. But the foreign sales corporation was used more readily than the DISC was. So in the Swanson Tool case, there was a DISC and a FISC owned by an IRA, and that case involved, actually, a tangential issue of the 995-G UBIT Income being imposed by the DISC.
David Spray: But not on the FISC?
Neal Block: Well, UBIT was never imposed on the FISC. The FISC always paid its own tax. The way the FISC worked, was it was a regular foreign corporation, but 16/23 of its income was tax-exempt, and 8/23 was effectively connected income with the U.S. trade or business. So when you paid a commission to the FISC, you got a deduction for 16/23 of the commission, I guess it was, and 8/23 the customers got remitted tax free.
David Spray: Okay, well that is interesting.
Neal Block: I might have my numbers mixed up, it's been a while since I did the math. The point is that a portion of the corporation's tax was exempt from U.S. tax. But the FISC only benefited corporations, because the dividends received deduction that you got on FISC dividends only applied to U.S. corporations.
David Spray: Okay. And C Corps at that, I guess, right?
Neal Block: Yeah, at all times, the DISC was a C corporation, the FISC was a C corporation. Although the FISC had to be located in a qualifying jurisdiction outside of the United States, commonly in the Virgin Islands.
David Spray: Okay. So then when we go to the next significant cases, that brings us to Helwig? Or were there any other cases that come to mind, that had some significance?
Neal Block: I'd have to think. I really didn't do a survey of all the different cases that came down, but our next big case was the Helwig case, where the service decided that they'd already lost on 482, they lost on substance of reform. They'd lost on just about everything else they could think of, so they decided that they'd graft with the excise tax, and what they did is they said that even though the DISC commissions were deductible for income tax purposes, the excise tax was a different animal, and you could not apply safe harbor rules to excise taxes that you could apply to the income taxes. So in the Helwig case, they allowed the deductibility of the DISC commissions, but they held that there was an excise tax due for an excess contribution, because you could not apply the DISC provisions to the excise tax provisions.
David Spray: Okay. And then so could we maybe just back up a little bit? Because I know this one has a lot of significance as it relates to SUMA, I believe. So on that Helwig case, you got involved, I guess when it was audited, or were you involved in the initial structuring of their DISC?
Neal Block: Well, we had Helwig, and we had another case called Oshman, O-S-H-M-A-N. And Helwig was one, I believe, that we instituted ourselves. From the ground up, we organized the DISCS, and the Roth IRA's. Well, we didn't organize, but we worked with the custodians. The Oshman case was one that was referred to us, and the Oshman case was a foreign sales corporation case, owning a Roth IRA, and the same result was that they allowed the FISC commission, but they didn't allow the constructive contribution to the Roth IRA's, held up in excess contribution in both cases.
David Spray: Okay. So could you just... I know we kind of went through that Helwig case kind of quickly. Could we just maybe take a step back? So what year, do you remember what year the legislation, or the litigation started on the Helwig case?
Neal Block: Oh, let's see. I'm trying to remember. I think 2011 was when it was finally decided. I don't have it right... I can grab it. But I think that's when the case finally came out. Incidentally, just about all the cases that we've tried have been fully stipulated. I think all the DISC cases were fully stipulated. We did not have to have any testimony presented at trial, everything came in as a fully stipulated case.
David Spray: Pardon my ignorance of that legal term. Could you just describe more what fully stipulated means?
Neal Block: Sure. In every case, the parties are supposed to stipulate the facts that are not being litigated, or agreed facts.
David Spray: Okay.
Neal Block: So if you have a fully stipulated case, that means that both parties agree on the essential facts of the case, and the court can decide the case based on the stipulated facts, rather than having to find facts as a matter of evidence.
David Spray: I see, tell me about that.
Neal Block: Okay. Because it's the standard review of a fully stipulated case, means that the reviewing court reviews the case what the call de novo. In other words, the reviewing court is not bound by any of the decisions of the court below it.
David Spray: Okay.
Neal Block: For a case that has evidentiary facts, the reviewing court must accept those facts as found by the lower court, unless clearly erroneous.
David Spray: Oh, that is really interesting. So, let me just make sure I understand this. When you have it fully stipulated, is that the term?
Neal Block: Yes.
David Spray: So when you have a fully stipulated case, when it goes up a level, it becomes a de novo case, in which the evidentiary items are not taken into account?
Neal Block: Well, all evidentiary items are being stipulated. In other words, for example, just as an aside in the Suma case, we stipulated with the IRS with the taxpayer's basis, and the DISC stock. I mean, the Roth IRA is basically the DISC stock was of value. We stipulated with them. That then came up later on in a companion case, that we were not part of, we talked to the attorneys, called Mazzei, M-A-Z-Z-E-I, in which the tax court found that the shared FISC situation was improperly valued, and therefore, they considered the owner of the FISC stock to be the related supplier, rather than a Roth IRA. In our case, we'd already stipulated that the DISC stock was owned by the Roth IRA's, and we also stipulated what the basis was. And therefore, the Suma cases were distinguished from the Mazzei case on the basis that was not an item of issue, and this was decided by all three courts that came up on appeal, that they were not going to address whether or not the stock was properly valued, because it was not an issue in the case.
David Spray: I see.
Neal Block: And because it was stipulated, they could not go behind it.
David Spray: Oh, that is very interesting. Well, I know I've been chomping at the bit. Is it time to get into the Suma case? To me this case is just so fascinating. If there's nothing else, let's get into the Suma case.
Neal Block: Well first, I think we should point out that the Helwig case was decided in favor of the taxpayer.
David Spray: Okay.
Neal Block: And that the court held that basically as long as you got a deduction for income tax purposes on the DISC commissions, that the services prevent it from finding a contribution to the Roth IRA's.
David Spray: Okay.
Neal Block: So that's the holding of the Helwig case. Interestingly enough, it was the last case that Judge Nims decided. He retired from the tax court immediately after our case was entered, and the handwriting on the wall was that the case was issued as a memorandum opinion of the court, rather than what they call a published opinion of the court. The significance is not as great as it used to be, but basically a decision is issued as a tax court decision, in the tax court volume, it has greater precedent than if it's issued as a memorandum opinion. Memorandum opinions are considered to have less precedential value than published opinions, even though they can be decided as precedent. And when the Helwig case and the Oshman case had the same result, we were surprised that they didn't come out as published opinions, but as memorandum opinions. But I think the reason for that, was when the next case came out, which was the Suma case, the Helwig case was not as a binding precedent, as it would have been, had it come out as a tax court opinion.
David Spray: I see.
Neal Block: So we think now, that even after the Helwig decision came out, there were certain judges that made more of a fuss about it, than they did, because Nims was retiring, and that was his decision, and they probably just let it go. So ours is the next case up, which was called Suma Holdings Inc. And Suma Holdings Inc. then became the next case up where the service, unlike the Helwig case, the service for the first time argued that you could not pay a DISC commission, where the DISC was owned by an Roth IRA on substance of reform principles.
David Spray: Okay.
Neal Block: So what they did in the Helwig case, is they accepted the DISC commission as giving rise to DISC benefits. In the Suma case, they took the position that there never was a DISC commission, that the entire commission could be reallocated as the destructive dividends to the related supplier shareholder, and then a constructive contribution to the Roth IRA's.
David Spray: Well, could you just kind of back up? Like you remember the year that the Suma started? I think it was '04 or '05 that they had their first years that they used it?
Neal Block: Yeah, I think 2002 was the first year that the Roth IRA structure was put in place, and we were involved in the structuring of the company. People ask what's the difference between litigation and planning, and I said one's before the fact, and the other one is after the fact. You're always planning. So in this case, we have the structure set up, and we did things the right way. We set up the Roth IRA's, and the Roth IRA's then formed the DISC, and they dropped the DISC stock, and put the DISC stock of the Roth IRA's. We also had a holding company, so I think maybe it was the Roth IRA formed the holding company, and the holding company formed the DISC. It didn't really matter. The point was, everything was done internally, and by the way, you cannot transfer property into an IRA, you can only transfer cash. And if your IRA makes an investment, it's got to make cash. So you cannot transfer stock into a Roth IRA, because that would be an invalid transfer of assets.
David Spray: Oh, okay. Well that's good to know. I was just trying to make sure I had the chronology. So they started using this in about '02, and then several years later the IRS audited them, or notified them that they didn't agree with their approach?
Neal Block: Yeah, they were audited from time to time. Now, they were around when the Helwig case was decided, and so it wasn't their turn yet, so to speak.
David Spray: Okay.
Neal Block: And interestingly enough, the only years they picked were the open years, 2008, even though there were no excise tax returns filed, but they took the same position in Suma as they had in Helwig, except for the fact that unlike Helwig, they were now disallowing the DISC commission.
David Spray: Okay. And so then your in initial argument then... or what was your response then to that when they were disallowing the commission?
Neal Block: Well, our official response was don't do it. Our unofficial response was a little more emphatic.
David Spray: Okay.
Neal Block: We felt that by this time they lost every single argument they made, and they were still attacking the structure. And now they're attacking the DISC commission, which seemed to be fairly straightforward. I mean, the DISC commission is provided for by statute, and since there were no exceptions for the DISC commission being deductible, and the income of the DISC. And so their position was that there never was a DISC commission. And it took us a while to figure out why they were saying that, but their position was is that the Roth IRA limitation provisions were being abused, and then in substance, because the DISC didn't do anything, there was nothing more than the constructive dividend from the related supplier to the shareholders.
David Spray: Okay.
Neal Block: They never imposed the gift tax, but they took the position that whether or not there was a gift tax there was a constructive contribution by the beneficiaries of the Roth IRA, to the Roth IRA. I should point out in both Helwig and in Suma, what you really had was a disproportion of ownership involved. You had the father, who had owned the stock of pretty much all the stock of the supplier, and the children owning the DISC stock, which then went into the Roth IRA, so that the ownership of the DISC was not the same as the ownership of the related supplier.
David Spray: And why did that bother the service? Because I mean, that's allowed for. There's no statutory prohibition, is there? That the ownership of the DISC have to be the same as the related supplier.
Neal Block: Well, because their problem was not so much that. Years before, when you talk about use of the DISC as being a deferral device, it was always accepted, or pretty much from the very beginning, is if you had the stock owned by the shareholders of the C corporation, you could avoid corporate tax on the DISC commissions.
David Spray: Okay.
Neal Block: So you had a C corporation, and it's really closely held because it was publicly held. But if you had a C corporation owned by X, Y, and Z, and then X Y and Z owned stock of a DISC, and X Y and Z were individuals, the DISC dividends, the DISC commissions were deductible to the C corporations, and the DISC dividends became taxable solely to the shareholders, and you avoided corporate taxation.
David Spray: Sure.
Neal Block: And the service issued a number of private letter rulings, and pronouncements, TCM's, what have you, accepting this result, even though it was clear that this was being done solely to avoid income tax.
David Spray: So, then what happens next with Suma then? Because I know that there were several appeals, so just kind of help me understand the sequence. The service was making their argument, you disagreed, and then what happened next?
Neal Block: Well, we argued that the result under Roth IRA had to be the same as under traditional IRA. I don't want to get into more of the details, but the tax court accepted that rationale, and said that the Helwig case really didn't get into the nuts and bolts of the ownership of the DISC, and the ability to disallow the DISC commission, because everything was accepted by the service. And because of the Roth IRA limitations on contributions being two, three, or four, $5,000, the DISC commissions were a abuse of those limitations, and therefore were vowed to the congress' intent. And so therefore to be disallowed as commissions to the DISC, and rather, be treated as constructive dividends.
David Spray: Okay.
Neal Block: And so to make the long story shorter, or I can make it as long as you want it, the tax court sided with the IRS, and said yes you're correct, this is an abuse, and therefore should be disallowed and rather than having DISC commissions, we had a constructive dividends to the shareholders of the related supplier, and then excess contributions by the children of the owner of the company, as excess contributions to the Roth IRA's. And also set up the pre appeals.
David Spray: Got you.
Neal Block: It turned out that the related supplier, Suma corporation, is located in Cleveland Ohio, and filed his tax return there, and therefore became a fixed circuit taxpayer.
David Spray: Okay.
Neal Block: But the majority owner of the company, a guy named Jim Bennison, is a resident of New York, and therefore was in the second circuit. His children, James third, and Clement, lived in Massachusetts, and therefore, the excess contributions to the Roth IRA's were deemed to made by them, and taxable to them, and they were in the first circuit.
David Spray: Okay.
Neal Block: So we wanted to go to sixth circuit, but the IRS insisted that the case be appealed to all three circuits that had jurisdiction over the individuals, so we had to file the appeals in the first, second, and sixth circuits.
David Spray: Okay, so that's why you had the three different court processes going on. So, which one was decided first?
Neal Block: Well, the first was one we think we wanted to get aside first, was the sixth circuit case. Because the sixth circuit had decided the Addison International case, and which there was held that there could not be substance of reform to a DISC. We thought that would be the best place to go.
David Spray: Okay.
Neal Block: So we appealed the case to the sixth circuit first, and then to the first and second circuits.
David Spray: What happened in the sixth circuit then?
Neal Block: One, since we were in the sixth circuit, we had to have the other two circuits postponed until the sixth circuit handed down its decision.
David Spray: Okay.
Neal Block: And interestingly enough, the first circuit said that they would do so, but we had to stipulate that we would be bound by the sixth circuit's decision. And so we agreed to that. And then the first circuit, which initially didn't buy the argument. When the first circuit... I'm sorry, the second circuit realized the first circuit was going to postpone the case, they agreed to postpone on the same basis, that if we agreed to be bound by the sixth circuit's decision, they would postpone hearing the case. And if you want a war story, this is on the side.
Neal Block: When I went before the second circuit, we had already won the cases in the first and sixth circuit, and the Chief Judge said to me, "Just don't put on your high hat. We know darn well that if you had lost the first two cases you'd be right here trying to get us to split up the circuits, just like the government is." And I said, "No, that's not true your honor." She said, "Why is that not true?" I said, "Because we stipulated we'd be bound by the sixth circuit. And if we had lost in the sixth circuit, we couldn't come before your court." So brownie points for us on that one, I guess. But anyway, so the sixth circuit did get briefed and argued before the first and second circuits.
David Spray: Okay. And then the findings, or the rulings of the sixth circuit then, was what?
Neal Block: The sixth circuit unanimously found that for the taxpayer, on us, for our side, that the statute was clear. There was no basis for departing from the statute. There was nothing to prevent a Roth IRA from owning stock of a DISC, and basically adopted the position we had in the tax courts, saying that there was nothing wrong with what we did, and therefore there was no constructive dividend to the shareholders, and no excess contributions to the Roth IRA's. And we thought that based on the sixth circuit's decision, we probably won the case in the other two circuits, because the sixth circuit addressed every issue that was before the other circuits. We were wrong.
David Spray: Okay.
Neal Block: We lost that, and the other two courts, we lost on that saying nice try, but we're going to decide both of your cases on the merits, just like the sixth circuit decided on the merits. Ultimately, we won both circuits, so it didn't matter. But when you look at the opinions of all three circuits, you'll see they were on the merits of the case, not on what they called res judicata, which is basically under the law you can't have the same case tried twice. And so if I won a case in the first circuit, and had the same issues with the same taxpayer in the sixth circuit, I'm going to get the decision in the sixth circuit too, because they're not going to depart... they call that res judicata.
David Spray: Okay.
Neal Block: But we couldn't get... because the company was in one circuit, and the father's in another, and we couldn't prove we had common ownership, make a long story short, each taxpayer had to prove up his own case, even though each taxpayer's case involved issues that were before the other circuits.
David Spray: Okay. And which circuit had the ruling where the judge really seemed to get addressing down to the service, and there's the Caligula reference? Was that the first circuit, or the second circuit?
Neal Block: Well, the dressing down came in the first circuit.
David Spray: Okay.
Neal Block: The Caligula reference came in the sixth circuit.
David Spray: Oh, okay. Can you just talk a bit.
Neal Block: Okay, well the judge in the sixth circuit has a reputation for being sort of flamboyant, and a good reputation. Jeffery Sutton is his name. And one thing I'll say, is that the pedigree of all the judges that we had was really top-notch. I could not say... I don't want to get into the current judicial appointees, but I can assure you, every judge that we had was thoroughly vetted by the senate, all U.S. court appeal judges have to be approved by the senate, and they have special committees for that purpose. And for the most part, up to that, these judges were all approved basically on not non-partisan, but certainly on a judicial qualification standard. And I think even Judge Sutton got turned down once before he was finally approved, and he's a first-class judge. But every judge we had was first quality. As a matter of fact in the sixth circuit, Judge Sutton's predecessor, who was a retired judge, who qualified after duty, was also on our panel.
Neal Block: I think one of the judges we had in the first circuit had tried the case of John Gotti when it was a district judge.
David Spray: Oh, wow. Now, the second court and the first court, did they also issue a unanimous opinions?
Neal Block: No.
David Spray: Okay.
Neal Block: We had eight out of nine judges vote to reverse the tax court. The ninth judge was in the first circuit, which was the same circuit that had just bound the tax court, interestingly enough. But the signing judge in the first circuit was the chief justice of the court of appeals for the first circuit. Highly respected, all the judges were. But she did not care for our case, and was more sympathetic to the tax court decision. All the differences, but she was the one who of course was the chief judge of our session, and by the way, I'm trying to remember the... Cosby, Bill Cosby's case was also on the same docket as ours.
David Spray: Really? Oh, wow.
Neal Block: So I can't say that the court was for our case, but-
David Spray: Understood. So you had these favorable rulings from all three circuits, so does that mean-
Neal Block: But the point was, that the first circuit majority is the one that told the tax court that... that the Roth IRA provisions having adopted the same rules as the traditional IRA's was bound by the first tax court to make the same finding for the Roth IRA's, as it would have made for the traditional IRA's.
David Spray: Which is why it goes back to the Helwig case, right? Because the Helwig case refers to the traditional IRA?
Neal Block: No, Helwig was a Roth IRA.
David Spray: Oh, it was? Okay.
Neal Block: Let's go back to 1998. Before 1998, I can't remember when IRA's were introduced, the IRA was the only IRA that you could have. But then in 1998, the Roth IRA's were introduced, in order to provide for the greater incentive to save, because the Roth IRA allowed you to pull all your money out at the age of 59 and a half, without any income being recognized. Whereas a traditional IRA you have to recognize income on the distribution of the IRA proceeds.
David Spray: Okay. Thanks for that clarification. So, now that you've prevailed in all three of these courts, I guess it's a done deal now, right? The Roth IRA on DISC is just bulletproof, no issues, no risks, is that accurate?
Neal Block: No.
David Spray: Yeah, I kind of figured that'd be the answer. So what's the wrinkle in it?
Neal Block: So, there's two things. One, each circuit is only binding for the courts in its own circuit. So the sixth circuit has, for example, a Ohio and Michigan, and the first circuit has Massachusetts, and Maine or a couple other states. And then the second circuit has New York, Pennsylvania, and New Jersey, I guess.
David Spray: Okay.
Neal Block: Maybe not Pennsylvania. But the point being, those are the only decisions that are binding. There's nothing before the supreme court, but any other circuit can decided to go along or not. As a practical matter, you might say that it's pretty much settled, but there's another case out there called Mazzei, M-A-Z-Z-E-I, and I made slight reference to them. And that's the case where the issue was who owned the DISC stock, and the foreign sales corporation area, there was a thing called shared FISC, which was designed for little tiny taxpayers to own a foreign corporation without having to spend a lot of money on it. For $500 you could buy in interest in a shared FISC, and the shared FISC could have 30 shareholders, so that each interest was treated as if it was a separate foreign corporation. But the FISC itself didn't have any substance, and it's basically a gimmick in order to allow people to have it.
Neal Block: In the Mazzei case, the court held that because the shared FISC was purchased, not originally incorporated, that you had to look to see whether or not the proper valuation was placed on the stock, and who got the benefit from the valuation, and the tax court held that in that case, the related supplier would be deemed to own the DISC stock, not the FISC stock in that case, rather than the Roth IRA. Now, the FISC is dead, and the shared FISC was unique for the FISC, it doesn't exist in the DISC area. But they did raise the issue as to whether or not the proper valuation was paid for the FISC stock. Now, that was a purchase in that case. Ours was original issue, which is a different animal. And the tax part differentiated between the the original issue from purchase.
Neal Block: But the fact is, all the courts of appeal made reference to the fact that we had stipulated our case, and it wasn't stipulated in the Mazzei case. The sword is still out there.
David Spray: So is the Mazzei case not been settled yet, or resolved?
Neal Block: No. The Mazzei case was decided in favor of the government, on the basis that-
David Spray: Oh, I see.
Neal Block: The true purchaser of the FISC stock was the related supplier, or shareholders. But in any event, there was no FISC benefit, there was a constructive dividend, not a constructive dividend, but the FISC was actually owned by the shareholders, and therefore the FISC dividend did not go to the IRA, it went to the individual shareholders.
David Spray: Okay.
Neal Block: And that case is on appeal to the ninth circuit.
David Spray: And is this a case that you're arguing?
Neal Block: No.
David Spray: Okay.
Neal Block: I've been in touch with the attorneys, obviously, on the case. But this is not our case.
David Spray: Okay. So is it safe to say then, that if a taxpayer is in the first, second, or sixth circuit, that their position is conceptually superior to a taxpayer that's not in one of those three circuits, or for practical matters... okay.
Neal Block: But I know of no cases that are pending in any other circuits.
David Spray: Okay.
Neal Block: And the fact that they had other cases conceded by the government, with the same issue. So I would say that the probability for success with the Roth IRA structure now is very high.
David Spray: Okay. So say somebody comes to you, a potential client, and says we're interested in this Roth structure, what are your thoughts Neal? Should we do it, should we not do it? How might you answer such a question?
Neal Block: Okay. Well first of all, there are other DISC structures that are available. And so that the Roth IRA structure may not be the structure which is the best for the individual taxpayer.
David Spray: I got you.
Neal Block: If you want to go with the Roth IRA structure, it should not be subject to attack, because it's the Roth IRA structure.
David Spray: Okay.
Neal Block: You still have to make sure you cross your t's and dot your i's, in making sure that you don't have primitive transactions and what have you. But the basic structure should be available.
David Spray: Okay, well that is helpful. Well jeez, I can't believe our hour is up already. I could go on for hours. So I tell you what, at this point, how about if we go ahead and wrap up this episode, and would you be available to have a second episode where we really go into detail on some of the different structures, and where they're appropriate?
Neal Block: Sure. As I told the second circuit, I consider these things as tutorials.
David Spray: Okay. That sounds great, then. So I guess the last question for you, if somebody needs to, or wants to reach out to you, or is interested in retaining you, what's the best way for them to reach you? Should they call you, or shoot you an email?
Neal Block: Any way they want, is fine. They can send me an email, they can call.
David Spray: Can you go ahead and state your phone number and your email address?
Neal Block: Sure. My phone number is area code 312-861-2937. And my email is neal.block@bakermckenzie.com.
David Spray: Okay, well that is great. And I believe from clients of ours that I've introduced to you, am I correct that your policy is such that you're kind of amendable to an introductory, kind of a brief exploratory call that you typically don't bill for. Is that correct? Just kind of help me understand what the parameters are if somebody calls you up.
Neal Block: Sure. There's no problem with a phone call to try and find out whether or not we think what they have is doable, and what have you.
David Spray: Okay.
Neal Block: If it takes all day long we might want to charge.
David Spray: Sure.
Neal Block: But a half hour of our time certainly is no problem.
David Spray: That's excellent. Well, I really appreciate your time Neal, and we'll look forward to the next episode where we get into some of the structure questions. And just a little teaser here, I also will share the story of the most valuable lesson that Neal Block taught me, about hiring experts. So we'll save that for that episode as well. Okay? Great, well again, thank you very much for your time, Neal. It was really a lot of fun, and I really loved all the war stories. I could just listen to the war stories all day long. So thanks for taking time.
Neal Block: No problem. Thanks for having me.
David Spray: All right, have a great day.
Neal Block: You too. Bye-bye.