The Roth IRA abuse continues, even though virtually every court ruling knocks them down with harsh taxes and penalties. The lure of tax-free growth is powerful, and the Roth IRA is a tempting place to find that, but advisers need to warn clients to avoid these highly questionable tax schemes.
In the most recent in a long line of U.S. Tax Court cases (Brian M. Polowniak v. Commissioner; T.C. Memo. 2016-31; Nos. 20589-11, 20606-11, Feb. 25, 2016), a business consultant found out the hard way the serious consequences that result from getting involved in an abusive Roth IRA scheme. The Internal Revenue Service determined that he owed more than half a million dollars in taxes, interest and penalties. Once again, the court sided with the IRS and held that the taxpayer owed taxes on gross receipts not reported, the 6% excess IRA contribution penalty, plus penalties for failing to file a tax return (IRS Form 5329) and failing to pay the 6% penalty. To top it off, he was also hit with an enhanced 30% accuracy penalty. That's the 20% accuracy-related penalty raised to 30% for non-disclosure of a reportable transaction.
ROTH IRA SCHEME
In 1997, Brian Polowniak established his consulting business, Strategies. Strategies was a subchapter S corporation with Mr. Polowniak as the sole shareholder, officer and director. He was also the company's only consultant. Delphi Automotive Systems, a global automotive parts supplier, awarded a big contract to Strategies for consulting services.
Mr. Polowniak's financial adviser suggested he meet with an attorney who promoted a scheme he called “privately owned Roth IRA corporations,” or PIRACs. In a PIRAC arrangement, an individual's new Roth IRA would purchase the stock of a new corporation. In most arrangements, the PIRAC would then engage in transactions with the individual's preexisting business, which was typically a pass-through entity like Strategies, a wholly owned S corporation.
Mr. Polowniak made the fateful decision to set up a PIRAC arrangement. His first step was incorporating Bevco Investments Inc. Then, Mr. Polowniak established a new Roth IRA and made an initial contribution of $2,000. He directed his Roth IRA to purchase 98% of Bevco's stock. Mr. Polowniak's wife also formed a new Roth IRA with an initial contribution was $655. Shortly after, she directed her Roth IRA to invest the funds in Bevco.
Following the purchase of Bevco by the Roth IRAs, Mr. Polowniak's wholly owned S corporation, Strategies, and Bevco entered into a subcontracting agreement for Mr. Polowniak's consulting services.
In 2004, Strategies transferred $680,000 (the entire Delphi contract payment) into Bevco's checking account. Delphi still expected Mr. Polowniak to personally perform the consulting services, and Strategies did not inform Delphi that any of the services under the contracts would be performed by an independent contractor or by any other employee of Strategies.
As part of a divorce settlement with his wife, Mr. Polowniak was awarded all of his wife's Roth IRA's shares in Bevco. Eventually, his Roth IRA owned 100% of Bevco.
The IRS said that Strategies had failed to report income it received from Delphi for its annual consulting contract. The IRS also determined Mr. Polowniak was liable for the 6% excess contribution penalty on the total amount of excess contributions remaining in a Roth IRA on a yearly basis.
In addition, the IRS determined that Mr. Polowniak failed to file Form 5329 to report the excess contributions to a Roth IRA and therefore, liable for additional taxes — one for failure to timely file Form 5329 and another for failure to timely pay the penalties owed on the excess contribution to the Roth IRA. The IRS was not done yet. It also said that Mr. Polowniak was subject to the 30% enhanced accuracy penalty. Mr. Polowniak brought the case to the tax court, but lost on all counts.
The court found that Mr. Polowniak had made excess contributions based on Notice 2004-8 and also the doctrine of “substance over form.” The notice describes typical fact patterns to include arrangements between the Roth IRA corporation and the individual or his pre-existing business that have the effect of transferring value to the Roth IRA corporation, comparable to a contribution to the Roth IRA. The notice includes a warning that the IRS will challenge the purported tax benefits resulting from such transactions. It states that in addition to any other possible tax consequences, the amount treated as a contribution is subject to the 6% penalty.
The court also referenced the doctrine of “substance over form” where a series of transactions taken as a whole has no legitimate purpose other than as a sham to avoid taxes.
Roth IRAs offer significant tax benefits, and it seems inevitable that some clients will want to push the envelope to exploit them, but these transactions are on the IRS radar. Mr. Polowniak's case is yet another warning. He was held liable for more than a half a million dollars in taxes and penalties. No adviser should want any part of these types of transactions.
Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group. He can be reached at irahelp.com.