IRS shoots down new Roth IRA ploy

When Roth individual retirement accounts were created, it was inevitable that some taxpayers would attempt to exploit their advantageous provisions. Since then, the Internal Revenue Service repeatedly has taken steps to minimize Roth IRA scams. A recent IRS ruling took another step in that direction, determining that transactions entered into by a husband and wife were substantially similar to transactions outlined in IRS Notice 2004-8.

An error in reporting the couple’s transactions, along with the transactions themselves, has left the two exposed to severe and potentially devastating penalties.

Let’s go back to IRS Notice 2004-8, in which the IRS described how a taxpayer/business owner used a Roth IRA to transfer value between the business he owned and a shell company owned by the Roth IRA.

The IRS deemed the strategy a likely illegal tax shelter designed to avoid annual contribution limits. As such, the notice declared it a listed transaction, subjecting it and other similar actions to additional reporting requirements and increased scrutiny.

In its latest ruling (ILM 200917030), the IRS determined that a transaction entered into by the husband and wife (let’s call them John and Mary), though not the same as the one outlined in Notice 2004-8, met the substantially similar requirement and was therefore subject to the same reporting requirements.

Prior to engaging in the listed transaction, John was working as a general manager and received consulting fees from at least one company. Mary was also self-employed and served as a bookkeeper for several unrelated companies.

At some point, Company A was created, and both John and Mary established and funded their own Roth IRAs. The Roth IRA funds were then used to purchase all of the stock of Company A, leaving each Roth IRA as a 50% owner.

Subsequent to the Roth IRAs’ acquisition of Company A, both John and Mary continued to do work for some of the same companies as they had before. However, they then offered these services as employees of Company A, and not as independent contractors.

For two years, the revenue received by Company A was distributed as dividends to shareholders. Since John and Mary’s Roth IRAs were the only owners of Company A’s stock, these distributions were made entirely to the two accounts.

The clear intent, of course, was to shift otherwise taxable income into the Roth IRA through the corporate dividends.

This is exactly the kind of transaction on which the IRS has said it will focus. In its ruling, the IRS stated: “Certain value-shifting transactions that are designed to avoid the statutory limits on contributions to a Roth IRA have been identified as listed transactions, and the purported tax benefits from such transactions will be challenged.”

That should be enough to keep clients away from these types of transactions.

Following the rules regarding listed transactions, Company A attached IRS Form 8886 and disclosed the transaction in question when it filed its first return. On the form, it further disclosed that the transaction was substantially similar to the one which had been described four years earlier in Notice 2004-8.

Although the company’s return satisfied the IRS reporting requirements, the couple’s joint return included only Form 5329, on which they claimed an excess contribution to the Roth IRA account that had subsequently been removed and corrected.

Because the transaction was substantially similar to that outlined in Notice 2004-8 and because of the lack of adequate disclosure on their return, John and Mary have subjected themselves to massive penalties and potential tax problems.

On the flip side, the IRS could act more harshly and impose a $100,000 penalty for failing to disclose the transaction as a listed transaction on IRS Form 8886 on their personal return. The IRS could also treat the value moved between businesses as if it were first paid to the taxpayer (as taxable income) and then contributed to his or her Roth IRA, which likely would create excess contributions.

Any amounts contributed to the Roth IRAs over the annual contribution limits (plus attributable earnings) would be subject to the 6% penalty for excess contributions for the years in which the Roth IRA were active and in receipt of such amounts.

Ed Slott, a certified public accountant in Rockville Centre, N.Y., created the IRA Leadership Program and Ed Slot’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.

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