Tax Planning for Retirees

Transfers to Roth IRAs: Part 2

Special Deferral of Tax on Rollovers to Roth IRAs in 2010. – For a “taxable qualified rollover contribution” (TQR contribution) to a Roth IRA in 2010, one-half the income generally is not taxable until 2011, and the other half generally not taxable until 2012 (unless the retiree elects to report it all in 2010). However, if the retiree dies or takes a distribution of any of the transferred funds before 2012, the retiree must accelerate payment of the deferred tax on the distributed funds. Nevertheless, a surviving spouse who is the sole beneficiary of the Roth account may elect to continue the deferral into his or her own tax returns. (Tax Increase Prevention and Reconciliation Act of 2005, Pub. L. No. 109-455, § 512; I.R.C. § 408A.) See Chapter 6 of the treatise.

MyRAs: A Now Terminated Type of Roth IRA. – The Treasury Department announced on July 31, 2017 that it was winding down and terminating the myRA program. A myRA was a type of account administered for a participant by the U.S. government The account was funded with payroll deductions remitted by employers. The federal government invested the remitted funds in U.S savings bonds paying a variable rate of interest. Accumulations in a myRA were limited to the lesser of $15,000 or 30 years of accumulations. The tax treatment of myRAs was the same as the tax treatment of other Roth IRAs. (White House Fact Sheet: Opportunity for All: Securing a Dignified Retirement for All Americans (Jan. 30, 2014); Treasury Department News Release, TDNR SM-0135, 2017FED ¶46,321.) See Chapter 6 of the treatise.

Using Multiple Rollovers to Make Tax-Free Roth IRA Contributions. – A retiree may combine a trustee-to-trustee rollover to a traditional IRA with a trustee-to-trustee rollover to a Roth IRA, all from a single qualified plan distribution. In fact, the retiree can make the rollovers totally tax-free by (1) limiting the Roth IRA rollover to an amount equal to the recovery of investment in the distribution and (2) allocating all the investment to the Roth IRA rollover. The direct rollover of the distributed pre-tax earnings to the traditional IRA is also tax-free. (Notice 2014-54, 2014-41 I.R.B. 670.) See Chapter 6 of the treatise.

Penalties Imposed for Artificially Shifting Value from Business Entities to Roth IRAs. – In 2004, the IRS announced that it would closely scrutinize transactions involving a Roth IRA and other entities related to the owner of the Roth IRA. The IRS was concerned that the owner of a Roth IRA might attempt to circumvent contribution limits by artificially shifting value to the Roth IRA. Since then, the IRS has had mixed results in challenging arrangements designed to shift value to Roth IRAs.

In one case, taxpayers formed two C corporations that were 98 percent owned by the taxpayers’ Roth IRAs. The taxpayers claimed to have formed the new corporations to provide services for a pre-existing S corporation owned by the taxpayers. However, the Tax Court found that actual services provided to the S corporation, if any, were woefully insufficient to justify the amounts paid for them. The court concluded that the entire arrangement was without substance and treated the service payments as dividends to the taxpayers. It held that the taxpayers had then effectively used the dividends to make Roth IRA contributions that were subject to the excise tax on excess contributions.

In a more recent case, taxpayers’ Roth IRAs owned all the stock of a holding corporation that in turn owned all the stock of a domestic international sales corporation (DISC). Another corporation owned by the taxpayers paid commissions to the DISC on the corporation’s international sales of industrial products. The DISC immediately distributed the amount of commission payments to the holding corporation, which then immediately distributed the after-tax amounts to the Roth IRAs.

The Tax Court held that the arrangement was without substance and treated the commission payments as dividends to the taxpayers that the taxpayers used to make excess contributions to Roth IRAs. On appeal, the Sixth Circuit reversed, stating that Congress had expressly authorized the use of DISCs for tax avoidance purposes and had expressly authorized the ownership of DISCs by tax-exempt entities such as Roth IRAs. (Summa Holding, Inc. v. Commissioner, T.C. Memo. 2015-119, rev’d, 848 F.3d 782 (6th Cir. 2017); Repetto v. Commissioner, T.C. Memo. 2012-168; Notice 2004-8, 2004-1 C.B. 333.)

In a related case, a three judge panel of the First Circuit followed the Sixth Circuit’s Summa case and held that the owners of the Roth IRAs in the Summa case had not made excess contributions to their Roth IRAs. The First Circuit panel agreed with the Sixth Circuit that the substance-over-form doctrine did not apply to the Summa DISC arrangement. However, one judge on the panel dissented, primarily on grounds the taxpayers had not availed themselves of any of the benefits Congress intended for DISC arrangements. (In dicta in a footnote, the dissenting judge stated that she would have dissented even if the taxpayers had actually availed themselves of those benefits.) (Benenson v. Commissioner, 887 F.3d 511 (1st Cir. 2018).)

Subsequent to the Sixth Circuit decision, the Tax Court declined to approve a similar arrangement involving a foreign sales corporation (FSC). The individual taxpayers’ had attempted to transfer funds from the taxpayers’ corporation through a FSC to the taxpayers’ Roth IRAs, in amounts in excess of Roth IRA contribution limits. The Tax Court held that, in substance, the FSC was owned by the individual taxpayers, and not by the Roth IRAs. The court stated that, in substance, the FSC after-tax profits were distributed to the taxpayers who then made excess contributions to their Roth IRAs. The court distinguished the Sixth Circuit case on various grounds, noting that the Sixth Circuit did not have to determine who substantively owned the DISC. (Mazzei v. Commissioner, 150 T.C. No. 7 (2018)) See Chapter 6 of the treatise.

Repeal of Recharacterizations of TQR Contributions. –After making a taxable qualified rollover contribution (TQR contribution) to a Roth IRA from a traditional IRA or other plan, a retiree may have second thoughts about the desirability of the transfer. In past years, the retiree could solve this problem by transferring some or all of the contributed funds to a traditional IRA from the Roth IRA that originally received the funds. The tax law then treated the recharacterized amount as retroactively rolled over to the traditional IRA from the originally distributing plan or IRA, in a nontaxable transaction. Unfortunately, the year 2017 was the last year a retiree could make a TQR contribution that was subject to recharacterization. Note that if a retiree wishes to recharacterize a 2017 TQR contribution, he or she must generally do so on or before October 15, 2018. (IRC § 402A(d)(6)(B)(iii); Tax Cuts and Jobs Act, Pub. L. No. 115-97, § 13611(b).) See Chapter 6 of the treatise.

View Joint Committee Statement on “Backdoor” Roth Contributions With Caution. –The Joint Committee on Taxation has acknowledged that a taxpayer may avoid the limitations on contributions to Roth IRAs by making contributions to an IRA and converting the IRA to a Roth IRA (so-called backdoor Roth contributions). The acknowledgement came in footnotes to the committee report for the Tax Cuts and Jobs Act of 2017. Unfortunately though, the committee report did not discuss or rule out application of the substance-over-form doctrine to certain preconceived backdoor plans intended to avoid Roth limits by making a Roth conversion immediately after an IRA contribution. Unfortunately also, statements in a committee report are far from binding on the IRS or the courts. For a detailed discussion of the substance-over-form issue, see here. (Conference Committee Report of the Tax Cuts and Jobs Act (HR 1)—Pub. L. No. 115-466_Individual Tax Reform, E.1, footnotes 268, 269, 276, and 277.)