Tax Planning for Retirees

Transfers to Roth IRAs: Part 2

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, partly 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). See also Benenson v. Commissioner, 2019-1 U.S.T.C. ¶ 50,101 (2d 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 Roth Conversions. –After making a Roth conversion to a Roth IRA from a traditional IRA or other plan, a retiree may have second thoughts about the desirability of the conversion. 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 Roth conversion that was subject to recharacterization. Note that if a retiree wishes to recharacterize a 2017 Roth conversion, 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.)