The Tax Court held on July 5 that the IRS properly assessed excise tax on a taxpayer’s excess contribution to a Roth IRA, since the attempted tax-free conversion of a regular IRA to a Roth IRA lacked economic substance. In addition, the court held that the taxpayer was subject to a penalty for failing to file Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, since the taxpayer could not show reasonable cause for his failure to file. The court further found that the statute of limitation did not bar the excise tax for three of the years in question, due to the failure to file the form with the tax returns.
If a taxpayer’s contribution to an IRA (including a Roth IRA) exceeds the maximum amount allowable, IRC § 4973 imposes an excise tax equal to 6% of the lesser of the excess contribution or the fair value of the IRA account at the end of the year. The tax is imposed each year until the excess contribution and its earnings are removed from the account. A taxpayer who has made an excess contribution is required to file Form 5329, and failure to file the form can result in a penalty of up to 25% of the excise tax. The penalty will not apply if the failure is due to reasonable cause.
Generally, allowable pretax contributions to a traditional IRA are tax-deferred until their withdrawal. Contributions to a Roth IRA are from currently taxable income, which includes amounts converted from a traditional IRA. In years prior to 2010, such conversions were restricted by taxpayers’ adjusted gross income (see “2010: The Year of the Roth Conversion?” JofA, Jan. 2010, page 28).
Robert K. Paschall, a married resident of California, worked his entire career for Rockwell International. Prior to his retirement in 1996, Paschall had established a regular IRA that by March 2000 had a value of $1,391,942. In early 2000, Paschall met with A. Blair Stover, a partner with a national CPA firm, who presented Paschall with a plan, which he accepted, to “restructure” his regular IRA into a Roth IRA.
In 2000, under Stover’s guidance and direction, Paschall rolled his IRA over into a self-directed traditional IRA. He also opened a self-directed Roth IRA, funding it with $2,000, and created two corporations. The Roth IRA purchased all the stock of one corporation for $2,000, and the traditional IRA purchased all the stock of the second corporation for close to the traditional IRA’s balance. The second corporation transferred the purchase amount (plus $120,000 paid as consideration in a merger) to the first corporation. The first corporation then transferred the proceeds, $1,272,802, to the Roth IRA, which then transferred the funds into a second Roth IRA.
In 2008, the IRS assessed deficiencies against Paschall and his wife totaling more than $425,000 for tax years 2002 to 2006 for the excise tax on the excess contribution of $1,272,802 to the Roth IRA in 2000 and assessed penalties of more than $103,000 for the same years for failure to file Form 5329. The taxpayers petitioned the Tax Court for relief.
The taxpayers argued that the statute of limitation barred the assessment of the excise tax for 2002 to 2004, since they had filed Form 1040 for those years. The court disagreed, holding that Form 5329 is a separate tax return because it provides the IRS with information necessary to properly compute the section 4973 excise tax liability. Under section 6501, if a tax return is not filed, the tax can be assessed at any time.
The court also held that the $1,272,802 transfer of cash to the Roth IRA was an excess contribution, since the substance of the series of Roth restructuring transactions was the transfer of the money from a traditional IRA to a Roth IRA without any taxes being paid. The court could not find a business, financial or investment reason for the series of transactions other than to avoid paying federal income taxes.
The taxpayers also argued that the penalty for Paschall’s failure to file Form 5329 should not apply, since his failure to file was due to reasonable cause, specifically, his reliance on Stover. The court disagreed, finding that it was unreasonable for Paschall to rely on the opinion of a tax adviser who was actively involved in the planning of the transaction in question and was tainted by an inherent conflict of interest. The court further stated, “Mr. Paschall should have realized that the deal was too good to be true.” Despite his doubts during the process, Paschall never asked for advice from an independent adviser, the court said.
In another case involving a similar Roth restructuring designed and executed by Stover, the Tax Court held that the taxpayers, Ronald and Donna-Kay Swanson, were liable for the accuracy-related penalty. The Swansons had conceded their additional tax liability but, like the Paschalls, contested the accuracy-related penalty, asserting they had relied in good faith on a professional. The court once again found that reliance on Stover was unreasonable because of his involvement in the transaction and his inherent conflict of interest. And, according to the court, the Swansons failed to demonstrate they acted in good faith. Although Ronald Swanson, like Paschall, had doubts about the transaction, he never asked for a written opinion letter or sought the advice of an independent adviser, the court said. Swanson, moreover, was a successful businessman who studied tax books and prepared his own tax returns and “must surely have realized that the deal was too good to be true,” the court said.
Robert K. and Joan L. Paschall v. Commissioner , 137 TC no. 2
Ronald V. and Donna-Kay Swanson v. Commissioner , TC Memo 2011-156
By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.
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