The Tax Court held that the IRS properly imposed the 6% excise tax due to excess contributions made by family members to their respective Roth individual retirement accounts (IRAs). According to the court, the taxpayers' arrangement used abusive transactions designed to avoid the dollar limitations for contributions by the taxpayers to their respective Roth IRAs.
Facts: In 1987, Jan Jansson started a concrete block business, Soil Retention Systems Inc., in southern California. He later designed and patented a retaining wall block system called the Verdura Block System. His business was very successful, and to reduce potential liability, he split the business into four corporations. Hoping that his business would survive his retirement, he engaged an attorney-entrepreneur, Bill Maxam, as his estate planner and investor.
In January 2001, the estate plan was implemented when Jansson granted an option to Maxam to buy the Verdura patents and, if the option was exercised, Maxam agreed to pay 10% of gross sales from the patents to SR Products, one of Jansson's corporations. Then Jansson, his wife, and their two sons all opened self-directed Roth IRAs with contributions of $2,000 each. Maxam formed Block Developers LLC and was its sole member and its tax matters partner. Then each of the four Roth IRAs purchased a 23.75% ownership interest in Block Developers for $1,912.
Later in 2001, Maxam exercised his option, and Jansson sold the patents to Block Developers for $250,000. Maxam and SR also signed a licensing agreement that obligated SR to pay a royalty of 10% of gross receipts from its sales of Verdura Blocks. From 2001 to 2007, SR Products paid royalties of about $1.2 million to Block Developers, with $800,000 ending up in the four Roth IRAs.
In 2008, the IRS sent each of the Roth IRAs, as partners of Block Developers, a notice of beginning administrative proceedings for tax year 2005 and less than a year later sent a notice for 2006. A series of motions followed, and eventually each Jansson family member was assessed an excise tax for excess contributions to a Roth IRA of $11,793, plus penalties of $4,481. The cases were consolidated after the Janssons petitioned the Tax Court for relief. Before ruling on the excise tax issue, the court held that the case related to tax year 2005 could proceed because the IRS's notification to each Roth IRA met its notification obligation and the Service was not also required to notify the taxpayers as indirect partners.
Issues: The amount a taxpayer is allowed to contribute to his or her Roth IRA is limited to $5,500, or $6,500 for taxpayers age 50 or older (the corresponding limits were $4,000 and $5,000 during the years at issue), subject to an income phaseout. If a taxpayer contributes more than the statutory limit, the excess contribution is subject to an excise tax of 6% of the excess contribution for each year the amount remains in the IRA. In 2003, the IRS issued Notice 2004-8, which identifies certain transactions as abusive Roth IRA transactions designed to avoid the statutory contribution limits. Those transactions involve (1) an individual who owns a business; (2) a Roth IRA maintained for that individual; and (3) the Roth IRA's substantially acquiring or owning the shares of a corporation. The business and corporation enter into certain types of transactions. The acquisition of shares and/or the transactions are not fairly valued, which has the effect of shifting value into the Roth IRA.
In Polowniak, T.C. Memo. 2016-31, the Tax Court applied Notice 2004-8, holding that the taxpayer was shifting value from his business to his Roth IRA through a newly created corporation (see "Tax Matters: 'Private Roth IRA Corporation' Is Held Abusive," JofA, June 2016). The court in Polowniak reached this conclusion because the newly created corporation had no effect on how the taxpayer's business operated, there was a lack of normal business dealings between the two corporations with commingling of employees' duties between them, and the court could find no legitimate business purpose for the new corporation.
Holding: The court upheld the IRS's assessments because, it said, Block Developers, like the corporation in Polowniak, had no real purpose other than to transfer wealth from Jansson's original corporation to the Roth IRAs. According to the court, the sale of the patents to Block Developers had no real impact on how Jansson operated his business, there was a great deal of administrative overlap between the original company and the newly created one, and there was no real business purpose for Block Developers.
- Block Developers, LLC, T.C. Memo. 2017-142
—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.