Because Roth IRA earnings that are distributed in qualified distributions are tax free (Regs. Sec. 1.408A-6), many schemes have been hatched to get around the contribution limits. In Notice 2004-8, the IRS identified transactions that improperly avoid the limits on contributions to Roth IRAs. (For the 2018 tax year, the Roth IRA contribution limit is the lesser of $5,500 (Notice 2017-64) or the taxpayer's taxable compensation; however, the contribution limit is phased out between certain levels of modified adjusted gross income (MAGI) (Regs. Sec. 1.408A-3).)
Facts in Notice 2004-8
The abusive transactions described in the notice typically involve three parties: (1) an individual taxpayer who owns a preexisting business such as a corporation or partnership; (2) a Roth IRA maintained for the taxpayer; and (3) a corporation owned by the Roth IRA (the Roth IRA corporation). That is, the Roth IRA corporation is a wholly owned subsidiary of the taxpayer's Roth IRA.
The general strategy of the abusive transactions is for the Roth IRA corporation to acquire shares of the business at less than their fair market value (FMV), resulting in the shifting of excess value to the parent Roth IRA that owns the Roth IRA corporation.
Two examples of those types of abusive transactions mentioned in Notice 2004-8 are: (1) The Roth IRA corporation acquires property, such as accounts receivables, from the business for less than its FMV; and (2) contributions of property, including intangible property, are made by a person other than the Roth IRA to the Roth IRA corporation without a commensurate receipt of stock ownership.
IRS asserts transactions are abusive
Because the taxpayer controls the business and is also the beneficial owner of the Roth IRA corporation, the IRS may assert that these abusive transactions are, in substance, a payment to the taxpayer, followed by a contribution by the taxpayer to the Roth IRA, and finally, a contribution by the Roth IRA to the Roth IRA corporation.
Under Sec. 482, the IRS has the power to allocate income between parties to prevent evasion of taxes and reflect income of a person dealing at arm's length with an uncontrolled person. As a result, taxpayers engaging in these transactions may have additional income to report and be penalized with an annual 6% excise tax for making excess contributions to his or her Roth IRA (Sec. 4973). This approach has been approved by courts.
The notice also says that if the business is a corporation, the IRS may require it to recognize gain on the transfer, under Sec. 311(b). Sec. 311(b) provides that if a corporation distributes property to a shareholder (the payment to the taxpayer), the corporation must recognize a gain if the property's FMV exceeds its adjusted basis.
Substantially similar abusive transactions mentioned in the notice include transactions that involve multiple taxpayers. For example, if the Roth IRA corporation is owned by multiple taxpayers' Roth IRAs, a substantially similar transaction occurs if that Roth IRA corporation enters into a transaction with a business of any of the taxpayers and distributions from the Roth IRA corporation are made to that taxpayer's Roth IRA based on the transactions done with that taxpayer's business or otherwise based on the value shifted from that taxpayer's business to the Roth IRA corporation.
Under Sec. 408(e)(2)(A), the IRS may take the position, where appropriate, that the transaction gives rise to one or more prohibited transactions between a Roth IRA and a disqualified person as defined in Sec. 4975(e)(2). Department of Labor regulation 29 C.F.R. Section 2510.3-101 provides that, in certain cases, when a retirement plan invests in another entity, that plan's assets now include the underlying assets of the other entity (plan assets). This is significant because, according to the secretary of Labor (who has interpretive jurisdiction over Sec. 4975), since the Roth IRA corporation would become a plan asset of its parent Roth IRA, certain transactions between the Roth IRA corporation and the business owned by the taxpayer (a disqualified person under Sec. 4975(e)(2)) would be prohibited transactions under Sec. 4975(c)(1)(C).
Department of Labor regulation 29 C.F.R. Section 2509.75-2(c) explains that a person may have engaged in a prohibited transaction by entering into a transaction with a corporation or partnership in which a retirement plan has invested, if that retirement plan has the power to force that corporation or partnership to enter into the transaction. For example, if a transaction between a disqualified person and a Roth IRA would be a prohibited transaction, then a transaction between that person and the Roth IRA corporation (which the Roth IRA controls) would be prohibited as well.
Disclosure of listed transactions
For the disclosure and registration requirements of Regs. Secs. 1.6011-4(b)(2), 301.6111-2(b)(2), and 301.6112-1(b)(2), the following persons are deemed to be involved in "listed transactions":
- Related persons described in Sec. 267(b) or 707(b);
- A business controlled by those individuals or related persons; and
- The corporation;
if they engage in one or more transactions with that corporation, including contributions of property to that corporation, if substantially all the shares of that corporation are owned by a Roth IRA maintained for the benefit of the individual or related persons.
Independent of their classification as "listed transactions," these transactions may also be subject to the disclosure requirements of Sec. 6011 (Regs. Sec. 1.6011-4), the tax shelter registration requirements of Sec. 6111 (Temp. Regs. Secs. 301.6111-1T and Regs. Sec. 301.6111-2), or the list maintenance requirements of Sec. 6112 (Regs. Sec. 301.6112-1).
In addition, the promoter and return preparer may be liable for penalties under Sec. 6694, Sec. 6700, and Sec. 6701.
The moral of the story of the notice is to remember that, as usual, substance takes precedence over form.
Application of the notice
A recent case illustrates the Tax Court's application of the notice to a Roth IRA scheme involving four taxpayers: a married couple and their two children. In Block Developers, LLC, T.C. Memo. 2017-142, the convoluted setup, in short, was:
- The taxpayers set up Roth IRAs;
- The taxpayers' Roth IRAs acquired 95% of a limited liability company (LLC);
- One of the taxpayers sold two patents to the LLC, which licensed them to an S corporation owned by the taxpayer who sold the patents; and
- The S corporation paid royalties back to the LLC, which then transferred them to the Roth IRAs.
In this case, the LLC is the Roth IRA corporation mentioned in the notice. The Tax Court was not persuaded that the LLC served any legitimate purpose; it was merely a way to funnel money to the Roth IRAs. The court mentioned the lack of employees, the lack of recordkeeping, and the lack of engaging in usual business dealings as proof that the LLC was a sham. This implies that if the LLC had been run as a full-fledged business, the court would have held that the notice did not apply.
To wit, the court noted that in a similar case "we didn't question the right of a Roth IRA to own an interest in a closely held corporation. We nonetheless concluded that the taxpayer's transfers were nothing more than a mechanism for transferring value to his Roth IRA" (Block Developers at *28).
The court opines that the main problem with the abusive transactions in the notice is not the moving of property to the Roth IRA corporation at less than fair value, but rather "the effect of transferring value to the Roth IRA Corporation comparable to a contribution to the Roth IRA" (Id. at *26, quoting Notice 2004-8).
All this opens up the possibility of getting around the restrictions in the notice by having the Roth IRA corporation run as a legitimate business, even while transferring property at less than fair value.
Allen Schulman (email@example.com) is an enrolled agent in Lakewood, N.J. To comment on this article or to suggest an idea for another article, contact senior editor Sally Schreiber at Sally.Schreiber@aicpa-cima.com.