The Migration...
A coming storm of increased tax rates is encouraging high net worth individuals and business owners to migrate to new lands and to take refuge in the Roth IRA's tax benefits. However, when viewing the lay of the land that makes up Roth's golden country, it is important to be aware of recent decisions that limit Roth's bounties.
Roth IRA Basics
The Roth IRA is a unique type of nondeductible IRA. Although
contributions to Roth IRAs are not deductible, all of the
qualifying distributions received from the Roth IRA are tax-free.
Unlike the Roth IRA, in a regular or traditional IRA, withdrawals
of contributions and earnings are taxable, but the money
contributed to the IRA is deducted from income.
The maximum annual contribution an individual can make to his or
her Roth IRA is subject to both a "dollar limitation"
(which caps contributions by a dollar amount) and an "AGI
limitation" (which stands for adjusted gross income, and caps
contributions based on the participant's modified adjusted
gross income).
Since the inception of the Roth IRA, individuals have sought to
avoid the statutory limits on Roth IRA contributions. Often,
transactions between different corporate entities are designed to
indirectly contribute to a Roth IRA in an attempt to protect assets
or evade taxes. The IRS has responded by challenging such avoidance
transactions, and in such cases, it has denied deductions, required
corporations involved to recognize the gain on the transfer,
required inclusion of the payment in the taxpayer's income,
and/or reallocated income to other involved entities in order to
prevent tax evasion or to reflect the income clearly. In addition
to these possible consequences, the amount treated as a
contribution is subject to a 6 percent excise tax under Section
4973 of the Internal Revenue Code.
Recent Decisions
Two recent decisions highlight some of the problems that can
arise when business owners seek to utilize the Roth IRA's
beneficial tax structure without considering the legal
limitations.
Repetto v. Commissioner
In a recent Tax Court decision, Repetto v. Commissioner (June 14, 2012), the court determined that two individuals who formed two subchapter C corporations in which their Roth IRAs held a 98% interest were subject to the excise tax on excess contributions.
The individuals involved, Steven and Gayle Repetto, owned all of
the stock in a subchapter S Corporation, SGR Investments, Inc.
(SGR). Relying on the advice of an attorney and a C.P.A., the
Repettos formed two C Corporations: (1) Yolo, Inc. (Yolo), which
was established to provide office and support services for SGR; and
(2) WFR Investments, Inc. (WFR), which was established to provide
marketing and business development services for SGR. Gayle
Repetto's Roth IRA owned a 98 percent interest in Yolo, and
Steven Repetto's Roth IRA owned a 98 percent interest in WFR.
Gayle Repetto, acting in her capacity as Yolo's president,
established a medical and dental expense reimbursement plan, which
made distributions to the Repettos for healthcare expenses. The
IRS, on audit, determined that the Repettos made excess
contributions to their Roth IRAs and were liable for the excise tax
under Code Section 4973. The IRS also disallowed WFR's and
SGR's deductions for facility support payments, as well as
Yolo's deduction for medical reimbursement expenses and officer
compensation expenses. Further, the IRS recharacterized some
payments from SGR to Steven Repetto as compensation, rather than as
a distribution. The IRS also assessed filing penalties and
penalties for reportable transaction understatements.
In court, the Repettos argued that their corporate structure had a
legitimate business purpose of asset protection, that payments
between the entities were legitimate because the entities that
offered support and development services to SGR actually provided
such support and development services, and that the IRS had
recognized the support and development entities by continuing to
retain over $112,000 in federal corporate income taxes. They also
noted that a Roth IRA may own shares of a C Corporation.
The court held that the Repettos were liable for the Code Section
4973 excise taxes for excess contributions to their Roth IRAs, and
concluded that the service agreements, and payments between the
entities, were nothing more than a mechanism for transferring value
to the Roth IRAs since the Repettos had continued to do the same
work that they had done prior to the time the agreements were in
place.
Taproot Administrative Services v. Commissioner of
Internal Revenue
In Taproot Administrative Services v. Commissioner of Internal
Revenue (Mar. 21, 2012), the Ninth Circuit Court of Appeals,
affirming the Tax Court's decision, held that a corporation was
not eligible for S corporation status because its sole shareholder,
a Roth IRA, was not an eligible S corporation shareholder, and
consequently, that the corporation was taxable as a C
corporation.
The individual taxpayer involved, Paul Di Mundo (Mundo), incorporated his business and elected subchapter S status. The sole shareholder of the corporation in 2003 was a custodial Roth IRA for the benefit of Mundo. After the IRS issued a notice of deficiency, determining that the corporation was taxable as a C corporation for 2003, Mundo filed suit.
The Tax Court agreed with the IRS, and concluded that the Roth IRA did not qualify as an eligible shareholder of the S corporation. On appeal, the Ninth Circuit rejected Mundo's corporation's argument that the custodial Roth IRA qualifies as an eligible shareholder for purposes of assessing S corporation taxation. The Ninth Circuit and Tax Court relied on IRS Revenue Ruling 92-73 (the only IRS guidance on this issue), which prohibits IRAs as S Corporation shareholders. The Ninth Circuit court, in reaching its decision to affirm the Tax Court's determination, noted that unlike grantor trusts and qualified subchapter S trusts, which are both taxed currently on their income, IRAs and Roth IRAs are subject to deferred taxation on current income, and thus are incompatible with the S corporation taxation rules. The court further noted that the legislative history of the S corporation statute favors limited eligibility.
The Migration Continues...
Although these decisions highlight some of the pitfalls that can occur when seeking tax safety, they will not deter the larger migration to Roth's golden country, and to other such refuges. Plan accordingly, and discuss these issues with your attorneys and financial advisors.
Originally published on For Your Benefit, September 2012
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.