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.
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 percent 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.