In the companion cases of Paschall v. Commissioner and Swanson v. Commissioner, the Tax Court found that taxpayers who employed a Roth IRA conversion tax shelter were liable for excise taxes on account of excess contributions to the Roth IRAs and were also liable for failure to file penalties.
The taxpayers had relied on a strategy promoted by a senior-level professional at a prominent accounting firm. The strategy was promoted as a product, where the taxpayers paid a lump sum for the advice and implementation of the tax strategy. Under the strategy, the taxpayers each formed two S corporations. The taxpayers then used their traditional IRAs to purchase all of the stock in one of their respective S corporations, resulting in a large quantity of cash in the first of the S corporations. Concurrently, the taxpayers each funded a new Roth IRA with $2000, and used that sum to acquire all of the stock in the second S corporations. The first S corporations then transferred all of their cash to the second S corporations, and shortly thereafter, the first S corporations were “merged” into the second S corporations underlying the Roth IRAs. Each of the taxpayers took the position that this alchemy converted their traditional IRAs into Roth IRAs, without triggering any tax. However, they did not properly report the transactions to the IRS. In 2004, the accounting firm informed that taxpayers that their names were being turned over the IRS as having engaged in a potentially “listed transaction.” Subsequently, notices of deficiency were issued characterizing the transactions as excess contributions to the Roth IRAs, thereby resulting in an excise tax and a failure to file penalty.
In citing basic tax principles of substance over form, the Tax Court rebuffed the taxpayers’ positions that the transaction did not result in an excess contribution to the Roth IRAs. Additionally, the Tax Court held against the taxpayers on the issue of penalties. The Tax Court found that notwithstanding the taxpayers’ reliance on the tax professionals, the taxpayers were still bound to exercise “ordinary business care and prudence.” Because the taxpayers did not conduct due diligence in response to the conflict of interest between the tax professionals as promoters and as advisers, the Tax Court found the taxpayers had not exercised ordinary business care and prudence. Accordingly, the Tax Court upheld the imposition of the excise tax and the failure to file penalties.