No Time Limit on Excise Tax on Abusive Roth IRA

Originally Published on forbes.com on July 6th,2011

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I was never that excited about converting regular IRAs to Roth’s.  You paid a big bunch of money now, maybe spread over a couple of years, so you wouldn’t have to pay in the future.  Always seemed a little like hitting your head against the wall because it feels so good when you stop.  The plans which projected enormous fortunes for your great grandchildren had two important assumptions.  The first was that you could pay the tax on the rollover with non IRA funds, so that the whole smash could go into the Roth.  The other was that you were some sort of investment genius.

Grant Thornton came up with a method that made the whole thing much more attractive.  Robert K. Paschall liked the idea , although, despite being an MITgraduate, he never quite understo0d how it worked.  In its decision yesterday, the Tax Court explained to him that the plan did not work.

Besides signing a lot of papers, Mr. Paschall had to do two things as part of the plan.  He had to open a Roth IRA funding it with $2,000 and he had to pay Grant Thornton $120,000.  His regular IRA with $1,392,801.96 was then rolled over to a self directed account.  Then two Nevada corporations were formed Telesis and West Star.  Frankly, it gets a little fuzzy here.  The Roth IRA purchased Telesis for $2,000 and the regular IRA purchased West Star for $1,272,801.96 (notice the $120,000 difference).  There was some money shuffled between the corporations.  Then they were merged with Telesis being the survivor.  When the dust had settled all the money was in the Roth.  The court summed up nicely why this was an excess contribution:

The substance of what happened in the instant case is that approximately $1.3 million began the year in Mr. Paschall’s traditional IRA and was transferred to his Roth IRA by the end of the year with no taxes being paid. Mr. Paschall did not attempt to provide a nontax business, financial, or investment purpose for what he did, and this Court cannot ascertain one. Instead, Mr. Paschall, incited by and at the urging of Mr. Stover, used corporate formations, transfers, and mergers in an attempt to avoid taxes and disguise excess contributions to his Roth IRA.
The Audit

Mr. Paschall’s 2000 return, the year of the transaction, was prepared by Grant Thornton for no extra charge.  His subsequent returns were prepared by Kruse Mennillo, where the Grant Thornton partner who had presented him with the plan had moved.Sometime in 2003 or 2004 Mr. Paschall received some distressing news:
Grant Thornton was turning over the names of people who had engaged in Roth restructures to the IRS. Mr. Stover at this time advised Mr. Paschall that the Roth restructure was legal but that he “might want to disclose on [his] income tax returns the structure”. Mr. Paschall thereafter attached to Telesis’ and his personal tax returns Forms 8886, Reportable Transaction Disclosure Statement.  Sometime in 2004 Mr. Paschall received, via Mr. Coopit, a memo concluding that the Roth restructure “was legal and met with all tax laws”.

Finally in 2008 Mr. Paschall received deficiency notices for the years 2002 through 2006.  The notices were not for income taxes, but for the excise tax for excess contributions to a Roth.  The excise tax is 6% of the lesser of the orignial excess contribution or the balance in the account.  That is each year.  Plus penalties of course.  Now the earnings of the Roth are tax free as are distributions from it.  So how bad is a 6% excise really ?  Suppose you put $1,000,000 into a Roth and you would have been subject to a 30% tax rate.  All you have to do is earn 20% and you beat the excise tax.
Statute of Limitations

Mr. Paschall argued that deficiencies for the earlier years were barred by the statute of limitations.  The excise tax is computed on Form 5329.  Generally the 5329 is attached to Form 1040.  Mr. Paschall had timely filed Form 1040 for all the relevant years.  That did not, however, start the statute of limitations with respect to the excise tax:

Section 4973 imposes an excise tax on excess contributions to Roth IRAs which is to be reported and disclosed on Form 5329. Upon review of Mr. Paschall’s Forms 1040, respondent was not reasonably able to discern that Mr. Paschall was potentially liable for a section 4973 excise tax. While a line on each Form 1040, i.e., line 54 for 2000, line 55 for 2001, line 58 for 2002, line 57 for 2003, line 59 for 2004, and line 60 for 2005 and 2006, states “Tax on qualified plans, including IRAs, and other tax-favored accounts. Attach 5329 if required”, Mr. Paschall left these lines blank, giving respondent no indication of his excess contribution.

Penalties

Mr. Paschall thought that he should not be subject to penalties since he had relied on qualified professionals.  He never went outside the loop of professionals who were being compensated on a value billing basis in seeking advice though.  It is reminiscent of EMC founder Richard Egan’s   doomed tax shelter:
Mr. Paschall should have realized that the deal was too good to be true. See LaVerne v. Commissioner, supra at 652-653. Mr. Paschall is a highly educated and successful businessman. He explained to this Court that because he grew up in the Depression, he was conservative with his investments and worried “about having enough money” to last through retirement. Yet he paid $120,000 for a transaction that he “did not fully understand”.

Mr. Paschall had doubts, repeatedly asking whether the Roth restructure was legal. Despite these doubts, he never asked for an opinion letter or sought the advice of an independent adviser, including Mr. Jaeger, who was preparing his tax returns at the time he met Mr. Stover. This was even after he received a letter warning him that there might be problems with the Roth restructure and that his name was being turned over to the IRS.

Other Recent Case

In the case of Michael Oshman, the IRS failed in its attempt to assert Roth excise taxes.  Mr. Oshman was building up his Roth balance by having his closely held company pay commissions to a foreign sales corporation owned by his Roth.  Since the IRS did not attack the income tax character of those payments, the Court did not allow it to treat the payments as disguised Roth contributions.  In Mr. Paschall’s case, the income tax sins all took place in 2000 and were old and cold by the time the IRS caught up with the transaction.