United States

Taxpayer penalized for excess Roth IRA contributions


On Feb. 25, 2016, in Brian M. Polowniak v. Commissioner, T.C. Memo. 2016-31, the Tax Court sustained several penalties assessed against the taxpayers for exceeding the Roth IRA contribution limitation. The taxpayer and his then wife opened Roth IRA accounts with small initial contributions and directed those Roth IRAs to purchase stock of a newly formed corporation. The newly formed corporation was described by the attorney promoting the idea as a Private IRA Corporation (PIRAC). The taxpayer served as the PIRAC’s sole officer, director and employee.

The taxpayer had an established consulting practice that he operated as an employee of his wholly owned S corporation. The S corporation and the PIRAC entered into a subcontracting agreement by which the S corporation would pay the PIRAC 75 percent of the S corporation’s gross revenue. The PIRAC did not pay the taxpayer a salary or reimburse him for any expenses. His S corporation paid all of the expenses of the operation and did in fact transfer substantial amounts of revenue (earned by the taxpayer’s efforts) to the PIRAC, resulting in the S corporation reporting substantial business losses that the taxpayer claimed as an S corporation shareholder loss on his personal return.

The revenue payments received by the PIRAC far exceeded the annual contribution limitations of a Roth IRA, and thus, if the IRS were to re-characterize the payments as disguised Roth IRA contributions rather than investment earnings, then the taxpayer as the owner of the IRA would be liable for the 6 percent excise tax on excess contributions to an IRA.

The IRS, in fact, did deem these payments to be Roth IRA contributions in a substance over form argument. The taxpayer controlled both the corporation owned by the Roth IRAs and the corporation making payments to it. The payments represented consulting fees earned by the taxpayer for services provided to yet another unrelated company. The existence of the new corporation owned by the Roth IRAs did not change the nature of that consulting arrangement with the outside company, and the company for which he consulted did not even know of the existence of it. Ultimately, the formation of the new corporation was nothing more than a way to get value into the Roth IRAs without a direct contribution. The IRS had previously identified abusive transactions of this nature and made them listed transactions in Notice 2004-8.

The Tax Court agreed with the IRS, and the results for the taxpayers were onerous. In addition to an excise tax on the excess of the payments over the annual contribution limitation, additional taxes and penalties were assessed. The excise tax should have been reported on a return in the year it occurred and it was not so additional taxes resulted from the failure to file returns and the failure to timely pay tax due with a return. In addition, as the taxpayers’ returns for the years in question included understatements related to a listed transaction, the taxpayers were subject to 20 percent accuracy-related penalty that the IRS increased to 30 percent because of the taxpayers’ failure to disclose the transaction on their personal tax returns.

Roth IRAs were introduced to provide taxpayers benefits from avoiding tax on the appreciation that occurs inside the Roth IRA. Because these benefits can be significant, the use of a Roth IRA has certain limitations, including the amount of contributions. Taxpayers should be wary of any transaction that is designed to circumvent these limitations because the IRS will likely consider them abusive (resulting in significant negative financial consequences).


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