Arrangement involving service agreements between business and companies owned by Roth IRAs is abusive Roth IRA transaction

Upholding the IRS, the Tax Court has held in a consolidated case that a married couple’s purported service agreements between their construction business and two corporations, owned in turn by two Roth IRAs, were shams. The arrangement was intended to allow the couple to make excess payments to their Roth IRAs in the form of disguised service payments, the court held.

Background

A married couple operated their construction business as an S corporation. In 2003, they organized two C corporations, which in turn were owned by two Roth IRAs (one Roth IRA was owned by the husband and the other Roth IRA was owned by the wife). The corporations were organized to provide services, such as facilities support, to the S corporation. The S corporation paid the C corporations for these services.

In IRS Notice 2004-8, the IRS announced it would challenge the purported tax benefits from what it considers are abusive Roth IRA transactions. Generally, these transactions involve an individual who owns a pre-existing business, such as an S corporation; a Roth IRA maintained for the individual; and a C corporation, substantially all the shares of which are owned or acquired by the Roth IRA.

After reviewing business and personal income tax returns, the IRS determined that the purported facility support agreements were nothing more than mechanisms for transferring value to the Roth IRAs and issued notices of deficiency. The Tax Court agreed with the IRS determination.

Substance determines tax consequences

The court first reiterated that the substance, not the form of a transaction, determines its tax consequences. Where a series of transactions taken as a whole shows either that the transactions are shams or that the transactions have no purpose, substance, or utility aside from their anticipated tax consequences, the transactions are not recognized for federal tax purposes. The court further noted that Code Sec. 4973 provides that an excess contribution to a Roth IRA is the excess of the amount contributed over the amount allowable as a contribution.

Despite the service agreements between the corporations controlled by the Roth IRAs and the S corporation, the court stated that the married couple failed to convince the court that they worked as the Roth IRA corporations’ indirect owners or employees rather than as the S corporation’s owners or that the services provided were worth the amounts paid under the service agreements. The service agreements did not change who provided the services, and the married couple continued to do all of the work that was done before the establishment of the agreements. The court determined that, based on credible evidence, “in substance the service agreements and resulting payments were nothing more than a mechanism for transferring value to the Roth IRAs.” The contributions made to the Roth IRAs were excessive and, therefore, subject to the Code Sec. 4973 excise tax.

The court further concluded that the taxpayers were liable for the Code Sec. 6651(a)(1) penalty for failure to file Form 5329 for each year they had excess contributions to the Roth IRAs and for the Code Sec. 6651(a)(2) penalty, which imposes an addition to tax for failure to pay timely the amount of tax shown on a return. Additionally, the court found the taxpayers liable for enhanced accuracy-related penalties under Code Sec. 6662A.

Source: Repetto v. Commissioner (TC).

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For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer’s Benefits Reports.

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