Limitations Period Remains Open If Excess Roth IRA Contributions Aren't Reported On Return

Paschall, (2011) 137 TC No. 2

The Tax Court has held that the statute of limitations for assessing the excise tax on excess contributions to a Roth IRA remains open where a taxpayer fails to report the contributions on his return. The excess contributions in the case were caused by an attempt to use a so-called “Roth restructure” transaction to disguise excess contributions to the taxpayer's Roth IRA. The taxpayer also was held liable for additions to tax under Code Sec. 6651(a)(1).

Background. Withdrawals from traditional IRAs funded with deductible contributions are taxable when withdrawn. By contrast, qualified distributions from Roth IRAs, which are funded with nondeductible contributions, are tax-free.

The amount of contributions a taxpayer may make in any given year to a Roth IRA is limited by Code Sec. 408A(c)(2) and Code Sec. 408(c)(3). Under Code Sec. 4973, a 6% excise tax applies to excess Roth IRA contributions, computed on the lesser of (1) the amount of the excess contribution, and (2) the fair market value of the account as of the end of the tax year. An excess Roth IRA contribution is the excess of the amount contributed over the amount allowable as a contribution. The excise tax is imposed each year until the excess contribution plus earnings is eliminated. Taxpayers must file a Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts, for each year they have excess contributions to their IRA.

Under Code Sec. 6501(a), the general rule is that the amount of any tax imposed by the Code shall be assessed within three years of the filing of the return. However, in case of a failure to file a return, the tax may be assessed “at any time.” (Code Sec. 6501(c)(3))

Under Code Sec. 6651(a)(1), a 5% addition to tax is imposed for each month or part of a month that a required return is filed after the prescribed due date, but not to exceed 25% in the aggregate. The addition to tax doesn't apply if it is shown that such failure is due to reasonable cause and not due to willful neglect.

Facts. Robert Paschall, a holder of several physics degrees and a management certificate for technical personnel, amassed a $1.3 million balance in a regular IRA. In 2000, a Mr. A. Blair Stover, Jr., then employed by accounting firm Grant Thornton, sold Paschall on the benefits of a “Roth restructure transaction” that involved corporate formations, transfers and mergers to turn Paschall's $1.3 million in his regular IRA into a $1.3 million transfer to a Roth IRA, with no tax being paid along the way. Grant Thornton charged Paschall $120,000 to set up the transaction. Relying on Stover and Grant Thornton, Paschall thought the transaction was legitimate, even though he didn't understand how it worked, and he didn't ask for or receive an opinion letter about it.

Paschall timely filed his tax returns on Form 1040 for the years at issue (2002 through 2006) but didn't attach Form 5329 to his returns. In either 2003 or 2004, he received a letter stating that Grant Thornton was turning over the names of people who had engaged in Roth restructures to IRS. He was advised by Stover that the Roth restructure was legal but that he “might want to disclose on [his] income tax returns the structure.” Paschall thereafter did so on Form 8886, Reportable Transaction Disclosure Statement.

In 2008, IRS issued notices of deficiency to Paschall for 2002 through 2006 indicating he owed large amounts of tax plus Code Sec. 6651(a)(1) additions to tax for each tax year.

Statute of limitations (SOL) issue. Paschall claimed that the SOL barred IRS from asserting deficiencies for tax years 2002—2004, because he timely filed Forms 1040 for those years. He asserted that Form 5329 was not a separate tax return from Form 1040, that the SOL started running when he filed the Forms 1040, and that the period of limitations had expired before IRS issued the notices of deficiency for the 2002, 2003, and 2004 tax years.

Agreeing with IRS, the Tax Court held that Form 5329 is a separate tax return from Form 1040 and that since Paschall never filed Forms 5329, the Code Sec. 4973 excise tax may be assessed at any time. Upon review of Paschall's Forms 1040, IRS was not reasonably able to discern that he was potentially liable for a Code Sec. 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”, Paschall left these lines blank, giving IRS no indication of his excess contribution. As a result, the Tax Court held that the filing of the Forms 1040 did not start the SOL running for purposes of the Code Sec. 4973 excise tax in the absence of accompanying Forms 5329.

Additions to tax. The Tax Court also upheld IRS's Code Sec. 6651(a)(1) additions to tax for failure to file, determining that Paschall could not show that his failure was due to reasonable cause and not wilful neglect. It was well established that it was unreasonable for a taxpayer to rely on a tax adviser actively involved in planning the transaction and tainted by an inherent conflict of interest. Paschall, a highly educated and successful businessman, should have realized the deal was too good to be true. Although he had doubts about the transaction, he never sought an opinion letter or the advice of an independent adviser.

References: For Roth IRAs, see FTC 2d/FIN ¶H-12290; United States Tax Reporter ¶408A4; TaxDesk ¶283,301; TG ¶8601. For effect of failure to file return on assessment period, see FTC 2d/FIN ¶T-4101; United States Tax Reporter ¶65,014.14; TaxDesk ¶838,011; TG ¶70549. For reasonable cause excuses for certain civil penalties, see FTC 2d/FIN ¶V-2750; United States Tax Reporter ¶66,514.06; TaxDesk ¶868,500.