More On Legal & Compliancefrom The Advisor's Professional Library
- Updating Form ADV and Form U4 When it comes to disclosure on Form ADV, RIAs should assume information would be material to investors. When in doubt, RIAs should disclose information rather than arguing later with securities regulators that it was not material.
- The Custody Rule and its Ramifications When an RIA takes custody of a clients funds or securities, risk to that individual increases dramatically. Rule 206(4)-2 under the Investment Advisers Act (better known as the Custody Rule), was passed to protect clients from unscrupulous investors.
Traditional IRAs allow deferral of income tax on contributions, but that deferral ends when assets are withdrawn from the account. However, in recent years Congress has given individuals the option of converting a traditional IRA accounts to a Roth IRA, paying income tax on the amount rolled over into the Roth. In contrast to a traditional IRA, withdrawals of both principal and income can be made tax-free.
The attraction of Roth conversion is muted by the fact that the taxpayer has to pay tax on the lump sum that’s rolled over into the Roth. But what if you could convert a traditional IRA to a Roth IRA without paying income tax on the conversion?
Various schemes to do just that have been sold to taxpayers in recent years but they have almost invariably failed, as discovered by the Swansons, who took their dispute over a Roth conversion to the Tax Court.
Mr. Swanson was approached by an accountant with a proposal to convert a traditional IRA with over a million dollars into a Roth IRA, which would permit tax-free withdrawals from the account, saving Mr. Swanson hundreds of thousands of dollars in income tax liability.
Although Mr. Swanson was aware that the Roth IRA contribution limit was only $2,000 at the time the Roth Restructure transaction was entered into, he nevertheless agreed to participate in the scheme, paying $120,000 to the accounting firm for a Roth Restructure.
The accounting firm agreed to defend Mr. Swanson if the transaction was challenged by the IRS and also agreed to indemnify him for any civil negligence or fraud penalties assessed against him by the IRS or state taxation authorities. Mr. Swanson ended up holding the firm to that promise.
The Roth Restructure
Mr. Swanson was the beneficiary of a thrift savings plan (TSP) through his employer and various other investment accounts. Withdrawals from any of those accounts would be taxed to Mr. Swanson. The Roth Restructure was supposed to convert those taxable amounts to nontaxable amounts held in a Roth account.
A series of corporations were formed as part of the restructure; Mr. Swanson was made president, secretary and treasurer of the corporations. Mr. Swanson then opened both Roth and traditional IRAs. He funded the traditional IRA with a rollover from his other retirement accounts. He then directed the IRA to purchase $1.2 million of stock in one of the corporations.
Then, through a complex series of maneuvers involving the IRA, Roth IRA and corporations formed as part of the restructure, Mr. Swanson transferred about $1.6 million from tax deferred accounts to Roth accounts.
The Roth Restructure Gets “Listed”
In 2004, the accounting firm informed Mr. Swanson that the Roth Restructure was potentially a “listed transaction” under a recent IRS Notice (Notice 2004-8). But when Mr. Swanson discussed the transaction with his attorneys, they concluded that his restructure was not covered by the notice. He did not seek advice about the Roth Restructure from anyone else.
Despite assurances from his attorneys that his transaction was not covered by the notice, Mr. Swanson disclosed his participation in the Roth Restructure to the IRS as a listed transaction.
State and IRS Audits and Tax Court Case
The California Franchise Tax Board audited the Swansons’ return but concluded that “no change” was in order. Despite clearance of the Roth Restructure by California, the IRS issued notices of deficiency to the Swansons showing $1.2 million in deficiencies and about $240,000 in accuracy-related penalties.
The Swansons appealed the accuracy-related penalties to the Tax Court. Under the Tax Code, a taxpayer can be subject to a 20% accuracy-related penalty when the taxpayer negligently disregards the tax rules and regulations. The Swansons argued that they had relied on the advice of the accounting and law firms that implemented the Roth restructure.
But the Tax Court believed that Mr. Swanson had not exercised “due care” in taking the position he did on his tax return. Mr. Swanson did not make a good faith investigation of the accountancy firm’s claims about the transaction and did not otherwise look into what should have appeared on its face to be a suspect tax avoidance transaction.
In short, Mr. Swanson repeatedly expressed doubts about the legality of the Roth restructure transaction but never asked for a formal opinion letter or sought assurances from other professionals before entering into the transaction.
The moral of the story? If it looks like a duck and quacks like a duck … take it to the vet and verify that it truly is a duck.
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See also The Law Professor's blog at AdvisorFYI.