Paul L. Caron

Monday, April 16, 2018

Lesson From The Tax Court: Better Lucky Than Good

Tax Court (2017)Most of us who are either preparing our returns last week (or today), or reviewing the returns prepared for us, honestly want to get it right. We try to be good. But just as life is complex, so is the tax shadow created by life activities and decisions. Last week’s decision in Stacey S. Marks v. Commissioner, T.C. Memo. 2018-49, is not so much a lesson about being good as it is a lesson that sometimes—just sometimes—you can get lucky.

Details below the fold.

The IRS audited Ms. Marks’ 2013 return and determined she had underreported income of $98,162 because she had received an early IRA distribution of $98,000 and she had received $162 in unreported dividends. There was no dispute about the $162, but Ms. Marks’ attorney argued her IRA distribution had been properly rolled over into a new IRA.

Here’s a summary of the facts: Ms. Marks had an IRA with Argent Trust Co. In 2013 she created a new IRA with Equity Trust Co. It appears both of these were self-directed IRAs. Ms. Marks then attempted to roll over her Argent account holdings into the new account. To accomplish the rollover she directed Argent to distribute the IRA assets to her. In December 2013, Argent did so, sending Ms. Marks: (1) cash of $96,508; (2) a promissory note in the face amount of $40,000 from Ms. Marks’ dad reflecting a loan made in 2005 by Argent using IRA funds; and (3) a promissory note in the face amount of $60,000 from one of Ms. Marks’ friends, reflecting a second loan made in 2012 by Argent, again using IRA funds.

Many readers are probably familiar with the rollover rules in §408 much better than I am. For those who are not, here’s a nice IRS website explanation. The best rollover method is for the old IRA custodian to send the assets to the new IRA custodian without the taxpayer ever having to touch the money. The other method is to have the old IRA custodian distribute the IRA to the taxpayer. The taxpayer then must put those funds into the new IRA within 60 days of the distribution.  Subject to the many complexities that cause only the stout-hearted to do ERISA work, the distribution must be reported as income under the applicable rules for that IRA.  §408(d)(3)(A).  

The method chosen by Ms. Marks is not really a good method because of the old saying “there is many a slip twixt cup and lip.” I am guessing that the promissory notes were what prevented her from the plan-to-plan rollover. I welcome any comments on that idea.

The bottom line was that while Ms. Marks successfully rolled over the cash, she was not able to transfer the promissory notes into the new IRA account within that time period. Her inability to roll over the notes meant that she should have reported their distribution as income. The IRS did not explain why it valued the notes at $98,000 instead of their face value of $100,000 and the opinion is also opaque about what happened to the notes. The opinion says her attorneys argued that the notes were successfully rolled over, but nothing more. So whether the notes were somehow transferred in or whether they were paid off and the proceeds later transferred to the new IRA is an unknown.

But here is where Ms. Marks got lucky. Judge Morrison spotted an issue that both parties had overlooked: was the 2005 loan from the old IRA to her dad a prohibited transaction per §4975(c)? The Judge asked the parties to brief the matter and both the taxpayer (natch!) and the government agreed: the loan was a prohibited transaction. The consequence was to disqualify the fund as an IRA in 2005. §408(e)(2)(A). The consequence of that was the government’s concession that Ms. Marks’ 2013 income “should not include a taxable distribution from the Argent account because that account was not an IRA in 2013.” On that basis, Judge Morrison did not sustain the deficiency.

How lucky is this? It’s luckier than you may think. First, and most obviously, it means that Ms. Marks did not have to report the $98,000 (the assumed value of the two promissory notes) as income in 2013, thus avoiding about $42,000 in taxes and penalties. Second, since the distribution was from a non-IRA account, and since the IRS was valuing the notes at less than their face value, the distribution contained no reportable earnings or gains. Sweet. Third, Ms. Marks escaped the earlier tax she should have paid because of the 2005 prohibited transaction. That is, although Ms. Marks received a constructive distribution of IRA assets in 2005---and should have reported that amount as income in 2005 as well as pay the applicable excise tax imposed by §4975---that year is now closed so she got that distribution tax-free as well. Even sweeter! Fourth, it means that while Ms. Marks should have reported all earnings in the now-disqualified IRA account each year from 2006 to 2013, all of those are now closed years as well. Sweeter still.  Sixth (!): consider that $96,508 cash distribution from Argent that Ms. Marks received in 2013. Was any of that income? Well, probably only a small amount because she still gets taxed cost basis for the prior years’ earnings that she should have, but did not, report as gross income. See Farid-Es-Sultaneh v. Commissioner, 160 F.3d 812 (2nd Cir. 1947)(in calculating gain on sale of stock, taxpayer was allowed to use fair market value of the stock when received as compensation in prior year even though taxpayer did not report receipt as income or pay tax thereon in the prior year).  Sweetness  perfection! 

Folks, try to be good. Try to get it right. But if you mess up, may the luck of Ms. Marks be with you!

Coda: Of course, Ms. Marks must take the bitter with the sweet. There is some potential bitterness here because if the old IRA was no longer an IRA in 2013, than I don’t see how she could “roll over” that $96,508 cash she received. When she took that cash and put in into the newly created Equity Trust Co. IRA account, I would think it was most likely an excess contribution. Section 4973 imposes an excess tax of 6% on excess contributions to an IRA. This is not an area I know very well but it appears from the statute that the computation of “excess contribution” is designed so that the excise tax gets imposed each year in which a prior year’s excess contribution remains uncorrected. I welcome comments on whether my understanding of how that works is correct. But if I am correct in my understanding, then Mrs. Marks probably needs to (1) fix the excess contributions problem and (2) filed amended returns for the open years to report and pay the excise tax. But even that, I suspect, will be less than the $42,000 in taxes that she escaped ... by getting lucky.

Bryan Camp is George H. Mahon Professor of Law at Texas Tech University School of Law

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Nice article. But in the count of how lucky Ms. Marks got, what happened to fifth?

Posted by: Avi | Apr 16, 2018 6:40:55 AM

@Avi: Sorry about that, chief. I don't know what happened to the fifth. The bottle was full yesterday. Or, maybe someone stole it! Someone who---wait for it, wait for it---really needed to take the fifth?? Or maybe in the heat of blogging I just lost count. Yeah, that's probably it. I promise to do better next time!

Posted by: Bryan Camp | Apr 16, 2018 6:57:24 AM

I blogged this case the day it came out on As to the notes, check the trust agreement setting up the IRA. Many trustees only want cash or marketable securities; some will accept closely-held securities. Private debt instruments and similar billets doux create headaches for trustees, and many won't take them.

Posted by: lew taishoff | Apr 16, 2018 7:39:36 AM

Great article! I just wanted to add that you are completely correct on the final part; the cash distribution wouldn't have been an eligible rollover distribution and therefore would be subject to the 6% excise tax on excess contributions. The tax is computed each year until the excess is removed.

Moreover, the tax is reported on Form 5329, which has actually been held to be a stand alone return since it has its own signature line. That means the statute of limitations wouldn't run until the Form is actually filed. The excess is reduced each year by the amount of eligible contribution the account holder could, but didn't, make for the year (i.e., maximum of $5,500 for 2017 plus $1,000 catch-up). Though that isn't much help with large excess contributions like we have here.

Nevertheless, I'd have to imagine you are correct in that the excess contribution penalty is well below what she otherwise would have (and frankly should have) faced.

Posted by: Jeremy Rodriguez | Apr 16, 2018 12:31:50 PM

Very interesting article but I am wondering how a company could permit a prohibited transaction in 2005?

Posted by: Peter Alessandro | Apr 17, 2018 10:16:33 AM

"Subject to the many complexities that cause only the stout-hearted to do ERISA work"... Made my day. Now I can skip that annual physical... I'm adding it to my ERISA lawyers quotes file.

Posted by: Dean Burri | Apr 20, 2018 4:22:53 AM

Great article. I don’t know much in this area of law; obviously it is very complex and kudos to all who are stout-hearted enough to deal with it. One thing that struck me – If I had been the attorney for Ms. Marks, I would have been somewhat embarrassed at not having seen this argument and having the judge point it out………………………

Posted by: Virginia La Torre Jeker, J.D. | Apr 22, 2018 1:40:58 AM

As a tax attorney that has worked heavily in this self-directed IRA area for 13+ years, I can tell you that the fact-pattern presented in this case is not unusual - although most of these situations never make it to tax court (and/or into the view of the IRS at all).

Several comments:
(1) An IRA-to-IRA "in-kind" transfer of assets (e.g., Notes) is absolutely possible, but it is extremely dangerous (as illustrated by the case) to execute that plan without first getting the "thumbs up" from the old and new IRA custodian. In this case, my guess is that ETC saw the Note between IRA and the IRA owner's dad and said "heck no!" (side note: that is one of the most obvious prohibited transactions there is - how it got by Argent in the first place is crazy!).
(2) There have been cases where the IRS has prevailed on the statute of limitations (SOL) issue by arguing that the SOL never expired because the prohibited transaction continued on a continuous basis (e.g., a disqualified person guaranteed IRA debt and the problem continued indefinitely; see Peek vs. Commissioner) - and it seems to me that they could have argued the same thing here.
(3) I definitely agree that the IRA owner cannot "rollover" the cash to a new IRA if the IRA cease to exist in 2005 (or anytime thereafter). However, if the only downside is the 6% excess contribution penalty, it's possible that the IRA owner actually earned a BETTER return than 6% annual return in years 2013-2018 (generally good economic/investment years), so she could still end up better off!
(4) The biggest long-term downside to this IRA owner is that she will have lost the ability to grow the account tax-free (assuming UBTI isn't applicable) long-term - particularly if she is relatively young - although getting all of the funds out tax free (except for the 6% penalty) is probably an even bigger win.
(6) [see what I did there?! :) ] This is an illustration of how the easiest way for a self-directed IRA owner to get audited is for the IRS to see a tax form (e.g., Form 1099-R from Argent) that appears inconsistent with another tax form (e.g., the IRA owner's 1040 and/or ETC's 5498). I see this quite frequently when it comes to Form 1099 (related to earnings within the SDIRA or SDIRA-owned entity) and Schedule K-1s. Unfortunately, these tax forms often falsely show the IRA owner's social security number and/or some other technical problem, which can lead to the IRS asking questions that should have never been asked in the first place!

Thanks for your blog posts - excellent, as always!

Posted by: Warren L. Baker | Apr 23, 2018 4:18:02 PM