Lesson From The Tax Court: Excise Tax On Messed Up IRA Rollover Different From Income Tax

The tax laws are conflicted.  They encourage retirement savings by permitting taxpayers to deduct contributions to their Individual Retirement Accounts (IRA’s).  But that encouragement is hedged by various restrictions and caps as well as a special excise tax imposed on contributions that exceed the applicable caps.  And Congress crosses its fingers if taxpayers take early distributions.  Those can result in penalties as well as inclusion in gross income.  However, Congress uncrosses those fingers if the early distributions are properly rolled into another IRA.

Given these various statutory hedges and crossed-fingers, it’s no wonder that navigating the tax rules for retirement accounts is tricky!  Particularly tricky are managing rollovers from one type of retirement plan to another.  Mistakes there can have both income tax consequences and excise tax consequences.  Thus, we must always keep straight the difference between different types of taxes, just like we saw in last week’s lesson.

This week, we learn how excise tax consequences are different than income tax consequences of a messed up IRA rollover.  In Clair R. Couturier, Jr. v. Commissioner, T.C. Memo. 2022-69 (July 6, 2022) (Judge Lauber), the taxpayer escaped a huge income tax liability for messing up some of the rollover rules because the limitation period for assessment had run, but got snagged for a $8.5 million excise tax for excess IRA contributions.  Yeah, we’re talking a lot of money here, putting enough at risk for the taxpayer to hire one of the best tax lawyers in the country to represent him.  Alas, even Lavar Taylor could not pull him out of the $8.5 million hole.  He tried to argue that the IRS was bound by the income tax characterization of the transaction.  The Court rejected that argument because...an excise tax is not an income tax.  Details below the fold. 

Law: The Income Tax Consequence of Messed Up Rollovers
Distributions from IRAs are generally taxed under the rules in §72. §408(d)(1)  That means any part of the distribution representing return of basis is excluded from gross income and the rest is included. §72(b).  If, however, the taxpayer rolls the distribution from one IRA into a second IRA within 60 days of receiving the distribution, then the distribution is ignored.  §408(d)(3)(A).

For example, in Dirks v. Commissioner, T.C. Memo. 2004-128, the taxpayer received a $118,000 distribution from one IRA on January 20, used it to help buy a home, got a $118,000 loan on the home, and put that money into a second IRA on April 4, more than 60 days after receiving the distribution.  Rejecting the taxpayer’s substantial compliance argument, the Tax Court sustained the NOD that treated the distribution as receipt of $118,000 of gross income.  If the taxpayer had not messed it up, there would be no income tax consequences of the $118,000 distribution.

Law: Excise Tax Consequences of Messed Up Rollovers
Section 219(a) gives taxpayers a deduction for qualified contributions to their IRAs.  Section 219(b)(5) caps the deduction at $5,000 ($6,000 if the taxpayer is 50 or older) and permits the IRS to adjust that cap for post-2008 inflation.  Thus, the cap for 2022 is $6,000 for folks under 50 and $7,000 for folks older than that.

If taxpayers attempt to contribute more than the cap, Congress hits them with an excise tax, found in §4973(a).  The tax is 6% of the excess amount contributed (or 6% of the fair market value of the account, if less).

Importantly, the excise tax is imposed each year until the excess contribution plus earnings is eliminated.  So the tax is not simply on the initial act of making the excess contribution, it is imposed on the continued failure to correct the problem.  And for each year where the taxpayer has excess contributions, the taxpayer is required to file Form 5329.  Only when the taxpayer files a Form 5329 does the §6501(a) three year limitation period on assessments start to run.  We know that from Paschall v. Commissioner, 137 T.C. 8 (2011).  There, the taxpayer attempted to convert a regular IRA into a Roth IRA in 2000 following a convoluted plan dreamed up and marketed by the good folks at Grant, Thornton.  Here’s how Judge Wherry explained it:

“The substance of what happened in the instant case is that approximately $1.3 million began the year in Mr. Paschall's traditional IRA and was transferred to his Roth IRA by the end of the year with no taxes being paid. Mr. Paschall did not attempt to provide a nontax business, financial, or investment purpose for what he did, and this Court cannot ascertain one. Instead, Mr. Paschall, incited by and at the urging of [Grant, Thornton’s] Mr. Stover, used corporate formations, transfers, and mergers in an attempt to avoid taxes and disguise excess contributions to his Roth IRA.*** Mr. Paschall sought to have his cake and eat it too, contributing the funds tax-free into the traditional IRA and withdrawing them tax-free from the Roth IRA, paying no tax on the conversion stratagem.” 137 T.C. at 20 (quotes omitted).

It took the IRS years to catch the error.  It sent an NOD in 2008.  The NOD asserting only an excise tax liability.  Mr. Paschall argued that the NOD was untimely because it came more than three years after He had filed his income tax return for 2000.  Judge Wherry disagreed.  Mr. Paschall’s Form 1040 for 2000 gave no hint of excess contributions subject to the excise tax. The purpose of the Form 1040 was to allow taxpayers to self-report income taxes.  But if they had excise taxes to report, than had to be done on Form 5329.  Judge Wherry emphasizes that it’s the Form 5329 that triggers the limitation period for excise taxes on excess contributions because it is “of crucial importance is whether the return, as filed, included sufficient information to allow the IRS to compute the taxpayer’s liability.” Id. at 22 (quotes omitted).  Since Mr. Paschall had never filed a Form 5329 for any year, the assessment period was still open.

Law:  Relationship Between Excise and Income Tax Consequences
Just as taxpayers like Mr. Paschall cannot have their cake and eat it too, neither can the IRS.  If the IRS investigates and treats a transaction one way for income tax purposes, it cannot later changes its mind and treat that same transaction a different way for excise tax purposes.

For example, in Hellweg v. Commissioner, T.C. Memo, 2011-58, the taxpayer ran a successful company and wanted to avoid the contribution limits to retirement accounts.  She attempted to do so through a series of transactions involving a Foreign Service Corporation (FSC), very similar to the fact pattern in Mazzei v. Commissioner, 150 T.C. 138 (2018), rev’d 998 F.3d 1041 (9th Cir. 2021).  For more on the substance of that transaction, see Lesson From The Tax Court: The Common Law of Tax, TaxProf Blog (Mar. 12, 2018).

In Hellweg, the IRS audited the taxpayer’s income tax returns and issued a no change letter, concluding that the transaction at issue did not give rise to any income tax consequences.  Later, the IRS figured out the game being played and attempted to assess the excise tax for excess contributions.  But that tax stemmed from the very same transaction that the IRS had reviewed for income tax purposes.  Judge Thornton concluded that if “[t]he Transaction [was] valid for income tax purposes, it must also be valid for purposes of section 4973.” Hellweg at 22.

Underlying Judge Thornton’s conclusion was his recognition that, while the excise tax was a different tax, it was still “intertwined with and inseparable from the income tax regime.”  Id.  Specifically, the excise tax only applied when there were excess contributions.  So, for example, if a rollover transaction was valid for income tax purposes, then it would not generate any excess contributions.  In Hellweg, the IRS had made no adjustment to income tax liabilities based on finding the transaction in question did not result in taxable distributions to the taxpayers.  So it could not then turn around and say the same transaction suddenly constituted distributions to petitioners for excise tax purposes.

The taxpayers in today’s case tried to squeeze into the Hellweg fact pattern, but that shoe did not fit.

Facts
Mr. Couturier was the president of a company owned by The Employee Ownership Holding Company, Inc. (TEOHC).  Through TEOHC he participated in four flavors of deferred compensation plans: an Employee Stock Ownership Plan; a non-qualified deferred compensation plan, an incentive stock ownership plan; and something called a Value Enhancement Incentive.  No idea what that last one is.  Maybe someone can explain in the comments?

In 2004 as part of a corporate reorganization, Mr. Couturier negotiated a buyout whereby TEOHC would contribute $26 million to his IRA in exchange for his ESOP shares and also in exchange for him relinquishing his interests in the other three plans.  Heck of a buyout.

On his 2004 income tax return, Mr. Couturier did not report any of the $26m as income.  He reported the distribution but checked the box saying it was a nontaxable rollover contribution. He did not report any amount of excise tax due nor did he submit Form 5329.  In fact, he never submitted any Form 5329’s in later years either.

As a result of a 2008 Department of Labor investigation into the ESOP, the IRS audited the ESOP in 2009 to see if it had engaged in any prohibited transactions with disqualified persons.  The 2004 transaction was part of that examination.  The IRS concluded there were no prohibited transactions but also concluded that “the value of petitioner’s stock in the ESOP was worth considerably less than $26 million, which caused the IRS to conclude that he had made excess contributions.”  Op. at 4.  Specifically, the IRS concluded that the value of the ESOP shares was about $830,000 and that the rest of the $26 million represented the value of the other three deferred compensation plans.  But those were not “qualified plans” so only the $830k was a valid rollover.  The rest was a taxable distribution.  That meant when he stashed it into his IRA it resulted in excess contributions subject to the excise tax.

The IRS did not get around to asserting all of this until 2016 which it issued an NOD for $8.5 million in excise taxes for the 11 years 2004-2014.  By that time the limitation period to assess 2004 income taxes had long expired and the IRS did not attempt to tag Mr. Couturier for any income tax liability.  Lucky him.  Still, $8.5 million is worth fighting for, so he went to Tax Court.

In Tax Court, Mr. Couturier urged Judge Lauber to find that the IRS was precluded from asserting the excise tax liabilities because it had failed to assert the income tax liabilities arising from the same transaction.

Judge Lauber resisted the urge.

Lesson:  Excise Taxes Are Not Income Taxes
Mr. Couturier first tried to argue that the interplay of the excise tax and income tax consequences on messed up rollovers were inextricably intertwined so that the IRS could not assert the excise tax without also asserting an income tax.

But excise taxes are not income taxes.  Judge Lauber pointed out that nothing in the statute, regulations, or even internal IRS guidance “makes the assertion of an income tax deficiency a precondition for determining an excise tax deficiency for the same year.”  Op. at 6.  Judge Lauber reviewed all the reasons why the IRS might actually only assert an excise tax deficiency without ever having asserted or even investigated an income tax deficiency.

Mr. Couturier next tried to argue that permitting the IRS to assert an excise tax here would allow it to take inconsistent positions, just like in Hellweg.  After all, the IRS here examined the ESOP’s returns and determined there were no prohibited transactions and thereby blessed the transaction which it now claimed gave rise to the excise tax.  Further, the IRS’s reason for the excise liability would mean that “petitioner had unreported income for 2004 in excess of the $25 million.  Because the IRS did not assert what would have been a very large deficiency in income tax, petitioner contends that the IRS is precluded as a matter of law.”  Op. at 7.

But excise taxes are not income taxes.  Here, the IRS did not take inconsistent positions with respect to the two types of taxes.  This case is like Paschall and not Hellweg.  Just like in Paschall, the IRS just never got around to auditing Mr. Couturier's the 2004 income tax return and asserting an income tax deficiency.  “The IRS’s failure to examine a return, or its failure to challenge a particular position that a taxpayer took on a return, does not constitute a concession or admission that the taxpayer’s position was correct.”  Op. at 8.

Comment:  One problem I see with Paschall is that it assumes taxpayers know they have excess contributions.  But taxpayers who mess up their rollovers will not always know it.  So if they see no reason why they messed up, they have no reason to file a Form 5329.  Taking Paschall seriously means that they are leaving themselves open forever to potential excise tax liability.  I would think, therefore, that the sensible practice would be to ALWAYS file a Form 5329 whenever there is a rollover in a given year.  Even if the amount of excise tax reported is zero, that at least starts the three-year clock in §6501.  I would be interested in reader comments on that idea.  Maybe it is something everyone already does?

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return to TaxProf Blog each Monday (or Tuesday, if Monday is a federal holiday) for another Lesson From The Tax Court.