Getting Around the Roth IRA Contribution Limits Isn’t As Easy As It Looks

Getting Around the Roth IRA Contribution Limits Isn’t As Easy As It Looks

Greed — Gordon Gecko opined — is good. But while that may make for a catchy movie tag line, in the real world, it’s greed that made a pariah of Kenneth Lay, a villain of Bernie Madoff, and motivates millions of Americans to look at their tax returns and think, “I need more.”

For as long as there have been tax laws, there have been those who’ve sought to circumvent the rules in search of more advantages and bigger deductions. Just ask the folks at BDO.

To illustrate, consider the Roth IRA. While I’m no retirement plan expert, I know enough toappreciate that Roth IRA’s are a kick-ass way to save money for the future. Unlike contributions to a traditional IRA, the money a taxpayercontributes toa Roth IRA is nottax deductible; however, all earnings accumulate tax-free, and all qualified distributions are tax-free. [i]It’s a trade-off most taxpayers are more than willing to take.

Of course, when Congress grants taxpayers the ability to earn tax-free growth, lawmakers are going to limit that benefit. For example, in 2012, depending on your filing status and adjusted gross income, your contribution to a Roth IRAiscappedat only$5,000 ($6,000 if 60 or older).

Although the Code does not prohibit higher contributions, I.R.C. § 4973(a) imposes an excise tax of 6% for excess contributions, computed on the lesser of (1) the amount of the excess contribution, and (2) the value of the account as of the end of the taxable year.

Since Roth IRAs came into play, taxpayers have sought ways around the annual contribution limit. Last Thursday, the Tax Court decided Repetto v. Commissioner, in which the taxpayer engaged in a series of transactions meant to avoid the cap onRoth IRA contributions and sock away excess cash. The Tax Court, however, saw through the taxpayers’ subterfuge, holding them liable for the excise tax on their excess contributions.

In Repetto, the taxpayers were real estate developers who stumbled upon a particularly inventive and aggressive CPA. A new structure was suggested whereby the Repetto’swould incorporate two new corporations that would provide management services to the Repetto’soperating corporation. The new corporations would be owned primarily by Roth IRAs established by the Repettos.

Each year, the operating company would pay fees to the new management corporations to compensate them for performing certain administrative functions. Each management corporation, in turn, would make dividend distributions of the cash to its owners, which just so happened to be the Repettos’ Roth IRA.

As a result, the Repettos were able to effectively generate $50,000 of dividend income to their Roth IRAs in 2004 and an additional $98,000 in 2005; not a bad return for an investment vehicle that was only permitted to receive a total of $6,000 in contributions during those two years.

The IRS stepped in and disallowed the administrative fee deductions to the Repettos’ operating company. The Service argued that the arrangement between the operating company and the two newly formed management companies was a sham meant to circumvent the annual contribution limitation on the Repettos’ Roth IRA. By paying the management companies for their “services” — which had until that point in time been performed by the operating company itself — the Repettos were able to get cash into the hands of their Roth IRA that would have otherwise been limited, but could now grow tax-free and be withdrawn tax-free in a later year.

In their defense, the Repettos argued that the management companies served a legitimate business purpose and that a Roth IRA was permitted by law to hold the shares of a C corporation.

The Tax Court sided with the IRS. The court determined that the formation of the management companies failed to change the underlying nature of the Repettos’ reponsibilities, as they personally performed all the services for the business both before and after the structure change.

As a result, the Tax Court concluded that the formation of the management companies was undergone strictly as a means to transfer additional value to the Repettos’ Roth IRA. Thus, the court sustained the Service’s disallowance of the administrative fee deductions to the operating company, while also holding the Repettos liable for the excise tax on the excess contributions to their Roth IRA.

The lesson? What Gecko failed to mention was that more often than not,while pigs get fed, hogs get slaughtered.