Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

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AviN
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Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by AviN » Mon Mar 07, 2016 7:51 am

In an interview with Christine Benz about Backdoor Roth IRA's back in January, Michael Kitces says: "We’ve heard from a couple of people now who just on a random audit had an IRS agent come in saw it [a Backdoor Roth IRA contribution], caught it, said uh uh that’s not appropriate, and the people actually had unwound it, in part because it was easier to unwind it than fight the IRS which is expensive compared to a $5500 IRA contribution."

Source: http://www.morningstar.com/cover/videoc ... ?id=741998

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by Toons » Mon Mar 07, 2016 8:00 am

Very Informative.
Learned a lot.
Thanks :happy
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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by am » Mon Mar 07, 2016 8:34 am

Seems to me like the agents are inappropriate since it is within the law. Will this change anyone's plan to do future back door Roths or even unwind some of their current positions?

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by JonnyDVM » Mon Mar 07, 2016 8:35 am

That was a very vague "A couple of people had problems". It didn't say what else they were audited for. I'm not scared of an audit. I do worry that the loophole will get closed. However, as the article notes, there really hasn't been any sort of successful tax policy changes in quite some time. I'm not acutely fine tuned into tax policy but the backdoor roth seems like a relatively small fish to come after.
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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by Grt2bOutdoors » Mon Mar 07, 2016 8:39 am

Fastest way to self-promote is to scream "fire" when a wisp of smoke arises from a few errant papers on the ground.
Prove it with fact that it's illegal, being vague with some auditor frowned during the audit does not mean or prove illegality.
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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by BTDT » Mon Mar 07, 2016 8:47 am

am wrote: Will this change anyone's plan to do future back door Roths or even unwind some of their current positions?
As I told my troops, when bullets are flying close to your head keep you head down. No, I will not stop or unwind :oops:
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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by midareff » Mon Mar 07, 2016 8:51 am

am wrote:Seems to me like the agents are inappropriate since it is within the law. Will this change anyone's plan to do future back door Roths or even unwind some of their current positions?

Nope, last year, this year and next year. Once I hit RMD in 2018 I'll be at 25% and do not consider it beneficial.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by retiredjg » Mon Mar 07, 2016 9:05 am

This is an informative video and everyone using the back door should watch it. People using the back door need to know this has happened at least once.

At this point, there is no indication this is a "crackdown" or that many auditors are doing the same thing. For all we know, there are thousands of random audits where the auditor was not concerned at all that a back door contribution may have happened.

Until there is something more definitive from the IRS, I can't see a reason for people to stop using the back door. When/if the IRS decides to challenge this procedure (as opposed to what might be one auditor's finding in one audit based only on personal opinion instead of official policy), word will get out. When/if Congress decides to close the loophole they created, word will get out.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by HueyLD » Mon Mar 07, 2016 9:08 am

retiredjg wrote:Until there is something more definitive from the IRS, I can't see a reason for people to stop using the back door. When/if the IRS decides to challenge this procedure (as opposed to what might be one auditor's finding in one audit based only on personal opinion instead of official policy), word will get out. When/if Congress decides to close the loophole they created, word will get out.
I agree.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by siamond » Mon Mar 07, 2016 9:38 am

I got troubles with the link in the OP, but I found another one, where the transcript is available.
http://www.morningstar.com/advisor/v/11 ... estors.htm

Seems to me that the audit quote was taken a bit out of context. Kitces was making a reassuring point that it is rather unlikely that a possible future change in congress would be retroactive. And the audit statement came a bit out of the blue in this context.

Here is the full quote:
The good news--at least for people that have been doing this over time: It almost certainly won't go retroactive if only because it's very hard for the IRS to even track these down retroactively. We've heard from a couple of people now who just on random audit had an IRS agent come in, saw it, caught it, said, that's not appropriate, and the people actually had unwound it in part because it was easier to unwind it than to fight the IRS, which is expensive compared to a $5,500 IRA contribution.

So, a crackdown on this probably won't go retroactive. It would probably just say, going forward, no more new Roth conversions of aftertax dollars as of this date, maybe starting next calendar year or something to that effect.

But I think it's only a matter of time before it happens. Unfortunately, the strategy has gotten out there. It's now on the radar screen in Washington. Congress has been very clear that it is not something that they intended to happen.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by wolf359 » Mon Mar 07, 2016 9:52 am

I think this discussion is focusing on the wrong part of the interview. The point isn't that there's some hearsay about some people who got audited and reversed it. Kitces provides valuable information about the grounds that the IRS would use to object to the practice, as well as how to avoid running afoul of it.

The IRS precedent is called "The Step Transaction Rule." If an affluent investor is prohibited from contributing to a Roth IRA due to income restrictions, but instead follows a series of legal actions to get around the prohibition, the IRS will attempt to disallow it because it violates that original prohibition. A backdoor Roth conversion is exactly that.

The solution is to STOP BACKDOOR ROTH IRAs. Do nothing to circumvent the Roth IRA contribution limits.

Invest in non-deductible IRAs because you're out of deductible space, and want the tax-deferred compound interest on earnings. Invest those funds for the long term, in equities. This is a legitimate, legally defensible action, and it has nothing to do with trying to avoid any income prohibitions. (There are NO income limits on non-deductible IRAs.) If, after a year or more has passed, you change your mind and decide to convert all your non-deductible IRA holdings to a Roth IRA -- well, that's not a backdoor contribution. That is a change in your investment strategy, if you believe that it is appropriate to make it at that time.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by ryman554 » Mon Mar 07, 2016 10:23 am

wolf359 wrote:I think this discussion is focusing on the wrong part of the interview. The point isn't that there's some hearsay about some people who got audited and reversed it. Kitces provides valuable information about the grounds that the IRS would use to object to the practice, as well as how to avoid running afoul of it.

The IRS precedent is called "The Step Transaction Rule." If an affluent investor is prohibited from contributing to a Roth IRA due to income restrictions, but instead follows a series of legal actions to get around the prohibition, the IRS will attempt to disallow it because it violates that original prohibition. A backdoor Roth conversion is exactly that.

The solution is to STOP BACKDOOR ROTH IRAs. Do nothing to circumvent the Roth IRA contribution limits.

Invest in non-deductible IRAs because you're out of deductible space, and want the tax-deferred compound interest on earnings. Invest those funds for the long term, in equities. This is a legitimate, legally defensible action, and it has nothing to do with trying to avoid any income prohibitions. (There are NO income limits on non-deductible IRAs.) If, after a year or more has passed, you change your mind and decide to convert all your non-deductible IRA holdings to a Roth IRA -- well, that's not a backdoor contribution. That is a change in your investment strategy, if you believe that it is appropriate to make it at that time.
Except that that still fails the IRS "step transaction" test for the reason that, upon initially contributing the non-deductible moneys, it was presumably impossible to contribute directly to a ROTH. No rational investor would choose to place money in an account which has tax-deferred growth when one has a tax-free growth available, along with *better* access to the invested basis.

No, "undoing" this transaction or "changing ones mind" would not be to covert tIRA funds to a ROTH a year later; it would be but an extension of the intended plan. "Changing ones mind" would be removing it from the tIRA completely and investing anew in a different platform; be it taxable, tIRA or ROTH.

So, I give you that you could perhaps do this "not a backdoor" for one year, as long as you have a year in which you meet the ROTH criteria. But if all you do is wait one year before converting, and do this every year, well, that duck still quacks and looks the same.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by swl » Mon Mar 07, 2016 10:48 am

More compelling argument is if the money is invested for that year, the variance would make the final result sufficiently different from a direct $5500 deposit into a Roth. Therefore to would be unreasonable to "merge" the steps into a direct Roth contribution.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by retiredjg » Mon Mar 07, 2016 10:56 am

ryman554 wrote:But if all you do is wait one year before converting, and do this every year, well, that duck still quacks and looks the same.
I too think it is a duck. But Kitces' suggestion is based on a previous IRS ruling. In that case (not back door) they ruled that a 1 year delay made the duck seem like a swan. Paraphrased, of course. :happy

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by wolf359 » Mon Mar 07, 2016 10:58 am

ryman554 wrote: Except that that still fails the IRS "step transaction" test for the reason that, upon initially contributing the non-deductible moneys, it was presumably impossible to contribute directly to a ROTH. No rational investor would choose to place money in an account which has tax-deferred growth when one has a tax-free growth available, along with *better* access to the invested basis.
That's the point. If you're maxing out your 401K and other retirement space, all you have access to is either non-deductible traditional IRA or a taxable account. You can't do a backdoor Roth without failing the step transaction test. So don't.

I'm not talking about undoing the transaction. I'm talking about actually investing in a TIRA for the long-term.
So, I give you that you could perhaps do this "not a backdoor" for one year, as long as you have a year in which you meet the ROTH criteria. But if all you do is wait one year before converting, and do this every year, well, that duck still quacks and looks the same.
You do a conversion just once, if it is appropriate for your financial situation. You don't do anything to provide grounds for the IRS to argue a step transaction. You don't have to meet the Roth contribution criteria, just the Roth conversion criteria in the year you do it.

Waiting a year and converting, then repeating it year after year gives the IRS grounds to claim you're trying to conduct a step transaction.

So does labeling your account "BACKDOOR ROTH CONVERSION ACCOUNT".

Don't do either of those things. Don't think in terms of cheating the system. You're not doing that.

Invest in the best tax-deferred vehicles available to you. If the non-deductible TIRA is it, invest in that. Invest for the long-haul. If it makes sense at some time in the future to convert your TIRA holdings to a Roth IRA, convert them.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by hulburt1 » Mon Mar 07, 2016 11:24 am

A little help. I'm 62 had to put $4000 in last year IRA for tax reasons. I'm now going to move about $10000 from IRA to a ROTH for this year. I do work, is that ok?

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by Spirit Rider » Mon Mar 07, 2016 11:41 am

Robert Keebler and Michael Kites have been spewing this FUD for as long as backdoor Roth's have been available. Last I knew someone else had told Mr. Keebler a while ago about a case where the agent wanted the Roth conversion re-characterized. So at this point this is fourth or fifth hand vague information at best. Who knows what the actual circumstances were.

I'm not buying it. This looks like typical IRS tax season propaganda to scare the masses before tax season. Watch within the next month the MSM (force fed by the IRS) will all trot out some IRS enforcement action on some other topic. It happens every year like clock work.

There is no reference to this issue in the 2015-2016 PRIORITY GUIDANCE PLAN. This issue does not exist in any guidance or audit training. To my knowledge this issue has never been raised by the IRS in any guidance, bulletins, or even agency informal Q&As (which are not binding) at tax/accounting conferences.

If these anecdotal reports are even true and on point, they are one offs and the tax payers were wussies to give in to the agent.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by dodecahedron » Mon Mar 07, 2016 11:54 am

Spirit Rider wrote: If these anecdotal reports are even true and on point, they are one offs and the tax payers were wussies to give in to the agent.
This judgment is unwarranted. Bear in mind that it appears from Kitces' reference that these audits were not originally triggered by the backdoor Roth. The IRS has very limited enforcement resources and most audits of taxpayers who fall in the backdoor Roth income category involve much larger issues. Presumably some much larger tax issue was the original trigger for the audit. Taxpayers who have hired a tax professional to represent them at an audit on a complicated return where large monetary consequences are at stake on other issues may well decide it is less expensive to concede on a particular (relatively minor and arguable) issue than to pay additional fees to their tax pro to continue to deal with the relatively minor issue, allowing their tax pros to spend the bulk of their time and energy on the bigger issues.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by EddyB » Mon Mar 07, 2016 12:32 pm

Spirit Rider wrote: There is no reference to this issue in the 2015-2016 PRIORITY GUIDANCE PLAN. This issue does not exist in any guidance or audit training. To my knowledge this issue has never been raised by the IRS in any guidance, bulletins, or even agency informal Q&As (which are not binding) at tax/accounting conferences.
Not knowing the specifics of the underlying (alleged?) instance, I won't dismiss the possibility that some confounding factors could make a particular backdoor Roth merit IRS scrutiny. However, I find it hard to credit the idea of a generalized IRS objection, given all the attention the backdoor Roth has received for half a dozen years. I am curious whether anyone here who has been a regular user of the backdoor Roth technique has been audited, or has represented an audit client, without any objection from the agent(s).

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by retiredjg » Mon Mar 07, 2016 12:50 pm

For those who missed it, Kitces described the audit(s) as random.

EddyB wrote:I am curious whether anyone here who has been a regular user of the backdoor Roth technique has been audited, or has represented an audit client, without any objection from the agent(s).
I'm curious about this too. Surely this forum has the most concentrated number of back door users available. Surely someone has been audited.

Come to think of it, it seems odd that nobody has posted anything about an audit in the last 6 years - surely that would have gotten a lot of attention no matter which way the auditor went.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by ryman554 » Mon Mar 07, 2016 1:05 pm

retiredjg wrote:For those who missed it, Kitces described the audit(s) as random.

EddyB wrote:I am curious whether anyone here who has been a regular user of the backdoor Roth technique has been audited, or has represented an audit client, without any objection from the agent(s).
I'm curious about this too. Surely this forum has the most concentrated number of back door users available. Surely someone has been audited.

Come to think of it, it seems odd that nobody has posted anything about an audit in the last 6 years - surely that would have gotten a lot of attention no matter which way the auditor went.
I have been audited.. =)

By the state of Oregon, likely for incorrectly representing ESOP income that was later fixed in an ammended filing. But they audited my moving expenses. No muss no fuss.

Of course, I didn't do the backdoor roth back then, so..... I now return you to the original thread.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by madbrain » Mon Mar 07, 2016 1:20 pm

Conversion contributions to Roth IRAs are treated differently than direct Roth IRA contributions by the IRS. The rules for withdrawals are different, for example.

IMO, one can use this to make the case that the 2-step transaction process is not equivalent to a direct contribution.

So, I'm not really sure how the "step transaction" doctrine can really apply here.

If the IRS wants to make the case that the 2-step process is equivalent to a direct contribution, the law doesn't support that claim, IMO. But I'm not a CPA or lawyer.
Last edited by madbrain on Mon Mar 07, 2016 1:21 pm, edited 1 time in total.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by sb2010 » Mon Mar 07, 2016 1:20 pm

I was picked for random (lucky me :)) Audit last year.
They initially tagged the withdrawal from IRA as ordinary income and also indicated my ESPP base as wrong.
I provided documents showing IRA was converted to Roth and ESPP base calculation was correct with 10% discount added and both were accepted and charges reversed.
Btw, I had a lawyer to represent me.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by neurosphere » Mon Mar 07, 2016 1:25 pm

madbrain wrote:Conversion contributions to Roth IRAs are treated differently than direct Roth IRA contributions by the IRS. The rules for withdrawals are different, for example.

IMO, one can use this to make the case that the 2-step transaction process is not equivalent to a direct contribution.

So, I'm not really sure how the "step transaction" doctrine can really apply here.

If the IRS wants to make the case that the 2-step process is equivalent to a direct contribution, the law doesn't support that claim, IMO. But I'm not a CPA or lawyer.
I think this is a compelling point.
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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by DaftInvestor » Mon Mar 07, 2016 1:29 pm

sb2010 wrote:I was picked for random (lucky me :)) Audit last year.
They initially tagged the withdrawal from IRA as ordinary income and also indicated my ESPP base as wrong.
I provided documents showing IRA was converted to Roth and ESPP base calculation was correct with 10% discount added and both were accepted and charges reversed.
Btw, I had a lawyer to represent me.
Out of curiosity - when you do your backdoor do you convert immediately or wait the 12 months that is sometimes recommeded?

In this video the statement is made to wait 12 months (Motley Fool and other places recommend this as well) before converting so if you are ever questioned you can state that you made two decision - one to invest then a second decision to make the conversion. Seems to me this is still making one decision and making this kind of statement for me would be false anyway because I would only make the T-IRA contribution in order to move to Roth. Just because I waited 12 months to try to make it look like 2-steps seems silly.

OP: Thanks much for sharing this video.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by Longdog » Mon Mar 07, 2016 1:35 pm

There is a time-limit of October 15 of the following year for undoing a Roth conversion for a particular year. By the time an audit completes for a given return, wouldn't that date most likely be passed? Can the IRS override that portion of the law using the step doctrine? How would that transaction occur?
Steve

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by sb2010 » Mon Mar 07, 2016 1:44 pm

DaftInvestor wrote:
sb2010 wrote:I was picked for random (lucky me :)) Audit last year.
They initially tagged the withdrawal from IRA as ordinary income and also indicated my ESPP base as wrong.
I provided documents showing IRA was converted to Roth and ESPP base calculation was correct with 10% discount added and both were accepted and charges reversed.
Btw, I had a lawyer to represent me.
Out of curiosity - when you do your backdoor do you convert immediately or wait the 12 months that is sometimes recommeded?

In this video the statement is made to wait 12 months (Motley Fool and other places recommend this as well) before converting so if you are ever questioned you can state that you made two decision - one to invest then a second decision to make the conversion. Seems to me this is still making one decision and making this kind of statement for me would be false anyway because I would only make the T-IRA contribution in order to move to Roth. Just because I waited 12 months to try to make it look like 2-steps seems silly.

OP: Thanks much for sharing this video.
I did my conversions within a week.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by DaftInvestor » Mon Mar 07, 2016 1:49 pm

sb2010 wrote:
DaftInvestor wrote:
sb2010 wrote:I was picked for random (lucky me :)) Audit last year.
They initially tagged the withdrawal from IRA as ordinary income and also indicated my ESPP base as wrong.
I provided documents showing IRA was converted to Roth and ESPP base calculation was correct with 10% discount added and both were accepted and charges reversed.
Btw, I had a lawyer to represent me.
Out of curiosity - when you do your backdoor do you convert immediately or wait the 12 months that is sometimes recommeded?

In this video the statement is made to wait 12 months (Motley Fool and other places recommend this as well) before converting so if you are ever questioned you can state that you made two decision - one to invest then a second decision to make the conversion. Seems to me this is still making one decision and making this kind of statement for me would be false anyway because I would only make the T-IRA contribution in order to move to Roth. Just because I waited 12 months to try to make it look like 2-steps seems silly.

OP: Thanks much for sharing this video.
I did my conversions within a week.
Excellent - thanks.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by Epsilon Delta » Mon Mar 07, 2016 2:21 pm

If you're doing a backdoor Roth for consecutive years I can't see how waiting 12 months would help. There is nothing that associates a particular conversion with a particular contribution. If the step transaction doctrine is applicable the IRS is free to associate the conversion with the nearest contribution. It could be treated as a first non-deductible contribution made long ago and left in the traditional IRA followed by a series of backdoor Roths with no delay. Maybe you should wait 6 months. :shock:

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I did face a "Form 1040 inquiry" re backdoor Roth

Post by PugetSoundguy » Mon Mar 07, 2016 2:42 pm

I wasn't technically audited, but did face what the IRS called a "Form 1040 inquiry." The problem was that the way I characterized a backdoor Roth conversion in TurboTax was inadvertently incorrect, leading the IRS computer to believe that I had taken an early IRA distribution and therefore owed more tax. The fault was clearly mine for not double-checking the manner in which TurboTax reported the data I entered. I talked to an IRS representative on the phone, explained exactly what we had done (the backdoor Roth procedure; we did it shortly after opening the traditional IRA) and what I was trying to report on the 1040. The representative was incredibly helpful and responsive. She figured out immediately what had happened and told me how to file the proper form with supporting documentation to straighten the matter out. A couple of weeks later, I got a notice stating: "Your 20XX Form 1040 inquiry is closed. Amount due: $0.00. Thank you for the response to the notice we sent you about your 20XX (Form 1040) taxes. We're pleased to tell you that the information you provided resolved the tax issue in question and that our inquiry is now closed." The form also noted, as did the telephone representative, that "This wasn't an audit. Your return may be examined in the future. Please keep this notice and your documentation in a secure place with your other important documents."

So I don't know what the IRS official position would be in a technical audit, but here is an anecdotal example of a backdoor Roth conversion where the IRS representative knew exactly what I was trying to accomplish and directed me to the proper way to report the transaction. As I said, she was very knowledgeable and helpful. If she had said there were some substantive problem with the backdoor conversion in our case, I of course would have followed her instructions to straighten out the matter.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by Leesbro63 » Mon Mar 07, 2016 3:09 pm

It seems to me what's going on here is a conflict between three tax periods. The earliest tax law was only willing to let higher earners contribute to an IRA without a tax deduction and with only a deferral of tax on the earnings. Later law allowed for contributions to an IRA without any tax ever on the earnings (original ROTH IRA legislation), but only for non-higher earners. The most recent tax law let ALL earners convert either of the two other types to a Roth, allowing the government to collect taxes now in turn for none ever again. My own non-legal and non-CPA opinion is that the backdoor Roth is legal under current law. Without enacting further legislation, there's really no way to make the legal case that it's any different than converting "old" Roth money. What's "old"? That can't be determined under current law.

I guess the "actionable" issue here is whether or not to take a chance that this will trigger an audit and/or if it will be disallowed. My own thinking is that until this is definitively determined to be improper, I would do it. The worst that can happen if it's determined that backdoor Roth IRAs are not permissible...retroactively...is that you'll be no worse off. Although the taxes that would then be due on the earnings might make it seem that you are. And I guess there COULD be penalties. Even if an auditor says "no" without a definitive tax law change, most do not want to be the test case, but the downside is not much worse than having not done the backdoor Roth at all. My own guess is that if this does ever definitively get clarified or changed, prior actions will be let alone. Again, I am not a lawyer or CPA so don't make decisions based on my bloviating here.


EDIT: This FORBES article from 13 months ago makes an interesting point that basically says that attempts to end the ability to do backdoor Roth IRAs affirms the current validity of backdoor Roth IRAs unless and until any such attempt becomes law.

"One unintended consequence of trying to kill off backdoor Roths is that the Administration has in effect given a tacit validation to the strategy, says IRA expert and CPA Ed Slott. “It seems to me they’re saying that was a good workaround, but we don’t want you to do it anymore,” he says."

http://www.forbes.com/sites/ashleaebeli ... d53dc557a3

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by White Coat Investor » Tue Mar 08, 2016 3:53 am

DaftInvestor wrote:
sb2010 wrote:
DaftInvestor wrote:
sb2010 wrote:I was picked for random (lucky me :)) Audit last year.
They initially tagged the withdrawal from IRA as ordinary income and also indicated my ESPP base as wrong.
I provided documents showing IRA was converted to Roth and ESPP base calculation was correct with 10% discount added and both were accepted and charges reversed.
Btw, I had a lawyer to represent me.
Out of curiosity - when you do your backdoor do you convert immediately or wait the 12 months that is sometimes recommeded?

In this video the statement is made to wait 12 months (Motley Fool and other places recommend this as well) before converting so if you are ever questioned you can state that you made two decision - one to invest then a second decision to make the conversion. Seems to me this is still making one decision and making this kind of statement for me would be false anyway because I would only make the T-IRA contribution in order to move to Roth. Just because I waited 12 months to try to make it look like 2-steps seems silly.

OP: Thanks much for sharing this video.
I did my conversions within a week.
Excellent - thanks.
I do mine the next day. For 7 years straight now. Come audit me. If I get audited, I'll go to tax court and we'll finally get a definitive answer. All it costs is my time. You don't HAVE to hire a lawyer to go to tax court. Here's the deal though, the only way to close this loophole is to change the rules back to what they were pre-2010. If the Tax Court says you have to wait a month, we'll all wait a month. If they say a year, we'll all wait a year. Whatever. It's all the same to me. It's a far better idea to just eliminate the income limit on direct Roth IRA contributions. Way easier way to "close the loophole."
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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by dodecahedron » Tue Mar 08, 2016 7:23 am

White Coat Investor wrote: I do mine the next day. For 7 years straight now. Come audit me. If I get audited, I'll go to tax court and we'll finally get a definitive answer. All it costs is my time. You don't HAVE to hire a lawyer to go to tax court. Here's the deal though, the only way to close this loophole is to change the rules back to what they were pre-2010. If the Tax Court says you have to wait a month, we'll all wait a month. If they say a year, we'll all wait a year. Whatever. It's all the same to me. It's a far better idea to just eliminate the income limit on direct Roth IRA contributions. Way easier way to "close the loophole."
Tax Court memoranda (TCM) are useful references but they are not "definitive answers."
A TCM is an opinion of the tax court that is not officially published but is available from commercial publishers. As unofficial publications TCMs are not supposed to have precedential value nor are they supposed to be cited. TCMs are deemed to be unofficial decisions not worthy of official publication because the issue decided is considered well settled.

It is the policy of the tax court to not cite TCMs in official "regular" opinions (a published opinion written by one tax court judge that represents the ruling of the entire court) or "reviewed" opinions (a published opinion that is reviewed by all the judges of the tax court) since TCMs are not supposed to have precedential value. However, despite this policy, tax court opinions do sometimes cite TCMs. Moreover, the sitting chief judge of the tax court was quoted as making remarks, a few years back, that taxpayers should not discount the value of TCMs in advocating a position in tax court.
Source: http://www.americanbar.org/newsletter/p ... ndley.html

Additional content deleted by dodecahedron in the light of more complete and correct technical information from bsteiner and alfaspider below.
Last edited by dodecahedron on Tue Mar 08, 2016 4:32 pm, edited 1 time in total.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by czeckers » Tue Mar 08, 2016 7:36 am

Our backdoor Roth IRA contribution got flagged last year. It got flagged because they saw the withdrawal from the traditional IRA and stated we owed income tax on it. I told them that it was a conversion of a non-deductible TIRA contribution to a Roth IRA and pointed out that this was documented on form 8606 which was submitted with the original return. That was the end of the matter.

They didn't seem to have a problem with the backdoor part of the transaction.

-K
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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by eskouster » Tue Mar 08, 2016 8:29 am

I incorrectly filled out my Form 8606 one year, and the IRS sent a notice that I had underpaid my taxes. But I just corrected my 8606 and the IRS accepted it.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by bsteiner » Tue Mar 08, 2016 9:11 am

I know both Michael Kitces, Bob Keebler and Ed Slott. They're all knowledgeable, but none of them is a lawyer.

This is an interesting issue, but I don't expect to see anything definitive on it any time soon. There aren't very many backdoor Roth IRAs, the amount involved in each one is small, and there's nothing to call attention to when a taxpayer does one. Anecdotal experiences one way or the other don't count for much.
dodecahedron wrote:... Tax Court memoranda (TCM) are useful references but they are not "definitive answers."
...
For an authoritative definitive judicial opinion, it is necessary to go a regular federal court, which does require an attorney, and which is subject to appeal by either party. Tax Court is a less formal alternative (administrative law rather than judicial law), does not require an attorney, cannot be appealed, and does not set precedent.
Unless you elect small case treatment, Tax Court cases are either "regular" or "memorandum." I think about half are "regular" and about half are "memorandum." Either can be appealed.

The taxpayer may elect small case treatment in the Tax Court if the amount involved is $50,000 or less. Those cases can't be appealed.

The taxpayer may generally choose among the Tax Court, the regular Federal District Court, or the U.S. Court of Federal Claims.

The Tax Court travels around the country to hear cases. There's no jury, the procedure is somewhat less formal, the judges are specialized, the IRS defends the cases, you don't have to pay first, and appeal lies to the Circuit Courts.

In the District Courts, the courts are local, you can get a jury, the judges aren't specialized, the Justice Department defends the case (except in the Southern District of New York the U.S. Attorney's office defends the case), appeal lies to the Circuit Courts, and you have to pay first and seek a refund.

In the Court of Federal Claims, the court is in Washington, D.C., there's no jury, the judges are semi-specialized (they hear claims against the United States), the Justice Department defends the case, appeal lies to the Federal Circuit, and you have to pay first and seek a refund.

You can go to any of these courts without a lawyer, though as a practical matter it's much easier to do so in the Tax Court.

The taxpayer's lawyer should advise as to the best choice of forum for a given case.

Before you get to court, if you don't resolve your case on audit, the IRS has an Appeals Division which handles administrative appeals. Most cases that aren't resolved on audit are settled in Appeals. Most cases in Appeals are handled by lawyers, but anyone authorized to practice before the IRS (such as CPAs and enrolled agents) may represent taxpayers in Appeals, and taxpayers may represent themselves in Appeals if they wish.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by alfaspider » Tue Mar 08, 2016 10:22 am

dodecahedron wrote:
For an authoritative definitive judicial opinion, it is necessary to go a regular federal court, which does require an attorney, and which is subject to appeal by either party. Tax Court is a less formal alternative (administrative law rather than judicial law), does not require an attorney, cannot be appealed, and does not set precedent.
I am a tax attorney, though I will state up front that I do corporate and international tax, so the issues specific to retirement accounts are not my area of expertise.

The paragraph I quoted above isn't quite right. The U.S. Tax Court is an Article I Federal Court, it is not an administrative body (like IRS Appeals). Although no court technically requires an attorney if you are representing yourself, it is my opinion (and likely that of most practitioners) that you are a fool to walk into Tax Court unrepresented. There are so many ways you could shoot yourself in the foot without even realizing it. Rulings of the Tax Court DO set precedent (although they do not bind other Federal Courts) unless they are unpublished (TCMs) and they may be appealed to the appropriate U.S. Court of Appeals (though see above note on small case treatment). A regular District Court, being a non specialist in tax matters, is also likely to place great weight on a finding of the Tax Court on a tax-specific legal issue.

If a Roth conversion case were to end up in a published Tax Court opinion, it wouldn't necessarily settle the matter for all time, but you would be hard pressed to find a tax attorney who would give you a favorable opinion on a next day conversion if the Tax Court applied the step transaction doctrine to a closely-timed contribution and conversion in a published ruling.

As for the specific substantive issue, I'm not about to give anybody specific advice on the internet. The application of substance over form doctrines is always highly facts-specific, and usually fraught politically. Everyone should do their research, talk to their tax adviser, and consider their personal comfort level on the issue.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by lack_ey » Tue Mar 08, 2016 10:47 am

Epsilon Delta wrote:If you're doing a backdoor Roth for consecutive years I can't see how waiting 12 months would help. There is nothing that associates a particular conversion with a particular contribution. If the step transaction doctrine is applicable the IRS is free to associate the conversion with the nearest contribution. It could be treated as a first non-deductible contribution made long ago and left in the traditional IRA followed by a series of backdoor Roths with no delay. Maybe you should wait 6 months. :shock:
You could make it 12 months in a chain of contributions by bunching IRA contributions.

In January 2016, contribute 2015 and 2016 IRA limits all at once. In January 2017, do the conversion. In January 2018, contribute 2017 and 2018 limits. In January 2019, do the conversion.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by bottlecap » Tue Mar 08, 2016 11:21 am

Apparently, Kitces isn't the only one who enjoys dancing on the head of a pin. But at least he gets paid for it!

If Kitces continues to scream from the mountain tops that this technique, which is likely used by only a tiny fraction of taxpayers who would even be eligible to do it, is a travesty of justice, perhaps he will fulfill his own prophecy. And then he can tell us how he had been right all along. Until then, I'm tuning out of this basically decade-long argument.

JT

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by Dulocracy » Tue Mar 08, 2016 12:44 pm

After reviewing this thread, I am still of the opinion that a backdoor Roth is permissible. I will continue to make the contributions and then convert for both myself and my wife. I agree, however, that changing the law to allow for direct contribution for all would be best, but until that happens, we will continue with what is available.
I'm not a financial professional. Post is info only & not legal advice. No attorney-client relationship exists with reader. Scrutinize my ideas as if you spoke with a guy at a bar. I may be wrong.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by dodecahedron » Tue Mar 08, 2016 2:06 pm

alfaspider wrote:
dodecahedron wrote:
For an authoritative definitive judicial opinion, it is necessary to go a regular federal court, which does require an attorney, and which is subject to appeal by either party. Tax Court is a less formal alternative (administrative law rather than judicial law), does not require an attorney, cannot be appealed, and does not set precedent.
I am a tax attorney, though I will state up front that I do corporate and international tax, so the issues specific to retirement accounts are not my area of expertise.

The paragraph I quoted above isn't quite right. The U.S. Tax Court is an Article I Federal Court, it is not an administrative body (like IRS Appeals). Although no court technically requires an attorney if you are representing yourself, it is my opinion (and likely that of most practitioners) that you are a fool to walk into Tax Court unrepresented. There are so many ways you could shoot yourself in the foot without even realizing it. Rulings of the Tax Court DO set precedent (although they do not bind other Federal Courts) unless they are unpublished (TCMs) and they may be appealed to the appropriate U.S. Court of Appeals (though see above note on small case treatment). A regular District Court, being a non specialist in tax matters, is also likely to place great weight on a finding of the Tax Court on a tax-specific legal issue.

If a Roth conversion case were to end up in a published Tax Court opinion, it wouldn't necessarily settle the matter for all time, but you would be hard pressed to find a tax attorney who would give you a favorable opinion on a next day conversion if the Tax Court applied the step transaction doctrine to a closely-timed contribution and conversion in a published ruling.
Thanks to both alfaspider and bsteiner for correcting my misunderstanding of the nuances of how Tax Court works. It now occurs to me that I have seen Tax Court opinions both with and without the disclaimer that they do not serve as precedent and alfaspider and bsteiner's posts have clarified how that distinction works.

The point I was trying to make, however, was reinforced by their observations. A taxpayer representing himself in Tax Court is very unlikely to win the case in a manner that authoritatively and definitively answers a tax controversy. In general, taxpayers who represent themselves can occasionally win a decision in their favor but it is hard to think of any significant definitive precedent set in Tax Court by such folks.

A few years ago, there was a celebrated case of a nurse wanting to deduct her MBA tuition who successfully represented herself against the IRS in Tax Court and surprised a lot of folks, but it could not be appealed and technically it was not a binding precedent, so it is a bit of a stretch to say that she got a generally definitive answer. That said, it is worth noting that she and White Coat Investor have a good deal in common: articulate and tenacious medical professionals who like to argue. :D
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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by White Coat Investor » Tue Mar 08, 2016 2:14 pm

The reason someone might do something like this without an attorney is that the penalty is less than the attorney fee, so why not try it? Otherwise, it's cheaper to just pay the penalty than the attorney.

That said, when I go to court on this, which one of you is going to come defend me and thus all Bogleheads pro bono? :) Surely one of you is up for it. You could get a little niche fame.
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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by hornet96 » Tue Mar 08, 2016 2:16 pm

Well, the backdoor Roth is something that even Vanguard itself recognizes as a legitimate tool available to high-income earners:

https://personal.vanguard.com/us/insigh ... oth-112014
Vanguard wrote:IRS income limits restrict high-income investors from making Roth contributions. However, there are no income restrictions on conversions. These investors can contribute through the back door by making a nondeductible traditional IRA contribution and then converting to a Roth IRA.

From a tax standpoint, this strategy works best if you don't have other traditional IRA assets, because otherwise part of the conversion would be subject to income tax.
Obviously this isn't authoritative literature, but it does indicate to me just how "mainstream" this procedure is becoming. Apparently the couple of IRS auditors cited in the story were not properly trained on these rules when they conducted their audits (assuming the purely anecdotal references are true and accurate).

If I am ever audited on this, I would be tempted to start my defense* by pointing the IRS to the link above, as well as the video linked therein where several Vanguard officials discuss this procedure at great lengths. Bottom line is that if this violates the so-called "step-doctrine" under existing law (which I don't believe it does), then Vanguard (and probably all the other large investment houses) would need to also be investigated for recommending illegal tax sheltering advice.

Also, as pointed out earlier, the very fact that the President's budget proposal mentioned "closing this loophole" as a means of raising tax revenue gives the existing backdoor Roth procedure even more legitimacy as a legal mechanism under existing law.

*Ok, lawyers, I know this isn't a real "defense." But I do believe that many (most?) of the IRS field auditors would probably need some education on this topic, as it seems that (as previously mentioned by others) there isn't even anything in the examination procedures/manuals that cover backdoor Roth conversions.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by dodecahedron » Tue Mar 08, 2016 2:20 pm

White Coat Investor wrote:The reason someone might do something like this without an attorney is that the penalty is less than the attorney fee, so why not try it? Otherwise, it's cheaper to just pay the penalty than the attorney.

That said, when I go to court on this, which one of you is going to come defend me and thus all Bogleheads pro bono? :) Surely one of you is up for it. You could get a little niche fame.
Actually, I think White Coat Investor would get far more fame if he somehow pulled it off (kind of a "man bites dog" news story) and it would be a big promotion for his already very successful blog. If WCI loses, I don't think there's much downside because he wouldn't be expected to win. (No one ever covers the "man doesn't bite dog" stories.)

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by JonnyDVM » Tue Mar 08, 2016 2:20 pm

White Coat Investor wrote:The reason someone might do something like this without an attorney is that the penalty is less than the attorney fee, so why not try it? Otherwise, it's cheaper to just pay the penalty than the attorney.

That said, when I go to court on this, which one of you is going to come defend me and thus all Bogleheads pro bono? :) Surely one of you is up for it. You could get a little niche fame.
I'm not an attorney but I'd be more than willing to come and throw you under the bus if it gets me out of trouble with the IRS :D I say this because I literally just got off the phone with our new accountant who called to ask about the backdoor Roth conversion I did. She went into a little spiel about how most people wait a year to convert you shouldn't really do it right away yada yada yada... I ended up sending her a link to your tutorial.
Sometimes the questions are complicated and the answers are simple. -Dr. Seuss

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by alfaspider » Tue Mar 08, 2016 3:27 pm

hornet96 wrote:
If I am ever audited on this, I would be tempted to start my defense* by pointing the IRS to the link above, as well as the video linked therein where several Vanguard officials discuss this procedure at great lengths. Bottom line is that if this violates the so-called "step-doctrine" under existing law (which I don't believe it does), then Vanguard (and probably all the other large investment houses) would need to also be investigated for recommending illegal tax sheltering advice.
That's probably a poor strategy. Kind of like telling the cop who pulled you over that everyone else is doing 10 over.

If merely discussing the steps of a transaction that could potentially be attacked under one of the substance over form doctrines constituted "illegal tax sheltering" advice, then most of the investment banks, accounting firms, and law firms in the country would have to be investigated. It's not unusual or illegal for an adviser to propose a transaction that has a degree of tax risk- investment banks are notorious for this. That's different from trying to sell a listed transaction or tax shelter where there is little genuine dispute as to the proper tax treatment. If an institution is going around issuing "will" level opinions for a fee when they know the transaction is likely subject to attack, that's the kind of thing that could get them into trouble.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by JamesSFO » Tue Mar 08, 2016 4:18 pm

I guess one question would be, do these IRS agents think there is ANY amount of time to wait to convert that would be ok (and thus avoid the step transaction doctrine)? If not, then they are just ignoring the statute which allows people to convert without limit, which was a clear change in the law.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by dodecahedron » Tue Mar 08, 2016 4:28 pm

alfaspider wrote:
hornet96 wrote:
If I am ever audited on this, I would be tempted to start my defense* by pointing the IRS to the link above, as well as the video linked therein where several Vanguard officials discuss this procedure at great lengths. Bottom line is that if this violates the so-called "step-doctrine" under existing law (which I don't believe it does), then Vanguard (and probably all the other large investment houses) would need to also be investigated for recommending illegal tax sheltering advice.
That's probably a poor strategy. Kind of like telling the cop who pulled you over that everyone else is doing 10 over.
Indeed, given that Vanguard is currently facing well-publicized tax controversy litigation of its own, and given that Vanguard includes its usual disclaimer at the bottom of any tax-related article telling you that you should "consult your tax advisor about your individual situation," it is clear that Vanguard is not holding itself out as a credential tax advisor and you would be on extremely shaky ground citing Vanguard's advice as any kind of legal authority for your tax position.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by dodecahedron » Tue Mar 08, 2016 4:29 pm

dodecahedron wrote:
alfaspider wrote:
hornet96 wrote:
If I am ever audited on this, I would be tempted to start my defense* by pointing the IRS to the link above, as well as the video linked therein where several Vanguard officials discuss this procedure at great lengths. Bottom line is that if this violates the so-called "step-doctrine" under existing law (which I don't believe it does), then Vanguard (and probably all the other large investment houses) would need to also be investigated for recommending illegal tax sheltering advice.
That's probably a poor strategy. Kind of like telling the cop who pulled you over that everyone else is doing 10 over.
Indeed, given that Vanguard is currently facing well-publicized tax controversy litigation of its own, and given that Vanguard includes its usual disclaimer at the bottom of any tax-related article telling you that you should "consult your tax advisor about your individual situation," it is clear that Vanguard is not holding itself out as a credentialed tax advisor and you would be on extremely shaky ground citing Vanguard's advice as any kind of legal authority for your tax position.

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Re: Michael Kitces says IRS auditors disapprove of Backdoor Roth IRA's

Post by hornet96 » Tue Mar 08, 2016 4:31 pm

alfaspider wrote:
hornet96 wrote:
If I am ever audited on this, I would be tempted to start my defense* by pointing the IRS to the link above, as well as the video linked therein where several Vanguard officials discuss this procedure at great lengths. Bottom line is that if this violates the so-called "step-doctrine" under existing law (which I don't believe it does), then Vanguard (and probably all the other large investment houses) would need to also be investigated for recommending illegal tax sheltering advice.
That's probably a poor strategy. Kind of like telling the cop who pulled you over that everyone else is doing 10 over.

If merely discussing the steps of a transaction that could potentially be attacked under one of the substance over form doctrines constituted "illegal tax sheltering" advice, then most of the investment banks, accounting firms, and law firms in the country would have to be investigated. It's not unusual or illegal for an adviser to propose a transaction that has a degree of tax risk- investment banks are notorious for this. That's different from trying to sell a listed transaction or tax shelter where there is little genuine dispute as to the proper tax treatment. If an institution is going around issuing "will" level opinions for a fee when they know the transaction is likely subject to attack, that's the kind of thing that could get them into trouble.
As expected, a lawyer jumps in on a couple of sentences and completely misses the point of a post. (I knew this would happen, which is why I added the asterisk. This kind of thing is becoming quite tiresome on this forum.)

Yes, indeed, I know for a fact that accounting firms are routinely "investigated" (or whatever term of art you chose) for the kind of tax advice they are giving to their clients (see: EY and its "VIPER" group, PwC and its Catepillar case....only a couple of the big obvious examples). Many other finance companies are investigated for the legality of their advice regarding offshore accounts and such (UBS, Deutsche Bank....others).

What we're talking about IN THIS PARTICULAR THREAD are a couple of individual IRS field auditors who apparently don't know that the backdoor Roth mechanism is WIDELY VIEWED as being within the confines of the existing rules (as in, no such official "step doctrine" ruling has been applied to any conversions that I'm aware of, nor is any guidance given on this topic in their field manuals). The examples I provided were merely intended to provide some context as to how the EXISTING RULES ARE WIDELY BEING INTERPRETED BEYOND THESE INDIVIDUAL FIELD AGENTS' OPINIONS (and as noted in my asterisk, would not be intended for use as a "real" defense).

Look, is there some gray area as to whether backdoor Roth conversions should be permissible? Sure. However, at the current present, even the President (and his army of lawyers, economists, tax advisers, etc.) thinks they are permissible under current law; otherwise, why would this show up in his proposed budget (rather than in some kind of executive order directing the IRS to put a stop to this practice?). I know that doesn't mean anything in court, but it does provide a hint that perhaps these particular IRS agents cited in the article have overstepped their bounds without being properly challenged on it. That is the main point I was trying to express (albeit in fewer words than this).

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