More support for backdoor Roth? [Roth IRA Decision reversing Tax Court]

[RoboticOwl]

The first paragraph on page 14 of the Court's decision in Summa Holdings v. Comm’r of Internal Revenue (http://www.opn.ca6.uscourts.gov/opinion ... 37p-06.pdf) suggests that it might well reject any attempt by IRS to use the "substance-over-form doctrine" to disallow backdoor Roth contributions.

[FiveK]

Sure does - thanks for posting.

[TIAX]

[Thread merged into here, see below. --admin LadyGeek]

I thought I would pass along this recent decision of the Court of Appeals for the Sixth Circuit, reversing the Tax Court. This could, perhaps, be relevant to Backdoor Roths and the so-called step transaction doctrine.

The court wrote:

Caligula posted the tax laws in such fine print and so high that his subjects could not read them. Suetonius, The Twelve Caesars, bk. 4, para. 41 (Robert Graves, trans., 1957). That's not a good idea, we can all agree. How can citizens comply with what they can't see? And how can anyone assess the tax collector's exercise of power in that setting? The Internal Revenue Code improves matters in one sense, as it is accessible to everyone with the time and patience to pore over its provisions.

In today's case, however, the Commissioner of the Internal Revenue Service denied relief to a set of taxpayers who complied in full with the printed and accessible words of the tax laws. The Benenson family, to its good fortune, had the time and patience (and money) to understand how a complex set of tax provisions could lower its taxes. Tax attorneys advised the family to use a congressionally innovated corporation—a “domestic international sales corporation” (DISC) to be exact—to transfer money from their family-owned company to their sons' Roth Individual Retirement Accounts. When the family did just that, the Commissioner balked. He acknowledged that the family had complied with the relevant provisions. And he acknowledged that the purpose of the relevant provisions was to lower taxes. But he reasoned that the effect of these transactions was to evade the contribution limits on Roth IRAs and applied the “substance-over-form doctrine,” Appellee's Br. 41, to recharacterize the transactions as dividends from Summa Holdings to the Benensons followed by excess Roth IRA contributions. The Tax Court upheld the Commissioner's determination.

Each word of the “substance-over-form doctrine,” at least as the Commissioner has used it here, should give pause. If the government can undo transactions that the terms of the Code expressly authorize, it's fair to ask what the point of making these terms accessible to the taxpayer and binding on the tax collector is. “Form” is “substance” when it comes to law. The words of law (its form) determine content (its substance). How odd, then, to permit the tax collector to reverse the sequence—to allow him to determine the substance of a law and to make it govern “over” the written form of the law—and to call it a “doctrine” no less.

As it turns out, the Commissioner does not have such sweeping authority. And neither do we. Because Summa Holdings used the DISC and Roth IRAs for their congressionally sanctioned purposes—tax avoidance—the Commissioner had no basis for recharacterizing the transactions and no basis for recharacterizing the law's application to them. We reverse.

[FiveK]

See also More support for backdoor Roth? - Bogleheads.org

[TIAX]

See also More support for backdoor Roth? - Bogleheads.org

Thanks for noting the other thread. According to the decision, similar cases are pending before the first and second circuits so it will be interesting to see if they similarly reverse the Tax Court.

[Alan S.]

Well, it was nice while it lasted: http://rsmus.com/what-we-do/services/ta ... overt.html

[jhfenton]

Well, it was nice while it lasted: http://rsmus.com/what-we-do/services/ta ... overt.html

I'm confused by your post. The article you link to discusses Sutton's favorable opinion. The Sixth Circuit held that form mattered when the statute was that explicit. (The Tax Court ruled in favor of the IRS. The Sixth reversed the Tax Court decision. The headline is misleading, since the Sixth held that they were not abusive transactions.)

I was going to post a link earlier in the week after I read the opinion, but I never got around to it. There is some great dicta, though, for taxpayers.

[jhfenton]

Yes. I read Sutton's opinion last week. It is outstanding. Beyond the holding, there is some great language--it's dicta, but it's still there--for taxpayers.

Seeing as I am in the Sixth Circuit, it's particularly good news if I ever need to tax advantage of the backdoor Roth.

[triceratop]

Well, it was nice while it lasted: http://rsmus.com/what-we-do/services/ta ... overt.html

I'm confused by your post. The article you link to discusses Sutton's favorable opinion. The Sixth Circuit held that form mattered when the statute was that explicit. (The Tax Court ruled in favor of the IRS. The Sixth reversed the Tax Court decision. The headline is misleading, since the Sixth held that they were not abusive transactions.)

I was going to post a link earlier in the week after I read the opinion, but I never got around to it. There is some great dicta, though, for taxpayers.

I'd also recommend giving a listen to the oral arguments, here: 6th circuit oral arguments audio.

The counsel for the commissioner was indignant that higher-income individuals and wealthy families can use the tax code to shelter income. Incidentally, counsel also stated that Roth IRAs defer mandatory withdrawal for up to 30 years, which is obviously not the case as there are no RMDs for roths.

The judge amusingly pointed out that many higher-income individuals use roth IRAs and he suspected it was primarily higher income individuals who did so (notwithstanding the contribution limits), perhaps a tap on the nose to backdoor roths?

[David Jay]

Incidentally, counsel also stated that Roth IRAs defer mandatory withdrawal for up to 30 years, which is obviously not the case as there are no RMDs for roths.

Actually, RMDs are required for the inheritor of the Roth. So 30 years is about right, a generational delay.

[triceratop]

^True, but the beneficiaries in this case were in their 20s. Point granted, though.

Also, on rebuttal the plaintiffs (Summa Holdings) explicitly mentioned tIRA rollovers to IRAs (backdoors) as a way of avoiding the income maximums for contributions, so the court was aware of this when ruling.

IANAL, but it occurs to me that much of the commissioners' case would have fallen apart had the kids initially purchased the shares in a traditional IRA and then rolled it over to a Roth before receiving the so-called commissions. Then they would have been converting $1500 in value (commissioner did not dispute valuation of shares in the holding company). Much of the indignation of the counsel for the commissioner came from their apparent avoidance of contribution limits. Of course, this technique would have infuriated the commissioner even more; but we might have had an opinion focusing more directly on Roth conversions.

[LadyGeek]

I merged TIAX's thread into here. The combined thread is in the Personal Finance (Not Investing) forum (taxes).

[jhfenton]

Well, it was nice while it lasted: http://rsmus.com/what-we-do/services/ta ... overt.html

I'm confused by your post. The article you link to discusses Sutton's favorable opinion. The Sixth Circuit held that form mattered when the statute was that explicit. (The Tax Court ruled in favor of the IRS. The Sixth reversed the Tax Court decision. The headline is misleading, since the Sixth held that they were not abusive transactions.)

I was going to post a link earlier in the week after I read the opinion, but I never got around to it. There is some great dicta, though, for taxpayers.

I'd also recommend giving a listen to the oral arguments, here: 6th circuit oral arguments audio.

The counsel for the commissioner was indignant that higher-income individuals and wealthy families can use the tax code to shelter income. Incidentally, counsel also stated that Roth IRAs defer mandatory withdrawal for up to 30 years, which is obviously not the case as there are no RMDs for roths.

The judge amusingly pointed out that many higher-income individuals use roth IRAs and he suspected it was primarily higher income individuals who did so (notwithstanding the contribution limits), perhaps a tap on the nose to backdoor roths?

Thanks. I'll give it a listen.

I really enjoyed reading the decision. I've been personally offended by the broad application of the substance over form doctrine since I took federal tax third year of law school. I understand calling a spade a spade, but the idea that you could comply with every letter of the law and then be told, nuh-uh, just didn't sit right with me.

[jhfenton]

^True, but the beneficiaries in this case were in their 20s. Point granted, though.

Also, on rebuttal the plaintiffs (Summa Holdings) explicitly mentioned tIRA rollovers to IRAs (backdoors) as a way of avoiding the income maximums for contributions, so the court was aware of this when ruling.

IANAL, but it occurs to me that much of the commissioners' case would have fallen apart had the kids initially purchased the shares in a traditional IRA and then rolled it over to a Roth before receiving the so-called commissions. Then they would have been converting $1500 in value (commissioner did not dispute valuation of shares in the holding company). Much of the indignation of the counsel for the commissioner came from their apparent avoidance of contribution limits. Of course, this technique would have infuriated the commissioner even more; but we might have had an opinion focusing more directly on Roth conversions.

I'll have to go back and review the facts and listen to the oral argument. I haven't read the briefs either. I thought the not-disputing-the-valuation aspect of it was key. I'm sure the commissioner would have loved to challenge the $1,500 valuations in the 2001 purchases by the Roths. If the commissioner had a legitimate complaint about the taxpayer's scheme, to my mind, that initial valuation was it. The substance-over-form argument was simply the last arrow the commissioner had in his quiver.

[triceratop]

^ True, statute of limitations were discussed in oral arguments as precluding the case from involving 2007 transactions; it's possible the commissioner was not able to bring forth the strongest possible case including 2001 acts.

[calif.engineer]

Anyone see the news below?

https://www.wsj.com/articles/the-secret ... 1487932202

"To lower their taxes, the brothers paired a common retirement account with an obscure export incentive. The Internal Revenue Service challenged these moves in court, arguing that even if the transactions didn’t break the letter of tax law, they violated the spirit of it.

But the transactions were upheld by the U.S. Sixth Circuit Court of Appeals. The decision, Summa Holdings Inc. v. Commissioner, provides new ballast for taxpayers who use legal techniques in ways the Internal Revenue Service objects to."

[triceratop]

See previous discussion: viewtopic.php?f=2&t=211297.

Edit: this thread has been merged into a previous discussion.

[triceratop]

I will add one point of subtlety where I think the WSJ writer / expert got it (slightly) wrong:

“It says that if there are two ways to structure a transaction and one
incurs less tax, then the IRS can’t force the taxpayer into the other
one,” says Robert Willens, an independent tax expert based in New York.

Except, no it doesn't, not really! Like, it seemed clear from the oral arguments and the decision that the decision narrowly applies only to a specific case. That is, when both transactions use congressionally-intended tax minimization strategies. I was disappointed that this aspect was left out.

The decision sure doesn't read like a complete repudiation of the substance over form doctrine.

But what do I know -- I am not a lawyer.

[FiveK]

The decision sure doesn't read like a complete repudiation of the substance over form doctrine.

Maybe, maybe not.

But the part mentioned by the OP, including

At any rate, Congress’s decision in 2005 to allow owners of traditional IRAs, who can make
contributions regardless of income, to roll them over into Roth IRAs no matter how many assets
the accounts hold or how high the owners’ incomes, see 26 U.S.C. § 408A(d)(3), undercuts this
contention. Those rollovers permit high-income taxpayers to avoid the income limits on Roth
IRA contributions, just as the DISC permitted Summa Holdings to avoid the contribution limits.

seems very direct in its support for backdoor Roths.

[triceratop]

Right, and I should clarify that my previous comment shouldn't be taken as undercutting the point that this is very good news for backdoor Roths. To be 100% clear the backdoor Roth is consistent with the test the court set up. It's just a gripe I had with the article.

[jh-1391]

I have successfully started to freak myself out over backdoor Roths. Finding this thread has given me more insight as to how the law treats them, but I'm curious.

How are most people handling their conversions if they're over Roth income limits? Do many use it systematically every year? Or do they wait to convert every few years to comply with the step transaction rule?

[rebellovw]

From all the reading that I've done - the wait period is simply silly as it is clear what the purpose of converting to the Roth is.


As far as the step issue - the step issue for other purposes is done to provide a complex path within a transaction to avoid paying something or getting some immediate benefit from the transaction. This is not true with the Roth conversion - as you follow the steps in a transaction - there is no immediate benefit. You start with say 13K - after you follow the steps - you end with 13K. During the step transaction you received no benefit. Also - it is perfectly legal to convert an IRA to a Roth period. Plain and simple - the Govt didn't completely close this off - and if they want to - they will need to change the law.

For now - it is legal from what I've read over and over.

[SlowMovingInvestor]

There is also the practical aspect of this -- millions of people have taken advantage of this loophole. It is simply impractical for the IRS to assess penalties on so many people even if backdoors were indeed not allowed (which is doubtful -- I think it's perfectly legal)

I'd guess Federal judges may have done the backdoor IRA too (given their income levels) although it shouldn't impact their judgments

[letsgobobby]

deleted

[learning_head]

I have successfully started to freak myself out over backdoor Roths. Finding this thread has given me more insight as to how the law treats them, but I'm curious.

How are most people handling their conversions if they're over Roth income limits? Do many use it systematically every year? Or do they wait to convert every few years to comply with the step transaction rule?

I normally converted within a day or two. Then last year decided to wait a bit and this year had a little more complex taxes as a result: even sitting in barely-any-interest account I got a few bucks of interest that needed to deal with on 8606. So, I am going back to converting right away and not worrying about it.

To minimize number of transactions, I do it once every 2 years - between Jan and Apr, contributing for both prior and current year and then converting both right away.

[TIAX]

To minimize number of transactions, I do it once every 2 years - between Jan and Apr, contributing for both prior and current year and then converting both right away.

You delay contributing by over a year just to avoid filing a form?

[learning_head]

To minimize number of transactions, I do it once every 2 years - between Jan and Apr, contributing for both prior and current year and then converting both right away.

You delay contributing by over a year just to avoid filing a form?

I file a tax form every year. I just prefer not to deal with contribution/conversion/purchases of 5.5k amounts every year, and instead do the same for larger 11k amount once every 2 years.

[Alan S.]

Can't say that I understand the angst over back door Roth conversion waiting periods.

If legislation eventually disallows the conversion of after tax dollars, it will certainly not be retroactive.

And if anyone is concerned that the IRS is frustrated with all the back door publicity and the term itself and wants to send a warning by invalidating someone's conversion per step transaction theory, what are the chances it is going to be YOUR particular conversion? Probably on the order of the risk of being struck by lightning the next time you walk out the door (the back door of course )