A tax plan hatched by a Kansas City-area tax advisor met disaster in Tax Court this week. The plan was the braincraft of A. Blair Stover, a former Grant Thornton tax practitioner. Mr. Stover has since come under unpleasant government scrutiny for overly-imaginative tax planning.
If everything worked out, it would have moved about $1.3 million from a traditional IRA, where it would have been taxable when withdrawn, to a permanently tax-free Roth IRA.
The plan was simple, yet absurd. When the smoke cleared, it worked like this: the taxpayer set up a new Roth IRA with a $2,000 contribution. He then had the Roth IRA and his existing traditional IRA set up new corporations. The Roth IRA-owned corporation got the $2,000 Roth contribution, while the Traditional IRA corporation got the $1.3 million in Traditional IRA assets. The Traditional IRA corporation then merged into the Roth IRA corporation. Suddenly the Roth IRA magically owned $1.3 million in assets, rather than $2,000. What could go wrong?
Mr. Paschall, the taxpayer, paid accounting firm Grant Thornton $120,000 to set up this transaction. GT's Mr. Stover took care of the paperwork details. The taxpayer probably took comfort in this from the GT engagement letter:
The engagement letter contemplated a fee of $120,000 and contained a clause providing that Grant Thornton would represent and defend Mr. Paschall or any related entity at no additional cost in case of audit by the Internal Revenue Service (IRS). The engagement letter also contained an indemnity clause providing that Grant Thornton would reimburse and indemnify the Paschalls and any related entity for any civil negligence or fraud penalty assessed against them by Federal or State authorities.
Unfortunately for the taxpayer, Mr. Stover's tax planning came under IRS scrutiny. The Tax Court explains:
In either 2003 or 2004 Mr. Paschall received a letter stating that Grant Thornton was turning over the names of people who had engaged in Roth restructures to the IRS. Mr. Stover at this time advised Mr. Paschall that the Roth restructure was legal but that he "might want to disclose on [his] income tax returns the structure". Mr. Paschall thereafter attached to Telesis' and his personal tax returns Forms 8886, Reportable Transaction Disclosure Statement.
When the taxpayer set up his Roth IRA, the annual limit for contribuitons was $2,000. The tax law applies a 6% annual penalty for excess contributions until the excess contribution and earnings are eliminated. The IRS said the $1.3 million moved into the Roth IRA was an excess contribution; over five years, that added up to $425,513 in taxes, plus another $105,000 or so in penalties.
The taxpayer naturally objected. The taxpayer first argued that the statute of limitations had expired on the tax, because he had filed timely 1040s more than three years before the assessment. The court ruled that the three-year statute never started running because he had never filed Form 5329, the form for reporting excess IRA contributions.
As for the substance of the transaction, the Tax Court said:
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 Mr. Stover, used corporate formations, transfers, and mergers in an attempt to avoid taxes and disguise excess contributions to his Roth IRA.
In upholding penalties against the taxpayer, Judge Wherry said the taxpayer should have known better:
Mr. Paschall should have realized that the deal was too good to be true. See LaVerne v. Commissioner, supra at 652-653. Mr. Paschall is a highly educated and successful businessman. He explained to this Court that because he grew up in the Depression, he was conservative with his investments and worried "about having enough money" to last through retirement. Yet he paid $120,000 for a transaction that he "did not fully understand".
Mr. Paschall had doubts, repeatedly asking whether the Roth restructure was legal. Despite these doubts, he never asked for an opinion letter or sought the advice of an independent adviser, including Mr. Jaeger, who was preparing his tax returns at the time he met Mr. Stover. This was even after he received a letter warning him that there might be problems with the Roth restructure and that his name was being turned over to the IRS.
The cost of this do-it-yourself Roth IRA conversion was a lot more than it would have been to wait until 2010 to do a legal taxable conversion of his traditional IRA. It would be interesting to know how Grant Thrornton's indemnification will hold up.
The Moral? Just the obvious:
- If it sounds too good to be true, it probably is.
- If somebody wants to sell you a tax plan, run it by a tax advisor who isn't getting a cut of the deal.
Cite: Paschall, 137 T.C. No 2.
Same result: Swanson, T.C. Memo 2011-156
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