Tax Court Decision Provides Lessons for Roth IRA Owners

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The Tax Court determined that a tax payer named Brian Polowniak created a C-Corporation called Bevco essentially for the sole purpose of trying to override his Roth IRA yearly contribution limits, as was evident through a fee-for-services agreement used by Bevco, and the way that payments were funneled through the Bevco into the Roth IRA.

The Backfill: Before the creation of Bevco, Polowniak created an S-Corp called Strategies, which provided business strategy consulting services. In 2001, Strategies entered into a $680,000 contract with a company called Delphi Automotive Systems for Polowniak’s consulting services. In December of 2001, Polowniak created the C-Corp called Bevco. In the same month Polowniak also created a Roth IRA, and added an initial $2,000 contribution.

In March of 2002, he directed his Roth to buy 98% of Bevco’s stock. Then, Bevco and Strategies entered into a subcontracting agreement with a retroactive effective date of January of 2002. Strategies would pay Bevco 75% of the revenue it received from its anticipated consulting contract with Delphi. In exchange for revenue Bevco was to provide “certain specified services” to Strategies – which Polowniak would personally provide. Delphi was never made aware of Strategies’ and Bevco’s contract agreement.  Curiously, the court did not mention the self dealing between Polowaniak and his Roth owned company Bevco, nor the agreement between Strategies and Bevco as being one that, both sides of which were negotiated by Polowaniak himself as being prohibited transactions.

Historically tax courts have enforced the idea that if a series of transactions seem to be shams or have no purpose beyond the anticipated tax consequences, then they are not recognize for federal tax purposes. Bevco never had an address, email account, or phone number assigned to it, meaning it clearly had no intention on marketing itself to other clients beyond Strategies. Bevco’s only source of revenue was from Strategies.

At the end of 2002, Delphi and Strategies entered into another contract. During the 2002 tax season, Bevco's elected to defer prepaid income until it was earned. In January of 2003, Strategies transferred the entire Delphi contract payment into Bevco's checking account ($680,000). The following year Strategies did the exact same thing with the second Delphi contract payment, and transferred an additional $680,000 into Bevco's checking account. Delphi expected Polowniak to personally perform the consulting services, and was still unaware of Bevco’s existence.

The Verdict: Polowniak's individual returns for 2002 through 2004 didn't report any additional tax on IRAs, nor did he file any Forms 5329 to disclosing excess contributions into his Roth IRAs. The tax court upheld IRS's determination that Polowniak's failure to file Form 5329 resulted in him being liable for penalties under Code Sec. 6651(a)(1) (failure to file) and Code Sec. 6651(a)(2) (failure to pay), as well as for enhanced accuracy-related penalties under Code Sec. 6662A for understatements attributable to listed transactions.

Take-Aways: There are three main mistakes that IRA owners should understand about this court case. The first involves Polowniak’s C-Corp Bevco entering into a contract with his S-Corp Strategies. An IRA holder cannot personally provide any goods or services to his or her IRA. By using his personal business Strategies to provide income to his C-Corp Bevco, which in turn funneled all of its revenue into Polowniak’s Roth IRA, Polowniak was engaging in an IRS prohibited transaction.

The second is the fact that Polowniak’s C-Corp Bevco was very clearly a sham corporation that was set up for the sole purpose of funneling more money than what is allowed by annual contribution limits into his Roth IRA, where it could remain tax-free. IRA-owned C-Corps must be legitimate corporations that have a real economic purpose and real economic transactions to support the purpose in order to stay off of IRS radar.

The third is Polowniak not filing a Form 5329 to disclose excess contributions into his Roth IRA. The money from Strategies’ and Bevco’s contract that was funneled into his Roth IRA count as over-contributions, and are subject to tax and sometimes penalty. The annual contribution limit for Roth IRAs at the time Polowniak made his contribution was under $3,000 – far less than the two contributions of  $680,000 that Polowniak had made.

Education is the first step to making sure you stay within legal bounds with your IRA’s transactions. When in doubt, reach out to a tax professional or your IRA provider to get the right answers. Exercise due diligence to find a credible IRA provider whose history and expertise and you can trust. Please don't hesitate to contact New Direction Trust Company at 877-742-1270 or with any questions or concerns that you may have.