IRS Notice 2005-43: Abusive Roth IRA Transactions

IRS Notice 2004-8 addresses a transaction designed to circumvent the legal limits on contributions to Roth Individual Retirement Arrangements (IRAs). The guidance identifies the scheme as a “listed transaction,” a designation for tax avoidance transactions. This classification triggers stringent disclosure requirements and imposes penalties for non-compliance. The notice serves as a warning that the IRS will challenge the purported tax benefits. It puts all parties involved—the individual, their business, and any advisors—on notice that their participation must be reported.

The Abusive Transaction Identified

The transaction targeted by the IRS involves a specific set of parties and a sequence of steps. The structure requires three participants: an individual taxpayer, a business owned by that individual, and a Roth IRA established for the same individual. A key element is the creation of a separate corporation, substantially owned by the Roth IRA, which serves as a vehicle to facilitate the transfer of value from the taxpayer’s main business.

The scheme unfolds as the individual’s business engages in a non-arm’s-length transaction with the corporation owned by the Roth IRA. A common example involves the business selling its assets, such as accounts receivable, to the Roth IRA’s corporation for an amount significantly below their fair market value. This artificially shifts value from the operating business to the entity held within the tax-free Roth IRA structure.

In other variations, the business might contribute property to the Roth IRA-owned corporation without receiving a commensurate ownership interest. The business then claims a tax deduction for the fair market value of the property transferred. The individual does not report the value transferred as personal income, viewing it as a valid investment activity.

The intended, but disallowed, tax outcome is for the business to secure a current tax deduction, reducing its taxable income. At the same time, the owner seeks to move value into their Roth IRA, far exceeding annual contribution limits, without recognizing taxable income on the transfer. All subsequent appreciation on these improperly contributed assets would then be sheltered from tax.

IRS Tax Treatment and Consequences

The IRS applies the “substance over form” doctrine to dismantle the claimed tax benefits. This principle allows the agency to look beyond the formal steps of an arrangement and tax it based on its underlying economic reality. The IRS recharacterizes the entire series of events, disregarding the taxpayer’s labels to reflect the true nature of the value transfer.

For the business entity, any tax deduction claimed in connection with the transaction is disallowed. The IRS asserts that the transfer of assets to the Roth IRA-owned corporation is not an ordinary and necessary business expense. Instead, the transfer is reclassified as a deemed distribution to the business owner, which is not deductible.

The fair market value of the property shifted into the Roth IRA structure is treated as a taxable distribution from the business to the owner. This amount must be included in the owner’s gross income for the year of the transaction and is subject to ordinary income tax rates, or qualified dividend rates where applicable. The owner is therefore liable for income tax on the very value they attempted to shield from taxation.

The amount transferred is not considered a valid contribution and is instead treated as an excess contribution. Excess contributions are subject to a 6% excise tax for each year they remain in the IRA. This tax is cumulative and continues to apply annually until the excess amount and its earnings are removed.

Furthermore, the IRS may classify the transaction as a “prohibited transaction,” which involves improper dealing between an IRA and a “disqualified person” like the IRA owner. Engaging in such a transaction can trigger an initial excise tax, with the potential for a 100% tax if not corrected promptly. In the most severe cases, a prohibited transaction can lead to the complete disqualification of the IRA, causing its entire value to become immediately taxable to the owner.

Disclosure Requirements and Penalties

The “listed transaction” designation imposes mandatory disclosure obligations on all parties involved. Any taxpayer who has participated in the abusive Roth IRA scheme must report their involvement to the IRS. Failure to comply carries its own penalties, applied independently of any tax or interest related to the underlying tax deficiency.

Participants fulfill this obligation by filing Form 8886, Reportable Transaction Disclosure Statement, with their federal income tax return for each taxable year their participation continues. On this form, the taxpayer must identify the transaction by its official name and number. They must also describe the transaction and provide information about the expected tax benefits and parties who advised on the arrangement.

The rules also extend to “material advisors,” any individual or firm that provides advice regarding the transaction and receives a minimum level of fees. These advisors must file Form 8918, Material Advisor Disclosure Statement, with the IRS Office of Tax Shelter Analysis. This form is due by the last day of the month that follows the end of the calendar quarter in which the person became a material advisor.

Material advisors are also legally required to maintain a comprehensive list of all clients to whom they provided advice on the transaction. This list must be made available to the IRS upon request. It must include detailed information about each client, the nature of the tax advice provided, and the potential tax benefits.

Penalties for failing to meet these disclosure requirements are substantial. For taxpayers, failure to file Form 8886 can result in a penalty of up to 75% of the decrease in tax shown on the return as a result of the transaction. For material advisors, failure to file Form 8918 or maintain the required investor list can lead to significant penalties, which are often applied on a strict liability basis.