Notice 2005-1: Abusive Roth IRA Transactions

The Internal Revenue Service (IRS) issued guidance in Notice 2004-8 to address a specific type of abusive tax avoidance scheme involving Roth Individual Retirement Arrangements (IRAs). The notice identifies arrangements designed to circumvent statutory contribution limits. The IRS has categorized this scheme as a “listed transaction,” a designation signaling to taxpayers that the agency will challenge the purported tax benefits claimed from such arrangements.

Transactions Identified in the Notice

The structure of the transaction includes an individual taxpayer, a business they own, a Roth IRA for that taxpayer, and a new corporation almost entirely owned by the Roth IRA. The core of the scheme is to artificially shift value from the taxpayer’s existing business into the new corporation held within the Roth IRA. This is done to bypass annual contribution limits.

This is accomplished through non-arm’s-length transactions between the taxpayer’s business and the corporation owned by the Roth IRA. For instance, the business might sell valuable assets to the Roth IRA’s corporation for a price below fair market value. In other variations, the business might contribute property to the Roth IRA-owned corporation without receiving a proportional ownership interest in return. The effect of these actions is a disguised contribution of value to the Roth IRA.

For example, a taxpayer with a profitable consulting firm establishes a Roth IRA and forms a new corporation, with all its stock placed inside the Roth IRA. The consulting firm then sells its future client billings, worth $500,000, to the new corporation for only $10,000. This transaction moves $490,000 of value into the Roth IRA, bypassing contribution limits and allowing it to grow tax-free.

The IRS will scrutinize any arrangement that has the effect of transferring value to the corporation owned by the Roth IRA in a way that is comparable to a contribution. The IRS views these structures as a method to artificially shift taxable income away from the business and into the shelter of the Roth IRA. The notice covers the specific examples described and any “substantially similar transactions” that achieve the same outcome.

Tax Consequences of the Transaction

The IRS may assert that the arrangement is a “prohibited transaction.” This occurs because the transfer of value between the taxpayer’s business and an entity owned by their IRA is considered improper dealing between the IRA and a “disqualified person,” which includes the IRA owner and entities they control.

If a prohibited transaction occurs, the entire Roth IRA can be disqualified as of the first day of that year. This means the IRA ceases to be an IRA, and its entire fair market value is treated as a taxable distribution to the taxpayer. This deemed distribution is fully taxable in the year of the prohibited transaction, potentially pushing the individual into a higher tax bracket.

The IRS can also impose a 6% excise tax on excess contributions. If property transferred to the Roth IRA-owned corporation was undervalued, the difference between its fair market value and the amount paid is treated as a contribution. This amount becomes an excess contribution subject to the 6% tax for each year it remains in the account.

The IRS also has the authority to tax the arrangement according to its economic substance, recharacterizing the transactions to reflect their true nature. For example, income generated by the assets transferred to the Roth IRA’s corporation could be reallocated back to the taxpayer’s business or directly to the taxpayer. This income would then be subject to income tax.

Disclosure Requirements for Participants

Because the IRS designated this scheme as a “listed transaction,” any participant is subject to mandatory disclosure obligations. This requirement applies to the taxpayer, the business involved in the transaction, and the corporation owned by the Roth IRA.

Participants must file Form 8886, Reportable Transaction Disclosure Statement. On the form, the transaction must be identified by its official name, “Abusive Roth IRA transactions,” as published in Notice 2004-8. The taxpayer must also note the tax year in which their participation began.

The taxpayer must provide a factual description of the transaction, detailing each step and identifying all parties involved, such as the taxpayer, their business, the Roth IRA, and the corporation held by the IRA. The form also requires a description of the expected tax benefits from the transaction, such as the avoidance of contribution limits and the tax-free accumulation of wealth.

How to File the Disclosure Statement

The filing process for Form 8886 involves two separate submissions. First, a copy of the completed form must be attached to the taxpayer’s federal income tax return for each year of participation. This includes the initial year the transaction was entered into and any subsequent years the taxpayer participated.

A separate copy of the same Form 8886 must also be mailed to the IRS Office of Tax Shelter Analysis (OTSA) concurrently with the tax return filing. The mailing address for this office is: Internal Revenue Service, OTSA, Mail Stop 4915, 1973 Rulon White Blvd., Ogden, UT 84404. This dual-filing requirement ensures that the IRS’s specialized unit for reviewing these transactions receives the information directly.

After filing the disclosure statement, taxpayers should be aware of the potential for increased IRS scrutiny. Submitting Form 8886 for a listed transaction increases the likelihood that the associated tax return will be selected for an examination.