A taxpayer recently informed us that he did a Roth conversion. After completing the conversion, he asked if the IRS could “undo” the conversion under the “step transaction” doctrine. As a side note, it is ALWAYS best to consult with your tax advisor before rather than after making a financial transaction.
The Roth Conversion: In its simplest form, a Roth conversion is when a taxpayer converts a traditional IRA to a Roth IRA. This is allowed by the Internal Revenue Code. When the conversion is made, the taxpayer incurs an income tax liability related to the untaxed earnings that have accumulated in the traditional IRA. Why would someone want to pre-pay their income taxes? Based on several factors which will not be discussed herein, it may be a sound financial decision to pay taxes today to avoid the future taxes that will be due when RMDs (required minimum distributions) are required to be made at age 70 ½ and there are also wealth transfer considerations. Remember that Roth IRAs do not have RMDs and the monies in a Roth account can be withdrawn tax-free once certain conditions are satisfied.
The taxpayer who asked the question was doing what is referred to as a “backdoor” Roth conversion. In this situation, the taxpayer is not eligible to make a Roth IRA contribution. The taxpayer then makes a non-deductible traditional IRA contribution and then (almost immediately) converts that IRA to a Roth IRA. Since the non-deductible traditional IRA likely has little or no earnings, there is little or no income tax due on the Roth conversion.
The Step Transaction Doctrine: This is a judicial doctrine that combines a series of formally separate steps, resulting in tax treatment as a single integrated event. This doctrine is often used in combination with other doctrines, such as substance over form. Thus, the taxpayer who is ineligible to make a Roth contribution as a single transaction is precluded from making the contribution by entering into a multiple of other steps to obtain the desired result. In other words, the multiple steps are collapsed into a single step.
Old and Cold: This is an unstated rule that is generally known to experienced tax practitioners. At some point, events are so old and cold that they acquire reality by themselves and cease to be part of an overall plan or transaction. How long this takes is unclear. Some practitioners would likely argue that a transaction has to be at least two tax years old. We have seen some taxpayers delay a transaction for one full year and a day in another tax year. For example, if a traditional IRA contribution is made in 2017 and the conversion occurs on January 2 in 2019, have two tax years passed? The taxpayer would argue that the step transaction and substance over form doctrines would not apply because the first step of the event occurred in the second preceding tax year.
However, the above old and cold argument is less likely to prevail if the taxpayer consistently each year converted his/her traditional IRA to a Roth IRA.
If you would like to discuss your business or personal tax planning, tax preparation and other financial concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
