Tuesday, November 10, 2009

Tax Court Rules on Roth IRA Tax Planning

The Tax Court, in Taproot Administrative Services, Inc. v. Commissioner, 133 TC 9 (2009), has ruled that a Roth IRA is NOT an eligible shareholder for an S corporation.

An S corporation, as opposed to a C corporation, taxes its earnings on the shareholder(s) tax returns and is not typically assessed tax at the corporate level. In this case, the sole shareholder of the corporation was a Roth IRA. The IRS issued a notice revoking the S status of the corporation (and thus changing it to a C corporation) due to the “fact” that a Roth IRA cannot be an eligible shareholder (and thus none of the earnings of the S corporation would ever be taxed with this entity set-up). To be an eligible shareholder requires the shareholder to be an individual (US resident), estates, certain trusts and certain exempt organizations. This was a case of first impression with the Court.

The Court noted at the outset that there were no rules which specifically prohibited a Roth IRA from being a shareholder in an S corporation. While there are current regulations to prohibit this (Regulation § 1.1361-1(h)(1)(vii)), there were none back in 2003 (the year at issue in this case). The court relied upon a older IRS Revenue Ruling (passed in 1992) which prohibited a traditional IRA shareholder to be a shareholder in an S corporation as primary authority for ruling against the taxpayer in this case. The rationale of this older Revenue Ruling was basically that an S corporation cannot have any shareholders that are not taxed currently on any profits of the business. In fact, all shareholders, including the eligible trusts previously mentioned, had this attribute.

A Roth IRA, by definition, is not currently taxed on any of its income and, in fact, is never taxed on its income. The court reviewed the facts and Congressional intention to rule that it would not permit a Roth IRA account to be the owner of shares in an S corporation.

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