Tax Court approves lucrative Roth IRA investment strategy

Reprinted with permission from "The McGill Advisory" newsletter, April 2011.

There are tremendous tax benefits of Roth IRAs, as well as our unique strategy to maximize amounts converted from regular to Roth IRAs, while minimizing federal and state income taxes due on the conversion. Since accumulations within Roth IRAs are tax-free, it follows that doctors should utilize an investment strategy to maximize their earnings.

How then can Roth IRAs be invested to achieve that goal? While most doctors believe that Roth IRAs can be invested only in stocks, bonds, or mutual funds, that’s not the case. Roth IRA funds can also be self-directed into real estate investments, as we have previously discussed in "Making the 'Perfect Storm' Work for You — How to Create Huge Tax-Free Real Estate Profits Using a Roth IRA.” Moreover, a self-directed Roth IRA can also invest in stock of a newly formed business with the potential for producing substantial profits.

However, the IRS takes a dim view if the business owned by the doctor’s Roth IRA is doing business with the doctor’s dental practice, or any other business owned by him or her. In IRS Notice 2004-8, 2004-1 CB at 333, the IRS served warning that it would challenge transactions where the taxpayer’s preexisting business (i.e., dental practice) enters into a transaction with a business owned by the doctor’s Roth IRA “if the acquisition of shares, the transactions, or both are not fairly valued and thus have the effect of unfairly shifting value into the Roth IRA.” While IRS notices do not carry the force of law, they still must be respected by the doctor and his or her tax advisors.

Yet, a recent Tax Court case (Hellweg vs. Commissioner, TC Memo 2011-58) shows that doctors can still prevail in generating large profits from businesses owned by their Roth IRAs, even after the IRS notice. In Hellweg, the individual owners of a business entered into a set of complex transactions involving several tiers of corporations, some of which were newly formed and owned by their Roth IRAs. The regular “C” corporations owned by the Roth IRAs were an active business generating profits on their transactions with other businesses owned by the owners, and paid corporate income taxes on their profits. These “C” corporations then made substantial annual dividend payouts to the Roth IRAs that owned them, of as much as $100,000.

The IRS objected, claiming the owners used this structure as a device to improperly make excess contributions into their Roth IRAs, and sought to impose a 6% excise tax penalty. However, the Tax Court disagreed, pointing out that the IRS had not challenged the transactions for income tax purposes, and found that the arrangement did not violate the prohibited transaction rules. Accordingly, the arrangement was successful in generating huge returns from the large annual dividends, which were received and grew tax-free within the business owners’ Roth IRAs.

"The McGill Advisory" is designed to provide accurate and authoritative information with regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal or accounting advice or other expert assistance is required, the services of a competent professional should be sought.

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