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Royalty Payments Reclassified as Excess Roth IRA Contributions under Substance over Form Doctrine

(Parker Tax Publishing August 2017)

The Tax Court recharacterized royalty payments to a partnership owned by a family's individual Roth IRAs as excess contributions to the Roth IRAs, thus finding the family members liable for the excise tax on excess contributions. The arrangement failed the substance over form test in Notice 2004-8 because the partnership was only a conduit to divert funds to the Roth IRAs. Block Developers, LLC v. Comm'r, T.C. Memo. 2017-142.


Jan Jansson is an engineer who patented a design for Verdura Blocks, a retaining wall system consisting of interlocking concrete blocks. Jansson currently sells the blocks at 30-40 outlet stores. Jansson originally formed an S corporation that he named Soil Retention Systems, Inc. He subsequently split his business into different S corporations (SR businesses) in order to minimize potential liability. One of the companies, Soil Retention Products (SR Products), has 30 employees and manufactures and distributes the blocks. The other companies include a company that rents equipment to Jansson's other businesses and a company that handles design work for particular jobs. Jansson's wife and two children are employed in various roles in these companies. Each business is technically run as a separate unit of Jansson's overall enterprise but the businesses share office space and management and resources. In addition, much of the SR businesses' documentation bears only the name of "Soil Retention."

Jansson hired Bill Maxam, a lawyer and entrepreneur, as his estate planner. Jansson's goal was for his businesses to survive his retirement. Jansson had previously considered selling his patents but a deal never materialized. Maxam came up with a complicated plan for Jansson's retirement. First, Maxam bought two of Jansson's most successful patents. Next, each member of the Jansson family opened a Roth IRA. Maxam then formed a partnership, Block Developers, LLC, and each Jansson Roth IRA acquired an equal interest in Block Developers. Maxam was also a partner in Block Developers. Jansson sold his patents to Block Developers for $250,000 and SR Products entered into a licensing agreement with Block Developers to pay a 10 percent royalty on its sales of Verdura Blocks. Block Developers paid for the patents in large part by allowing SR Products to reduce its royalty payment by $249,000. From 2001 through 2007, SR Products paid around $1.2 million to Block Developers in royalties, $800,000 of which went into the Janssons' Roth IRAs.

On their individual tax returns for 2005 and 2006, none of the Janssons reported excess contributions to their Roth IRAs. In December 2008, the IRS sent each of the Roth IRAs, as partners of Block Developers, a notice of beginning of administrative proceeding (NBAP) to notify them that it was auditing Block Developers' 2005 tax return. Less than a year later, the IRS also sent NBAPs to the IRAs for Block Developers' 2006 return.

In December 2009, NBAPs were sent to each Jansson individually to provide notice that Block Developers' 2005 and 2006 returns were being audited. The IRS advised that the NBAPs were untimely, and that the Janssons could elect to have their items in the partnership treated as nonpartnership items. Each Jansson opted out of the partnership proceeding for both years. The IRS later rechecked its records and realized that it had sent NBAPs to the Roth IRAs in December 2008 for 2005. The IRS closed its investigation and issued each of the Janssons a notice of deficiency for 2006. A notice of final partnership administrative adjustment (FPAA) was sent to Maxam as the tax matters partner of Block Developers.

The Janssons filed petitions for review in the Tax Court, arguing that the court lacked jurisdiction because all items in the notices of deficiency were partnership adjustments that had to be determined at the partnership level. Therefore, only the Block Developers case could go forward, according to the Janssons. The IRS argued that the Janssons' election to opt out for 2005 was ineffective because the IRS had in fact sent timely NBAPs to the IRAs, and it was their responsibility to pass on the NBAPs to the Janssons as indirect partners of Block Developers.

The Tax Court dismissed the Janssons' individual petitions for lack of jurisdiction because the notices were issued before a final partnership determination. Based on the lack of jurisdiction, the court did not decide whether the Janssons could elect to treat their partnership items as nonpartnership items for 2005. Block Developers' petition for 2005 went forward as the only proceeding in the case for that year.

The IRS then realized that the NBAPs to the Janssons were untimely for 2006, meaning the Janssons had the right to opt out of the partnership proceeding for 2006. The IRS sent notices of deficiency to the Janssons for 2006 only, and the Janssons filed Tax Court petitions to challenge them. Thus, the Tax Court had to consider Block Developers' petition for review of the FPAAs for 2005 and 2006, and the Janssons' petitions for review of their individual notices for 2006.


First, the Tax Court addressed a procedural challenge by the Janssons regarding 2005. The Janssons argued that as indirect partners of Block Developers, the IRS was required to send NBAPs to each of them. The Janssons argued that because they did not personally receive NBAPs for 2005, they should be allowed to opt out of the partnership proceeding for that year.

The regulations under Code Sec. 6223 provide that an agent is not required to search IRS records for information on indirect partners. The parties agreed that the revenue agent learned that the Janssons were indirect partners, and the issue was whether, having made that determination, the agent was required to send NBAPs to the indirect partners rather than just to the Roth IRAs. The Tax Court determined that under the regulations, the IRS was permitted, but not required, to use information it discovered on its own. Therefore, the Janssons were not permitted to opt out of the partnership proceeding for 2005.

Next, the Tax Court looked at whether the Janssons had made excess contributions to their Roth IRAs. Code Sec. 4973 imposes an excise tax of 6 percent for excess Roth IRA contributions. Excess contributions are the lesser of (1) the amount of the excess contribution, or (2) the value of the account as of the end of the tax year. The tax applies each year until the excess contributions are eliminated. An excess contribution is defined in part as a contribution to a Roth IRA that exceeds the amount allowable as a contribution.

In Notice 2004-8, the IRS identified some transactions using Roth IRAs as abusive tax avoidance transactions, and it identified excess contributions as their key element. The Notice describes transactions involving an individual who owns a business, has a Roth IRA, and has a corporation owned by the Roth IRA. The transactions typically include the exchange of property from the existing business to the corporation owned by the Roth IRA for less than fair market value. The effect of the transaction is to transfer value to the corporation comparable to a contribution to the Roth IRA. The Notice states that the IRS will challenge these types of transactions under several theories, including substance over form.

The Janssons argued that Notice 2004-8 did not apply because the sale of the Verdura Block patents and the corresponding royalty rate were both at fair market value. They also asserted that there were legitimate business reasons for the arrangement. The patents were sold to generate cash, Block Developers was formed to protect Jansson's assets, and Block Developers would increase profits by licensing the patents to other manufacturers, the Janssons said.

Applying the substance over form doctrine, the Tax Court found that Block Developers was nothing more than a conduit to get money into the Roth IRAs, and was not engaged in any real business activity. First, the court rejected the argument that the patent sale and licensing agreement was at fair market value and thus not prohibited under Notice 2004-8. According to the court, the applicable test was whether the transaction lacked substance, and proper valuations of the patents and royalty rates did not by themselves determine that issue.

The Tax Court found important similarities in this case to the facts in Polowniak v. Comm'r, T.C. Memo. 2016-31, where the substance over form analysis was applied to a Notice 2004-8 transaction. The court observed that, as in Polowniak, Block Developers did not keep consistent records, and billing statements to SR Products did not match up with payments. There was little evidence as to any actual services provided by Block Developers, which did not have a single employee, the court noted. The court found that the parties did not adhere to written agreements regarding royalty payments. Block Developers, the court said, did not employ anyone to perform even menial administrative tasks, and there was no evidence that it ever tried to market the Verdura Block patents.

The court found the Janssons' arguments that Block Developers had a legitimate business purpose to be without merit. The sale of patents to generate cash was illogical, according to the court, because the money Block Developers paid for the patents came from SR Products, so no new capital was raised. The claim that Block Developers would protect Jansson's assets was unfounded because no evidence showed any additional protection of the assets beyond the web of corporations Jansson had already formed. Jansson said he hoped to increase profits on the patents by having Block Developers license them to other companies, but the court found that Block Developers did not attend trade shows or produce any marketing materials for Verdura Blocks. Rather, the court found that this work was done by Jansson or through SR Systems.

Finally, the court acknowledged that the substance-over-form doctrine is not something the IRS can use to pound every Roth IRA transaction it doesn't like. The Sixth Circuit, the court noted, recently reversed Summa Holdings, Inc. v. Comm'r, 2017 PTC 58 (6th Cir. 2017), one of the Tax Court's decisions rooted in the doctrine. In Summa, the taxpayers had a similar setup: a business entity whose sole purpose was to transfer money into Roth IRA accounts. The Tax Court distinguished the Sixth Circuit's holding because the conduit entity in that case was a domestic international sales corporation (DISC) whose sole purpose was to transfer money into Roth IRA accounts. The Sixth Circuit said that a DISC's congressionally approved purpose was tax avoidance, so the transactions at issue could not be recharacterized under substance over form. The Tax Court concluded that, unlike a DISC, Block Developers was an LLC that was meant to have a real business purpose, and that the substance over form doctrine therefore applied.

For a discussion of Roth IRA transactions that the IRS considers abusive, see Parker Tax ¶135,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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