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Eighth Circuit Reverses Tax Court on IRA Rollover, Chastises IRS for "Appalling" Arguments. (Parker Tax Publishing June 4, 2014)

Reversing the Tax Court, the Eighth Circuit agreed with the taxpayer's contention that he rolled over an IRA distribution within 60 days and thus was not taxable on a $120,000 distribution. Haury v. Comm'r, 2014 PTC 227 (8th Cir. 5/12/14).

IRA Rollover Issue

Harry Haury developed proprietary technology in the late 1990s and licensed it to several companies for which he also worked as an employee and in which he held substantial ownership interest. By 2007, two of these companies were competing as subcontractors for a substantial government contract. To fund product development and working capital needs, Harry made secured loans to these companies in 2006 and 2007, and three loans in 2007 were funded using distributions withdrawn from Harry's IRA account. Harry was less than 59 1/2 years old, so his IRA distributions were taxable as ordinary income subject to a 10 percent additional tax. The following are the IRA transactions in 2007 that were at issue: (1) a withdrawal on February 15 of $120,000; (2) a withdrawal on April 9 of $168,000; and (3) a contribution on April 30 of $120,000. According to the IRS, all the 2007 IRA distributions were taxable and the $120,000 contribution was not a rollover of previously distributed funds.

Under Code Sec. 408(d)(3), an individual can exclude an IRA distribution from taxable income if it is rolled over into an IRA account. The entire amount is excluded if it is paid into an IRA for the benefit of the individual not later than the 60th day after the day on which he receives the payment or distribution. A partial rollover, an amount less than the entire distribution, is likewise excluded if it is paid into an IRA. Code Sec. 408(d)(3)(D); but see Lemishow v. Comm'r, 110 TC 110 (1998) (articulating that the same money or property distributed must be rolled-over). The rollover contribution exception does not apply if the distributee used the exception to exclude another distribution in the year before the date of the distribution in question.

Proceeding pro se in Tax Court, Harry explained at trial that his April 30 $120,000 contribution came as the result of repayment by the companies of a prior loan funded by his IRA account. Seizing on the fact that the $120,000 April 30 contribution matched a $120,000 February 15 withdrawal, the IRS argued that it was not a qualifying rollover contribution because it was not made within the 60-day time limit in Code Sec. 408(d)(3)(A)(i). The Tax Court agreed and included the $120,000 in Harry's taxable income.

On appeal, Harry was represented by counsel and argued that the $120,000 IRA contribution on April 30 was a qualifying partial rollover of the $168,000 IRA distribution made on April 9, less than 60 days before the contribution. This time the IRS conceded the point, but asserted two defenses. First, it argued that the partial rollover issue was forfeited because Harry failed to argue it to the Tax Court. Second, the IRS argued that the court could not grant relief on the basis of a qualifying partial rollover because Harry failed to prove that he had not made a prior rollover contribution within one year of April 30, 2007.

The Eight Circuit rejected the IRS' contentions holding that the $120,000 was not includible in Harry's income. Saying it was "appalled" by the unfairness of the IRS's first argument, the court reiterated the fact that it was the IRS attorneys who matched up the two $120,000 transactions and ignored the obviously applicable partial rollover provision in Code Sec. 408(d)(3) by asserting that the rollover contribution was untimely. According to the Eighth Circuit, the Tax Court was obligated to fairly apply that statute to the facts presented, particularly for a taxpayer who is pro se. Noting that it did not generally consider issues not previously raised, the Eight Circuit said it was obliged to in this case because an injustice might otherwise result.

With respect to the IRS's second argument that Harry failed to prove that he had not made a prior rollover contribution within one year of April 30, the court admonished the IRS for making an argument that was factually without merit, if not "downright silly." The court bluntly reminded the IRS that it had access to the transactions in Harry's IRA account during the year before April 30, 2007. Had there been a prior rollover contribution, it would have been a complete defense to Harry's rollover contention because the one-year limitation in Code Sec. 408(d)(3)(B) applies to all rollover contribution claims, whether complete or partial. Had the IRS's exhaustive review of the transactions in Harry's IRA account revealed a disqualifying prior rollover contribution during the prior year, the court stated, the IRS would have asserted this defense before the Tax Court, making the 60-day limit the IRS in fact asserted unnecessary. As the IRS did not raise the one-year issue, the court said, Harry had no need to address it at trial.

For a discussion of rollovers of distributions from traditional IRAs, see Parker Tax ¶134,540.

Bad Debt Issue

The Eighth Circuit also affirmed the Tax Court's holding that the loans made by Harry to the companies that licensed his technology, which subsequently became worthless in December 2007, were nonbusiness bad debts. Code Sec. 166(d)(2) requires a proximate relation between the loss due to the loans becoming worthless and the taxpayer's trade or business. The Supreme Court in U.S. v. Generes, 405 U.S. 93 (1972), resolved a circuit conflict over the meaning of "proximate" by holding that one must determine the "dominant motivation" in making of the loan. Importantly, Generes dealt with a similar factual situation to the instant case where the taxpayer was both a shareholder and an employee, hence the need for a determination of the taxpayer's dominate motivation, which might not be obvious.

In this case, the Tax Court's analysis was affirmed that the worthless loans were nonbusiness bad debts because the dominant motivation of the loans was the protection of Harry's investment interests in the companies, rather than the protection of his salary as an employee, as Harry had argued. Even though Haury received significant salaries from his companies, he and his wife held significant ownership and controlling interests, had little involvement in the day-to-operations, testified that he intended the loans to help keep the companies afloat, and the companies where the investment vehicles for his technology. Accordingly, Harry's claim of a worthless-debt deduction under Code Sec. 166(a) was denied.

For a discussion of business bad debts vs. nonbusiness bad debts, see Parker Tax ¶ 98,425. (Staff Editor Parker Tax Publishing)

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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