Originally published on Forbes.com Mar 24th, 2014
If you take money out of an IRA and put it into another IRA within sixty days, you are not taxed on the distribution and don’t have to concern yourself with early withdrawal penalties even if you are one of those youngsters under 59 1/2. This feature, which presumably is intended to give you some time to transfer from one custodian to another, presents a temptation to some. The temptation is to use the IRA as, in effect bridge financing. Succumbing to that temptation is dangerous to your fiscal well-being, as Thomas Alexander recently found out from the Tax Court.
Mr. Alexander is a licensed electrician. In 2009, the general contractor he was working with hit a snag and was unable to timely pay him $130,000. One of the principals in the general contractor offered Mr. Alexander some reassurance. He would give Mr. Alexander a promissory note secured by a piece of real estate that he owned. The story takes an odd turn from there.
But there was a catch: The property was burdened with a past-due mortgage and was subject to imminent foreclosure. Petitioner would have to pay SunTrust Bank (SunTrust) $36,000 to stop the foreclosure and thus the loss of the property that was to be his security.
I’m still trying to wrap my head around that transaction. Somebody doesn’t pay you for your services when due. So he wants to give you security, but you have to pay off one of his debts in order to have the security interest. It reminds me of one of Herb Cohan’s wise sayings – “You’ll never get out of debt by borrowing”.
At any rate, Mr. Alexander spoke with his Charles Schwab financial adviser about the matter. The adviser helpfully suggested that Charles Schwab could loan Mr. Alexander the money. Unfortunately, Charles Schwab could not process the loan quickly enough to avoid the foreclosure. No problem. Just withdraw the money from the Charles Schwab SEP-IRA and replace it when the loans proceeds come through. That was the plan anyway.
The loan was supposed to take 20 to 45 days to process. $36,000 went from Mr. Alexander’s] SEP-IRA to his checking accounting and thence to SunTrust, which staved off the foreclosure. The loan took longer. Mr. Alexander received the distribution on July 31 and the loan proceeds on September 30. He then mailed a check which was deposited in his SEP-IRA on October 5, sixty-six days after the withdrawal. Too late.
Mr. Alexander tried two arguments. The first was that since he really intended a rollover, that should be controlling. The Court did not buy that argument.
Although petitioners argue that their intent was to effect a rollover, it is well established that a taxpayer’s intention to take advantage of favorable tax laws does not determine the tax consequences of his or her transactions.
The second argument was that the distribution was actually a loan. The Court was even harder on that one.
The attempted characterization of the distribution as a loan falls into the realm of “e careful what you wish for.”
With respect to IRAs, section 408(e) provides that if the individual for whom the IRA was created, or his beneficiary, engages in a transaction prohibited by section 4975 as to the account, the account will not be treated as an IRA as of the first day of the tax year, and the account will be treated as having distributed all of its assets.
The only bright spot was that the accuracy-related penalty was not upheld.
Petitioners provided their accountant with the Form 1099-R they received from Schwab. The accountant advised petitioners when preparing their return that unless they got the Form 1099-R “corrected” they would have an increase in income because of the distribution as well as a 10% additional tax for early withdrawal. Petitioners contacted Hoag to request a “corrected” Form 1099-R, and Hoag informed them that “it is all good” because they had put the money back into the SEP-IRA. Petitioners put Hoag and the accountant “in contact together”, and the accountant prepared the return without including the distribution.
I think is an instance of the Service being too quick to assert the accuracy penalty. It is hard to see what more Mr. Alexander could have done.
The Court pointed out to Mr. Alexander that he might have tried to ask for a break under Revenue Procedure 2003-16. One of the factors considered under that procedure is “the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed)”. Something tells me that that procedure will not be much help to people who are effectively looking to use the rollover provision to engineer a bridge loan.
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