Distributions from account that had ceased to be an IRA were not taxable

Marks, TC Memo 2018-49

Stacey Marks owned a retirement account, the custodian of which was the Argent Trust Co. (the Argent account). Before 2005, the Argent account qualified as an IRA.

In 2005, the Argent account made a $40,000 loan to Marks' father. It received a promissory note in exchange. In 2012, the Argent account made another loan, of $60,000, to one of Marks' friends, again receiving a promissory note in exchange.

As of December 2013, the Argent account had the following assets: (1) the two notes (with a combined face value of $100,000) and (2) $96,508 in cash. In December 2013, Marks opened a new retirement account, the custodian of which was the Equity Trust Co. (the Equity account). In December 2013, Marks attempted to roll over the assets of the Argent account to the Equity account.

On her 2013 tax return, Marks did not report that she had received a taxable distribution from the Argent account.

IRS initially determined that Marks successfully rolled over the $96,508 into the Equity account, but that the two notes were not successfully rolled over and thus had to be included in income in 2013. In its deficiency notice, IRS found that she had received a $98,000 taxable distribution from the Argent account (representing the two notes; it's unclear why they weren't valued at their full $100,000 face value), and that this amount was subject to the 10% additional penalty on early distributions under Code Sec. 72(t), and that Marks had a substantial underpayment of tax and was thus subject to a $7,071 accuracy-related penalty.

Marks challenged the determination, asserting that the two notes were distributed to her then rolled over into the Equity account.

The Tax Court, after reviewing the parties' positions, ordered them to file additional memoranda addressing the effect of the prohibited transaction rule under Code Sec. 408(e)(2)(A).

Both sides agreed that, by making the loan to Marks' father in 2005, the Argent account had engaged in a prohibited transaction and ceased to be an IRA.

Accordingly, as agreed by the parties, the Tax Court held that Marks was not required to include the $98,000 in income for 2013 because the distribution was not from an IRA. As a result, the early distribution penalty didn't apply, and there was no substantial understatement of tax giving rise to a penalty under Code Sec. 6662.

What the court did not address was whether a tax can be levied against the taxpayer for the prohibited transaction in 2005. As the audit year was 2013 it is likely that the 3 year and 6 year statute of limitations has expired and barring fraud there would be no way for the IRS to make an assessment.