In our previous blogpost, we discussed Roth IRA conversion and IRA Aggregation Rule, now we will discuss the step transaction doctrine.
Complication II. Step Transaction Doctrine
The step transaction doctrine is the legal principle that a series of related steps in a transaction should be taxed based on the overall economic nature of the transaction, not "just" based on the separate individual steps.
In the context of the contribute-then-convert strategy, the step transaction doctrine would examine the overall result of the transaction - dollars came out of a taxable account and ended up in a Roth IRA - and tax it according to the substantive result that occurred: that the taxpayer constructively made a contribution to a Roth IRA. After all, the taxpayer contributed to the non-deductible IRA for the sole purpose of converting it to a Roth IRA, and did those two steps together for the sole purpose of getting a new annual contribution into a Roth IRA.
Of course, Roth IRA contributions themselves are not actually taxable anyway. They are a contribution of after-tax funds in the first place. But treating the transaction as being substantively the same as a Roth IRA contribution does mean that one who made a Roth IRA contribution while income is too high. And if income exceeded the limits when the Roth contribution was made, it is an excess contribution, that must either be unwound or be subject to the 6% excess contribution penalty tax.
Thus, if the step transaction doctrine adjusts the strategy to be "what really happened" - a Roth IRA contribution - then when the IRS "taxes" it accordingly, it may assess the penalty tax for excess contributions if income was, in fact, too high. And if the strategy is implemented repeatedly for years, one could face an excess contributions tax of 6%, per year, per contribution, for as far back as the statute of limitations allows (in addition to being responsible for unwinding the contribution itself, along with all subsequent earnings).
So, does the strategy of contributing to a non-deductible IRA and converting it to a Roth IRA to avoid the Roth IRA contribution income limit constitute a step transaction scenario?
The reality is that the application of the step transaction doctrine is done on a case-by-case basis, and depends on a subjective interpretation of the facts and circumstances of one's particular situation. What do the courts look for in evaluating the potential of a step transaction? Simply put, they are looking for a series of transactions, all inter-related, where the final outcome of the overall series of transactions was to accomplish the equivalent of another single-step (or fewer steps) transaction.
In the case of someone who contributes to a non-deductible IRA, specifically for the purpose of converting it, and does those multiple steps precisely because it is a way to try to avoid the Roth IRA contribution income limits, then it seems clear that the step transaction doctrine could be applied.
How to Make Step Transaction Doctrine Not Applicable?
The easiest way to make the case that the step transaction doctrine shouldn't apply is the passage of time, and the possibility that the tax and economic situation could change between the steps. Although a pre-meditated decision to contribute to a non-deductible IRA with the specific intention to convert it shortly thereafter can be viewed unkindly by the IRS over any time period, an individual who has contributed to non-deductible IRAs in the more distant past and now chooses to convert is less likely to face scrutiny than someone who completes the conversion just a few days later. Many taxpayers choose to implement the strategy by converting a prior year's non-deductible IRA contribution, and then making a new non-deductible contribution for the current year, specifically to introduce at least some economic uncertainty to the situation, reducing the likelihood of step transaction treatment.
It's also notable that step transactions are not something that is typically captured in the "automatic reporting" processes for non-deductible IRA contributions and Roth conversions on IRS Forms 1099-R and 5498 and the tax return itself with a supporting Form 8606. Accordingly, many people may choose to "take the gamble" and proceed with such a transaction anyway, under the auspices that there is a low probability they will be caught. While that may be true, it does not change the fact that one would face a high risk of losing, if he/she was caught, if the IRS and/or the courts decided to view the transaction through the lens of the step transaction doctrine.
Conclusion
In the end, the contribute-and-then-convert strategy is not expressly prohibited by the tax code, but the IRS does have the right to tax a transaction according to its true economic reality. And if the express goal and intent of one is merely to circumvent the clear intent of the law, and is done in a manner that blatantly disregards it, beware. While the reality is that the likelihood of getting caught is extremely low, when the IRS believes that a transaction is abusive, not only do they act to shut it down, but they don't always provide leniency for those who have already tried to take advantage of it in the past.
Complication II. Step Transaction Doctrine
The step transaction doctrine is the legal principle that a series of related steps in a transaction should be taxed based on the overall economic nature of the transaction, not "just" based on the separate individual steps.
In the context of the contribute-then-convert strategy, the step transaction doctrine would examine the overall result of the transaction - dollars came out of a taxable account and ended up in a Roth IRA - and tax it according to the substantive result that occurred: that the taxpayer constructively made a contribution to a Roth IRA. After all, the taxpayer contributed to the non-deductible IRA for the sole purpose of converting it to a Roth IRA, and did those two steps together for the sole purpose of getting a new annual contribution into a Roth IRA.
Of course, Roth IRA contributions themselves are not actually taxable anyway. They are a contribution of after-tax funds in the first place. But treating the transaction as being substantively the same as a Roth IRA contribution does mean that one who made a Roth IRA contribution while income is too high. And if income exceeded the limits when the Roth contribution was made, it is an excess contribution, that must either be unwound or be subject to the 6% excess contribution penalty tax.
Thus, if the step transaction doctrine adjusts the strategy to be "what really happened" - a Roth IRA contribution - then when the IRS "taxes" it accordingly, it may assess the penalty tax for excess contributions if income was, in fact, too high. And if the strategy is implemented repeatedly for years, one could face an excess contributions tax of 6%, per year, per contribution, for as far back as the statute of limitations allows (in addition to being responsible for unwinding the contribution itself, along with all subsequent earnings).
So, does the strategy of contributing to a non-deductible IRA and converting it to a Roth IRA to avoid the Roth IRA contribution income limit constitute a step transaction scenario?
The reality is that the application of the step transaction doctrine is done on a case-by-case basis, and depends on a subjective interpretation of the facts and circumstances of one's particular situation. What do the courts look for in evaluating the potential of a step transaction? Simply put, they are looking for a series of transactions, all inter-related, where the final outcome of the overall series of transactions was to accomplish the equivalent of another single-step (or fewer steps) transaction.
In the case of someone who contributes to a non-deductible IRA, specifically for the purpose of converting it, and does those multiple steps precisely because it is a way to try to avoid the Roth IRA contribution income limits, then it seems clear that the step transaction doctrine could be applied.
How to Make Step Transaction Doctrine Not Applicable?
The easiest way to make the case that the step transaction doctrine shouldn't apply is the passage of time, and the possibility that the tax and economic situation could change between the steps. Although a pre-meditated decision to contribute to a non-deductible IRA with the specific intention to convert it shortly thereafter can be viewed unkindly by the IRS over any time period, an individual who has contributed to non-deductible IRAs in the more distant past and now chooses to convert is less likely to face scrutiny than someone who completes the conversion just a few days later. Many taxpayers choose to implement the strategy by converting a prior year's non-deductible IRA contribution, and then making a new non-deductible contribution for the current year, specifically to introduce at least some economic uncertainty to the situation, reducing the likelihood of step transaction treatment.
It's also notable that step transactions are not something that is typically captured in the "automatic reporting" processes for non-deductible IRA contributions and Roth conversions on IRS Forms 1099-R and 5498 and the tax return itself with a supporting Form 8606. Accordingly, many people may choose to "take the gamble" and proceed with such a transaction anyway, under the auspices that there is a low probability they will be caught. While that may be true, it does not change the fact that one would face a high risk of losing, if he/she was caught, if the IRS and/or the courts decided to view the transaction through the lens of the step transaction doctrine.
Conclusion
In the end, the contribute-and-then-convert strategy is not expressly prohibited by the tax code, but the IRS does have the right to tax a transaction according to its true economic reality. And if the express goal and intent of one is merely to circumvent the clear intent of the law, and is done in a manner that blatantly disregards it, beware. While the reality is that the likelihood of getting caught is extremely low, when the IRS believes that a transaction is abusive, not only do they act to shut it down, but they don't always provide leniency for those who have already tried to take advantage of it in the past.
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