IRS Explains Result of Failed Roth Conversion

In an IRS Service Center Advice (SCA 200148051 (20 Sep 2001)), the Service explained the ramifications of an improper Roth conversion. This notice also appears to answer the question of what happens when the conversion appears to be proper at the time it is made and at the time the tax return for the conversion year is filed, but a change in the tax return results in the conversion being improper.

In the facts of the SCA, the taxpayer converted his Roth IRA in 1998 and elected to report the income over the four year period. The deadline for recharacterizing a year 1998 conversion was December 31, 1999. In April, 2000, the IRS issued the taxpayer a notice of unreported income. The additional income resulted in the taxpayer's income exceeding the $100,000 threshold, thus rendering the conversion invalid.

The Service never specifically addresses the aspect that a later adjustment to income is what is making the conversion invalid. The Service's discussion of the other aspects of the failed conversion makes it clear that income over $100,000 results in a failed conversion, no matter whether the income is reported on the original filed return, or is the result of a later audit.

There is no surprise in the treatment of a failed conversion. A failed conversion is a distribution from the traditional IRA, and an improper contribution to a Roth IRA. As such, the distribution is subject to full income tax in the year of the failed conversion, and is also subject to the 10% early distribution additional tax, unless an exception enumerated in Section 72(t) applies. In addition, Section 4973 imposes a 6% annual excise tax on excess contributions to a Roth IRA. This tax is imposed every year until the excess contribution is withdrawn.

In the instant case, when the taxpayer received the notice from the IRS that his income was under reported, the deadline for recharacterizing the conversion had passed. The taxpayer argued that he should be permitted to do a late recharacterization because he was unaware of the need for a recharacterization until after the deadline.

The Service has, in various Private Letter Rulings, permitted taxpayers to do late recharacterizations when the taxpayer has come to the Service for relief under Reg. Sec. 301.9100. One of the questions of the SCA was whether the Taxpayer Advocate could grant the taxpayer permission to do a late recharacterization. The SCA makes it clear that the Taxpayer Advocate does not have that power, and that the only way the taxpayer can get relief is via the Private Letter Ruling route. The SCA is silent on how the Service would rule on this taxpayer's request for relief, should such a request be forthcoming. In the published Rulings on late recharacterizations, the Service has made it a point that the taxpayer has come forward for relief prior to the Service contacting the taxpayer. However, the Service has informally indicated that relief will not be granted if they believe that the taxpayer tried to deceive the Service. Whether the Service will view the failure to properly report income as an attempt to deceive the Service will remain to be seen.

Finally, the SCA stated that the tax adjustments resulting from a failed conversion must be addressed by the Service through the statutory deficiency procedures, and cannot be considered as mathematical errors subject to immediate assessment.

The Statute of Limitations for timely filed 1998 tax returns will expire on April 15, 2002. Some taxpayers with improper 1998 Roth conversion may think that they will be home free if the IRS does not contact them by that date. However, there is no statute of limitations on the Service determining that the Roth IRA is improper. Nor will the statute start to run on the 10% early withdrawal tax or the 6% excess contribution tax if a Form 5329 is not filed, meaning that these taxes can be assessed at any time. Also, once the statute runs on the tax return, it will be too late to get permission for a late recharacterization. Any taxpayers with improper Roth conversions are therefore be strongly advised to correct the problem rather than hoping it goes away.