By Ed Morrow, J.D., LL.M., MBA, CFP®, RFC®

In Bobrow v. Commissioner (TC Memo 2014-21), the tax court laid down the gauntlet regarding multiple 60 day IRA rollovers, threatening what may be thousands of other taxpayers’ past IRA rollovers. The tax court denied some IRS arguments that would have been even worse for taxpayers had they been upheld.

Let’s revisit IRA rollovers and then go into why this case is so important. “Rollovers” is a term that is often confusing and applies broadly to some different concepts and techniques that have very different rules and consequences.

You can make any number of tax-free “rollovers” that are trustee to trustee transfers between plans (here, we equate custodians with trustees) – from a 401k to an IRA, to another IRA, to a 403(b), etc. With trustee to trustee transfers, funds never come into the custody of the taxpayer, they go from one retirement plan custodian/trustee to another. Most advantageously, these transfers require no tax withholding, and there is no 60 day or “one per year” rule. IRC §408(d)(3)(A).

By contrast, “60 day rollovers” allow a taxpayer to receive the funds outright, but if the taxpayer contributes the same amount distributed within 60 days to a new (or the same) IRA, such transfers may also be permitted tax-free. These require tax withholding and have much more stringent requirements, foremost is the “one-rollover-per-year” rule. (Note: The one-year limitation has no relation to the calendar year).

Compliance with this rule is important, because a failed rollover means the distribution is taxable, and, if the taxpayer is under 59 1/2, subject to additional 10% penalty, not to mention accuracy related penalties under IRC §6662 for failure to properly report the income. Previously, practitioners and custodians understood this provision under IRC §408(d)(3)(B) as a “one-rollover-per-year-per-IRA” rule, citing a longstanding IRS interpretation (see IRS Publication 590 and discussion of the IRS’ previous liberal interpretation of the statute at Natalie Choate’s Life and Death Planning for Retirement Benefits, 7th edition, ¶2.6.05). But the Bobrow court, on the arguments of the IRS, found otherwise, that the rule instead prohibits all but one-60 day-rollover-per-year, including all IRAs together.

This is a significant difference in interpretation, as we will see from the Bobrow case:

Alvan Bobrow, a tax attorney, and his wife Elisa Bobrow made a series of three “60 day rollovers” from their IRAs. Alvan had two traditional IRAs (I will refer to them as IRA #1 and IRA #2) and his wife had one (Elisa’s IRA). In April 2008 Alvan took a distribution of $65,064 from IRA #1 and in June 2008 he took a distribution in the same amount from IRA #2. Elisa took a distribution from her IRA in the same amount in July 2008.

Alvan’s Two IRA Rollovers

Regarding the first distribution, the IRS and tax court was at least somewhat reasonable -although Alvan had made two requests and the April distribution came from two separate funds, this was deemed to be one distribution (holding contrary would serious hamper rollovers as a practical matter, since people often have multiple funds/assets in one IRA).

The main issue for Alvan was in characterizing the attempted recontributions of the same amounts within 60 days back into his two IRAs. To Alvan, consistent with Publication 590, each of his two $65,064 distributions were properly and timely returned to each respective IRA within 60 days, perfectly within the “one-per-year” rule as described in the IRS publication. The IRS made two arguments. First, it speciously objected to the timing and tracing of Alvan’s recontributions, but the tax court ignored the IRS’ argument on that point, thus deeming Alvan’s first recontribution to IRA#1 in June to be a valid tax-free rollover within 60 days of his April distribution.

The IRS was more persuasive on its second argument as to the “one-per-year” rule, arguing that IRC §408(d)(3)(B) applied to limit 60 day rollovers within one year from all IRAs together, rather than per IRA. The tax court agreed with the IRS and held that Alvan’s second attempted recontribution back to IRA #2 violated the “one-per-year” rule, even though it came from a different IRA which had not been involved with any other rollovers within one year. To be fair to the tax court, it’s a reasonable reading of the plain language of the statute, but the IRS was clearly arguing against its own longstanding liberal interpretation in published instructions to taxpayers, discussed later herein. [1]

Elisa’s IRA

Alvan’s IRA rollovers were irrelevant to Elisa’s issues, since she is considered a separate taxpayer for this purpose, even if filing jointly. The IRS, however, had two other arguments regarding her IRA rollover. First, it tried to argue that Elisa’s rollover was disqualified because she had placed the distributed funds into a joint account before recontributing them from the same joint account to her IRA. The tax court thankfully gave short shrift to the first argument, finding that the placement/titling of the distributed funds during that 60 day time period was completely irrelevant. It’s disturbing the IRS would even make that argument.

The IRS, however, made a second, more tenable argument that the September 30 recontribution was not within 60 days of her July 31 distribution. The tax court sustained this argument, finding that 60 days after July 31st is September 29th, and the 30th thus falls outside of this 60 day window – on the 61st day, despite arguments from Elisa blaming Fidelity for the delay and claiming that they had requested the transfer of funds before that date. The tax court acknowledged the revenue procedures and occasions when a “financial institution error” argument will win a waiver of the 60 day requirement on appropriate facts, but Elisa produced no convincing evidence of any delay on Fidelity’s part.

Penalties

Not only were Elisa and Alvan forced to take two of the three $65,064 distributions into income, but because Elisa was under 59 1/2 at the time, the tax court found the 10% early withdrawal penalty applied to her distribution. The court did not address a potential 6% penalty for excessive contributions. Adding insult to injury, the tax court found an accuracy related penalty applied due to a substantial understatement of tax. This penalty is assessed regardless of any finding of negligence on the taxpayer’s part, but a taxpayer can rebut and reduce the penalty if he can cite “substantial authority” (which is an objective standard) or reasonable cause and good faith reliance (which is subjective) for the position.

Strangely, it does not appear that Alvan cited any of the dozens of secondary authorities, not to mention IRS Publication 590, that would indicate his position on the “one-per-year per IRA” interpretation was reasonable. These sources would have gone far to show Alvan’s subjective and reasonable good faith reliance on the “common wisdom” out there and would have given him a good chance at getting around some of the accuracy related penalty, at least as regards to his IRA.

Here is the example from page 25 of Publication 590, http://www.irs.gov/pub/irs-pdf/p590.pdf (the portion in bold is contrary to the IRS position and tax court holding in Bobrow):

“You have two traditional IRAs, IRA-1 and IRA-2. You make a tax-free rollover of a distribution from IRA-1 into a new traditional IRA (IRA-3). You cannot, within 1 year of the distribution from IRA-1, make a tax-free rollover of any distribution from either IRA-1 or IRA-3 into another traditional IRA.

However, the rollover from IRA-1 into IRA-3 does not prevent you from making a tax-free rollover from IRA-2 into any other traditional IRA. This is because you have not, within the last year, rolled over, tax free, any distribution from IRA-2 or made a tax-free rollover into IRA-2.”

Lessons Learned

Some of the harsh treatment of the Bobrows undoubtedly occurred due to the abusive tint of the transactions – these were not rollovers to facilitate transition to another IRA provider or a different plan after retirement – they appear to be back door attempts at getting short-term, interest-free loans. Still, the case provides important lessons – don’t do 60 day rollovers unless you have good reason, don’t do more than one a year (examining ALL IRAs), and if you do a 60 day rollover, track it diligently – don’t wait until the last day (and count the days, some months have 31 days!!). Keep copies of any instructions to or correspondence with the IRA provider, and if there is a question as to the taxability but a reasonable basis to argue otherwise, disclose the relevant facts on the tax return, and you may get around accuracy related penalties if you’re wrong.

Impact on Taxpayers Who Made Similar Rollovers

The most disturbing impact of this case may be the potentially thousands of taxpayers who relied on IRS Publication 590 instructions (or the various secondary sources that cited or relied on it) and assumed more than one “60 day rollover” could be done within a year if from a different IRA. Since it is doubtful they filed anything to alert the IRS to the transaction (like the Bobrows), the statute of limitations may never run to prevent a future assessment.

Not only does this leave those taxpayers open to future tax penalties, but it also threatens the asset/creditor protection of any IRAs receiving an improper 60 day rollover. Even if the IRS never pursues the issue and never disqualifies an IRA rollover, a creditor or bankruptcy trustee might – in the Willis case, the creditors researched back 12 years for bogus IRA rollovers to successfully pierce the debtor’s IRA. [2] Bankruptcy courts can independently find improper retirement plan administration to disqualify plans from protection even if the IRS has never investigated the issue.

Creditors and bankruptcy trustees should be salivating at the prospects of piercing IRAs involved in 60 day rollovers – potentially even those that were not disguised short-term loans as in the Bobrow or Willis cases.

Hopefully the IRS will come out with some kind of safe harbor or revenue procedure to mitigate the widespread havoc this case may cause. When technical deficiencies were found to cause inadvertent prohibited transactions potentially blowing up millions of Schwab, Merrill Lynch and probably other brokerage firm IRAs, the IRS and DOL issued retroactive rulings to stem the contagion. [3] However, those cases involved such a large problem the IRS and DOL were penned into a “too big to fail” problem – the IRS may not be so inclined to do that in this case, especially since it prosecuted the Bobrow case so vigorously.

[1] IRC §408(d)(3)(B) Limitation
This paragraph does not apply to any amount described in subparagraph (A)(i) received by an individual from an individual retirement account or individual retirement annuity if at any time during the 1-year period ending on the day of such receipt such individual received any other amount described in that subparagraph from an individual retirement account or an individual retirement annuity which was not includible in his gross income because of the application of this paragraph.
[2] Menotte v. Willis (In re Willis), 411 BR 783 (Bankr. S.D. Fla. 2009), affirmed by Willis v. Menotte,  2010 U.S. Dist. LEXIS 44773.
[3] Yoshioka v. Charles Schwab Corp., 2011 U.S. Dist. LEXIS 147483 (N.D. Ca. 2011), dismissed without prejudice after IRS announcement at 2012 U.S. Dist. LEXIS 168967 (N.D. Ca. 2012). See IRS Announcement 2011-81 and the subsequent proposed prohibited transaction class exemption amendment from the DOL at https://federalregister.gov/a/2013-12362.