12/31/2001 Service Center Advice 200148051

Adjusted Gross Income Adjustment Dooms Roth IRA Conversion; IRS Taxpayer Advocate Can't Provide Relief

In significant service center advice (SCA), IRS concludes that a Roth IRA conversion that failed when IRS determined two years later that the taxpayer's modified Adjusted Gross Income exceeded the conversion threshold, had to be treated as a regular IRA distribution, triggering various taxes and penalties. IRS adds that its Office of Taxpayer Advocate does not have discretion to allow a taxpayer to re-characterize a failed IRA conversion. (Service Center Advice 200148051)

Background. An individual can convert amounts in a traditional IRA account to a Roth IRA if certain requirements are met. One of the requirements is that the taxpayer's modified Adjusted Gross Income (not counting the taxable amount of the conversion) can't exceed $100,000. The conversion is taxable. A failed conversion (i.e., one effected by a taxpayer who turns out to have had Adjusted Gross Income in excess of $100,000) is treated as a withdrawal from the traditional IRA.

A conversion to a Roth IRA can be reversed by way of a re-characterization (transferring the conversion contribution made to the Roth IRA, plus any earnings or less any losses, to a traditional IRA in a trustee-to-trustee transfer). Generally, the re-characterization should be made by the due date (including extensions) of the taxpayer's income tax return for the affected year, and reflected on that return. But IRS permits a re-characterization even after the taxpayer has filed his return for the year for which a conversion to a Roth IRA was made. Ann 99-104, 1999-44 IRB allowed 1998 conversions to be re-characterized as late as December 31, 1999. A post-1998 conversion may be re-characterized as late as six months after the original due date for filing the return for the conversion year, e.g., by October 15, 2001 for a 2000 conversion. If necessary, an amended return should be filed reflecting the re-characterization. (Ann 99-57, 1999-24 IRB; Form 8606 Instructions (2000), p. 4)

Under Reg § 301.9100-3, IRS may grant an additional extension of time to re-characterize an IRA contribution. A request to re-characterize an IRA contribution is considered a letter ruling request.

Facts. A taxpayer we'll call Sam converted his traditional IRA to a Roth IRA in 1998. Sam believed that the conversion was allowed because he thought his modified Adjusted Gross Income for 1998 was less than $100,000. He chose to include the income from the conversion over a four-year period.

The option to include the income resulting from a Roth IRA conversion over a four-year period was limited to conversions in 1998. A taxpayer who now converts to a Roth IRA must include all of the resulting income in the current year.

In 2000, IRS issued an under reporter notice (generally a CP 2000 Notice based on document matching, i.e., matching data on the return with information reported by third party payers on Forms W-2, 1099, etc.) for the 1998 tax year which resulted in Sam's modified Adjusted Gross Income being more than $100,000. Sam filed an amended return for 1998, seeking a refund of the taxes he paid on the Roth conversion because it was a failed conversion. On the amended return, Sam indicated that because he did not know of the increase to his Adjusted Gross Income until 2000, he was unable to take advantage of the opportunity to correct the failed conversion by the December 31, 1999 deadline.

Taxable distribution. IRS responded by telling Sam that his failed Roth conversion resulted in a distribution of the traditional IRA in 1998. As a result:

... the entire distribution from the traditional IRA was includible in Sam's income for 1998 (apparently, he had not made any nondeductible contributions to it);

... the transaction was treated as a contribution to the Roth IRA, subject to the excise tax under Code Sec. 4973 on excess contributions to an IRA (6% per year until the excess is withdrawn); and

... the distribution from the IRA was hit with a 10% penalty tax under Code Sec. 72(t) on early distributions, i.e., before age 59½.

Faced with this dilemma, Sam turned to the Taxpayer Advocate for help. In turn, the Taxpayer Advocate asked for guidance on whether it was within his discretion to allow Sam to re-characterize the failed Roth IRA conversion after the December 31, 1999 deadline for re-characterizing a 1998 contribution.

Taxpayer Advocate can't intervene. The SCA concludes that the Taxpayer Advocate's mission is to assist taxpayers in resolving account management-type problems with IRS. The determination of whether the requirements for re-characterizing a failed IRA conversion have been met is substantive in nature and beyond the scope of the Taxpayer Advocate's authority.

Relief may still be available. The SCA adds that in the absence of a re-characterization, the severe tax consequences described above apply. Once the normal time frame for re-characterization (December 31, 1999 for 1998; October 15 of the following year for years after 1998) has expired, a taxpayer may re-characterize a conversion to a Roth IRA only by obtaining an extension of the deadline to re-characterize under the procedures of Reg § 301.9100-3, i.e., by filing a request for a private letter ruling and paying the applicable user fee.

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