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May 18, 2021

Tax Court Provides Solution for Untracked Tax-Free IRA Balances : Using the Cohan Rule

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Denise Appleby explains how to avoid double taxation of otherwise untracked basis in IRAs, using the Cohan Rule.

IRA owners can find themselves paying income tax on distributions of nontaxable amounts because of insufficient records proving nontaxability. A recent tax court memorandum provides a solution for these IRA owners.

 

Maintaining proper records for an IRA makes it easy to determine how much of the account balance is basis and should therefore be nontaxable when distributed. For this purpose, the primary record is IRS Form 8606, Nondeductible IRAs (Form 8606).

But what should one do if one’s IRA balance includes basis, but Form 8606 is missing? One often-recommended solution is to create an accurate accounting of the basis amount by filing Forms 8606 for nondeductible contributions and distributions (that include basis) that occurred in previous years.

That solution is not always practicable, though, especially for IRA owners who have limited records that could prove basis amounts. Fortunately, a recent tax court memorandum, Shank v. Commissioner, U.S. Tax Court, Dkt. No. 1752-17, TC Memo. 2018-33 (T.C. Memo. 2018-33) provides a solution for such individuals.

Background

Nondeductible IRA contributions

Eligible individuals can claim a tax deduction for regular contributions that they make to their traditional IRAs. These contributions would be pretax amounts and taxed as ordinary income when distributed.

One might be ineligible to claim a deduction for a regular contribution to a traditional IRA if one is covered by an employer-provided retirement plan or married to someone who is an active participant, and one’s modified adjusted gross income (MAGI) exceeds a certain amount. In such cases, one may make a nondeductible contribution to a traditional IRA.

Even if one is eligible to claim a deduction for a traditional IRA contribution, one may choose to treat that contribution as nondeductible.

Nondeductible contributions create basis in IRAs. Basis is also created from rollovers of after-tax amount from employer plans such as 401(k)s.

Distributions of basis amounts are nontaxable. However, earnings on both pretax and basis amounts are taxable when distributed.

Tracking basis

The responsibility for keeping track of basis amounts in an IRA rests with the IRA owner, and is done by filing IRS Form 8606. Form 8606 is required to be filed for every nondeductible contribution to a traditional IRA. If an individual’s traditional IRA balance includes basis, Form 8606 must also be filed for any distribution made from any of the individual’s traditional IRA, SEP IRA or SIMPLE IRA.

Reporting IRA contributions and distributions

IRA custodians are required to report IRA contributions on IRS Form 5498, IRA Contribution Information (Form 5498); and report distributions on IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. (Form 1099-R).

IRA owners are required to report IRA distributions on their tax returns, and show how much is taxable.

The IRS document matching program

The IRS uses a document matching program, to identify taxpayers who underreport or do not report income on their tax returns. For instance, failure to include a distribution amount on one’s tax return, would be detected by the document matching system which compares the amount on the 1099-R with the amount reported (or not reported) on one’s tax return.

Burden of proof

Generally, if the IRS determines that an amount is taxable, that determination is presumed to be correct; and, the burden of proving otherwise rests with the taxpayer.

Highlights of the case

Mr. Andrew G. Shank (Mr. Shank) established a traditional IRA in the late 1990s, to which he made regular traditional IRA contributions. During that period, the contribution limit was $2,000.

Mr. Shank had no documentation showing whether the contributions were deductible, and the IRS was unable to retrieve copies of his tax returns—which would have included any filed copies of Forms 8606—from their archives.

Relying on Mr. Shank’s testimony that he was an active participant, with his MAGI exceeding the eligible limits for deducting traditional IRA contributions, the Court determined that his traditional IRA contributions would have been nondeductible.

Documentation provided to the Court showed initial investments of $4,760—reasonably determined to be the contributions made in the late 1990s, and a total market value of $27,745 at the time the IRA balance was distributed to Mr. Shank.

As is required by the IRS, the IRA custodian reported the distribution on IRS Form 1099-R as follows:

  • Box 1—Gross distribution: $27,745
  • Box 2a—Taxable amount: $27,745
  • Box 2b—Taxable amount not determined (checked)
  • Box 7: Distribution code(s): Code 7 (indicating that the distribution was normal and therefore not subject to the 10% early distribution penalty)

By checking Box 2b, the custodian—rightly—puts the onus on Mr. Shank to let the IRS know if and how much of the distribution was nontaxable. The process for doing so includes reporting distribution on his 2014 tax return, and indicating how much of it was nontaxable. However, he did not include the amount on his tax return, and the discrepancy was detected by the IRS’s document matching system, which led to the IRS issuing a notice of deficiency in which they treated the amount as fully taxable.

Mr. Shank petitioned the Court for a redetermination of the deficiency.

Using the Cohan Rule

Inevitably, there will be taxpayers who do not have sufficient documents to prove basis in property. Such was the case in Cohan v. Commissioner, 39 F.2d 540, 542-544 (2d Cir. 1930), where the court used what reasonable evidence was available to estimate the basis amount in Mr. Cohan’s property—an approach which since then is referred to as the Cohan rule.

In making its decision for Mr. Shank’s case, the Court took into consideration the fact that it has been more than 20 years since the contribution was made, and the credibility of the information provided by Mr. Shank. This included records which—under application of the Cohan rule—reasonably showed a basis amount of $4,760, making only the remaining balance of $22,985 ($27,745 – 4,760 = $22,985) taxable.

What this could mean for your affected clients

While filing IRS Form 8606 is the standard method of tracking these basis amounts, it is not filed in many cases. And although Form 8606 can be filed for prior years—in which it should have been filed but wasn’t—it is not always practical to do so. In such cases, T.C. Memo. 2018-33 shows how you can use the Cohan rule to help clients for whom there is insufficient documentation, to identify the correct basis amounts in their IRAs; thereby, helping to ensure that they do not pay income taxes on these tax-free amounts.

Under the Cohan rule, providing “reasonable evidentiary basis” to the IRS could be sufficient. Such evidence could include some or all of the following, if available:

  • Copies of Forms 5498 or account statement showing the contributions,
  • Copies of Form 1099-R, showing any distributions made from the individual’s IRAs, and
  • Copies of tax returns—showing whether deductions were claimed for the contributions, whether any basis was claimed for any distributions from the individual’s IRAs, and the IRA owner’s MAGI for the contribution years.

Remind your clients to keep copies of these documents, just in case they are needed to avoid paying income taxes on these amounts that should be tax-free.

 

Written By

Denise Appleby

Denise is CEO of Appleby Retirement Consulting Inc., a firm that provides IRA resources for financial/ tax/legal professionals. She has over 20 years of experience in the retirement plans field, which includes training and technical consultation.

Denise writes and publishes educational /marketing tools for advisors; available at http://irapublications.com. Denise co-authored several books on IRAs

Denise is a graduate of The John Marshall Law School, where she obtained a Masters of Jurisprudence in Employee Benefits, and has earned 5 professional retirement designations.
She has appeared on numerous media programs, sharing her insights on retirement tax laws.

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