Tax Court Nixes Attempted Rollover of Cash Proceeds from Sale of Partnership Interest

(Parker Tax Publishing November 2023)

The Tax Court held that a taxpayer who received a distribution from his individual retirement account (IRA) of his interest in a partnership after he failed to report the fair market value of the partnership interest to the custodian in accordance with the custodial agreement, was taxable on the value of the partnership interest at the time of the distribution. The court found that under the same property rule in Code Sec. 408(d)(3), the taxpayer's contribution of the cash proceeds from the sale of partnership interest to another IRA did not qualify as a nontaxable rollover contribution. Estate of Caan v. Comm'r, 161 T.C. No. 6 (2023).

Background

James Caan was an actor whose successful Hollywood and television career lasted over six decades and proved very lucrative. Throughout his career Caan focused on his acting roles, leaving to his business managers and financial advisors the tasks of managing his wealth and his day-to-day financial affairs.

Caan held two individual retirement accounts (IRAs) with Union Bank of Switzerland (UBS). Both IRAs were governed by a custodial agreement between Caan and UBS. One of the IRAs held a partnership interest (P&A Interest) in the P&A Fund, a hedge fund. The custodial agreement between Caan and UBS stated that it was Caan's responsibility to provide UBS with the P&A Interest's yearend fair market value (FMV) every year. When Caan did not satisfy this responsibility for tax year 2015, UBS notified Caan that it had distributed the P&A Interest to him pursuant to the relevant terms of the custodial agreement.

UBS issued Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., to Caan, reporting a distribution. More than a year after the notification from UBS, Caan's financial advisor, acting on Caan's behalf, liquidated the P&A Interest and contributed the cash proceeds to another IRA Caan owned at Merrill Lynch. The transfer of the cash proceeds to the Merrill Lynch IRA was processed in three separate wire transfers on three separate dates between January and June of 2017.

On his 2015 income tax return, Caan reported an IRA distribution but claimed that it was nontaxable as a rollover contribution. The IRS disagreed and issued a notice of deficiency, determining that there was a taxable distribution. Caan requested a private letter ruling to waive the 60-day period for rollover contributions. He also filed a Tax Court petition for redetermination of his 2015 income tax deficiency. The IRS declined to issue the private letter ruling, stating that the 60-day period could not be waived because Caan was required to contribute the P&A Interest (not cash) to Merrill Lynch in order for the distribution to be nontaxable as a rollover contribution.

Caan died in 2022. A representative of his estate argued before the Tax Court that UBS's distribution of the P&A Interest was a "phantom distribution." The estate alleged that UBS resigned as the P&A Interest's custodian - and purported to "distribute" the interest - without notifying Caan. The estate further alleged that UBS merely generated, without actually mailing, the letters that requested the P&A Interest's 2014 yearend fair market value and only later notified Caan of a purported distribution. The estate further argued that no distribution occurred because Caan was never placed in actual or constructive receipt of the P&A Interest. In addition, the estate contended that, even if UBS distributed the P&A Interest, Caan contributed it to his Merrill Lynch IRA in a manner that would qualify as a nontaxable rollover contribution under Code Sec. 408(d)(3). Finally, the estate argued that the IRS abused its discretion in declining to issue a waiver of the 60-day rollover period.

Code Sec. 408(d)(3) provides that an IRA distribution is not taxable if "the entire amount received (including money and any other property)" is contributed into another IRA within 60 days of the distribution. Under the "same property" requirement in Code Sec. 408(d)(3)(A)(i) and (D), if a distribution from an IRA consists of noncash property, the taxpayer must contribute that exact same property in order for the distribution to be considered a nontaxable rollover contribution. Reg. Sec. 1.408-4(b)(1) states that a distribution is nontaxable only if "the entire amount received (including the same amount of money and any other property) is paid into an [IRA]." Under Code Sec. 408(d)(3)(B) taxpayers are limited to one nontaxable rollover of an IRA distribution per one-year period.

Analysis

The Tax Court held that Caan's P&A Interest was distributed in tax year 2015 within the meaning of Code Sec. 408(d)(1). The court further held that Caan did not thereafter contribute the P&A Interest in a manner that would qualify as a nontaxable rollover contribution under Code Sec. 408(d)(3), because he changed the character of the property when he liquidated the P&A Interest. The court also disagreed with the estate that the IRS abused his discretion in declining to issue a waiver of the 60-day rollover period, as such a waiver would not have helped Caan in this case.

In the court's view, there were three problems with the way the P&A Interest was handled. First, and most importantly, in liquidating the P&A Interest, Caan changed the character of the property; yet Code Sec. 408(d)(3)(A)(i) and Reg. Sec. 1.408-4(b)(1) required him to contribute the P&A Interest itself, not cash, to another IRA in order to preserve its tax-deferred status. Second, the contribution of the cash proceeds from the liquidation occurred long after the January 25, 2016, deadline. And finally, the P&A Fund's three transfers to the Merrill Lynch IRA constituted three separate contributions; yet Code Sec. 408(d)(3)(B) allows for only one rollover contribution in any one-year period, making only the first transfer potentially eligible for a tax free rollover.

The court found that the text of Code Sec. 408(d)(3)(A)(i), the legislative history behind Code Sec. 408(d)(3), the Tax Court's caselaw, and the regulations all make clear that Caan was required to contribute the P&A Interest, not cash, to the Merrill Lynch IRA in order to preserve its tax-deferred status. Because he did not do so, the court held that the cash proceeds from the liquidation of the P&A Interest were not contributed in a manner that would qualify as a nontaxable rollover contribution under Code Sec. 408(d)(3)(A)(i).

The court also held, on an issue of first impression, that it has jurisdiction to review the IRS's denial of a waiver under Code Sec. 408(d)(3)(I) and that such a denial is reviewed for abuse of discretion. The court found that neither Code Sec. 408(d)(3) nor its legislative history preclude judicial review, and whether the IRS grants a waiver under Code Sec. 408(d)(3)(I) is a discretionary determination that would affect a taxpayer's deficiency. The court further found that the IRS's denial of a waiver on the basis that Caan liquidated the P&A interest after the distribution from UBS and, in so doing, ran afoul of the same property requirement, was not an abuse of discretion. The court reasoned that it cannot be an abuse of discretion for the IRS deny a waiver where granting the waiver would not have helped the taxpayer in any way.

Observation: The court observed that this case is a quintessential example of the pitfalls of holding nontraditional, non-publicly traded assets in an IRA. Failure to follow the "labyrinth of rules" surrounding these assets, the court noted, can mean forfeiting their tax-advantaged status.

For a discussion of rollovers of distributions from traditional IRAs, see Parker Tax ¶134,540.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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