Deductibility of IRA contribution

[manyhappyreturns]

Client did his 2010 tax return on Turbo Tax and reported IRA distributions of $64,000 as fully taxable. He got a letter from the IRS saying he had K-1 income in 2010 that he did not report. Come to find out, the K-1 income ($4469) and the information documents as well went to his investment company, and the company deposited the income in his IRA. Client doesn't think he should pay taxes on that amount because he says if he pays taxes on it as income for 2010 and it has been deposited in his IRA, then he will have to pay tax on that same amount again when he withdraws it. The IRS told him he needed to file an 8606, but that just relieves him of paying tax on a small percentage of the $4469 contributed because his IRA is valued at over $400,000. He thinks the $4469 should be considered return of capital for 2010. He was 70 yrs old (not 70-1/2 yet) in 2010, so doesn't that mean he can deduct the $4469 contribution on line 32, as it is being reported as income on line 17?

Any input on this would be most appreciated. Thanks!

[FEDUKE404]

More facts needed

I find it difficult to believe any investment firm would "deposit" any new funds into an IRA account without the explicit approval/instructions of the individual.

As for "deducting" those funds as an allowable item on the tax return, there are a number of issues not yet explained, such as amount of wage/self-employment income received and overall income shown on the tax return. Even filing status could present some issues.

Don't believe you can have anything remotely resembling a "return of capital" within an IRA account.

I think you need some more facts.....and likely need to take a careful look at the accuracy of the 2010 return. There may be a need for a Form 8606...for numerous reasons. Did this guy ever make any NON-deductible IRA contributions in the past??

You also need to find the relevant Form(s) 5498.

FE

[JohnH]

It is odd that a company would deposit funds into an IRA without specific directions from the client. If this is what really happened, he will have a better chance of recovering the taxes from the company than he will escaping the tax consequences from IRS.

[smithtax]

Agree with Feduke404.

Also curious - what was the IRS Notice number?

[Kram BergGold]

Let's make some assumptions

If this went the way you describe then here is what needs to be done.
First, if client is eligible for a deductible IRA claim the maximum allowed.
Second, net it against the K-1 amount (this might eliminate the extra tax).
Third, file Form 8606 to claim a non deductible contribution if you can't claim a deductible.
Fourth, remove any excess contribution and ask for a penalty waiver as it was the fault of the broker.

[ChEAr$]

That K-1 income of 5 4XX WHATERVER, was it from a partnership K1? or a Sub S K-1? There's a big difference there as to eligibility to make an IRA contribution.

[manyhappyreturns]

a few answers

Thanks everybody for your responses. Obviously, IRAs aren't my area of expertise, so this is all really helpful. Here are some answers to the questions you asked. I will be calling my client tomorrow to get the rest of the story.

1. The K-1 income is partnership income, and the client doesn't have any other income that qualifies as compensation for IRA contribution purposes. The fact that he didn't even know (or at least that's what he says) that he even had the income makes me think it must be passive in nature. I'll verify this with him tomorrow.

2. He brought in two 5498s for his 2 IRA accounts, but only the 1st 2 out of 4 pages, so all I have is the FMV of each of the accounts on 12/31/2009 and 12/31/2010, not the client's basis in either account on those dates.

3. I'm assuming what he meant by "return of capital" was the portion of his distributions that was his basis in the accounts, but I won't have that info till I talk to him tomorrow. The 2010 return that he filed showed all his IRA distributions as taxable. The 1099s had the full amount of box 1 also in box 2, but the "taxable amount not determined" box was checked as well. I hate it when they do that, especially when the client doesn't know what their basis is in the account.

4. IRS notice # is CP2000. There were 7 different K-1s that had been reported to the IRS with a combination of ordinary income, interest, dividends, capital gains, rents and royalties. All of the K-1 income was deposited in one or the other of his 2 IRA accounts.

It really does seem surprising that an investment company would deposit all these amounts in his IRA without him knowing about it.

Thanks again everybody. This is really helpful. Now at least I know what to ask my client.

Linda

[smithtax]

[IRS notice # is CP2000]

Interesting. Apparently K-1s have been incorporated into the AUR program.

[FEDUKE404]

Addressing your response

Thanks everybody for your responses. Obviously, IRAs aren't my area of expertise, so this is all really helpful. Here are some answers to the questions you asked. I will be calling my client tomorrow to get the rest of the story.

1. The K-1 income is partnership income, and the client doesn't have any other income that qualifies as compensation for IRA contribution purposes. The fact that he didn't even know (or at least that's what he says) that he even had the income makes me think it must be passive in nature. I'll verify this with him tomorrow.

2. He brought in two 5498s for his 2 IRA accounts, but only the 1st 2 out of 4 pages, so all I have is the FMV of each of the accounts on 12/31/2009 and 12/31/2010, not the client's basis in either account on those dates.

3. I'm assuming what he meant by "return of capital" was the portion of his distributions that was his basis in the accounts, but I won't have that info till I talk to him tomorrow. The 2010 return that he filed showed all his IRA distributions as taxable. The 1099s had the full amount of box 1 also in box 2, but the "taxable amount not determined" box was checked as well. I hate it when they do that, especially when the client doesn't know what their basis is in the account.

4. IRS notice # is CP2000. There were 7 different K-1s that had been reported to the IRS with a combination of ordinary income, interest, dividends, capital gains, rents and royalties. All of the K-1 income was deposited in one or the other of his 2 IRA accounts.

It really does seem surprising that an investment company would deposit all these amounts in his IRA without him knowing about it.

Thanks again everybody. This is really helpful. Now at least I know what to ask my client.

Linda

There is something not quite correct here.

From my experience, assets within an IRA account will be "owned" by the custodian. Using the classic "black box" definition of any IRA, all distributions that exit the IRA are subject to tax regardless of whatever previously happened "inside" the IRA. I cannot imagine a CP2000 would be generated for unreported income to "Merrill Lynch, custodian for IRA of Joe Smith." If that is the case, we all are in trouble!!

It really sounds to me as if the guy has income from some taxable (non-IRA) investments that were not reported to the IRS. If such were held within a regular investment account, the income from those K-1s would NOT have appeared on the Forms 1099-INT/DIV/B for the brokerage firm, although the "cash distributions" would likely have been shown on the monthly/annual statements from the firm. The information from each K-1 would have needed to be entered into his TurboTax software, with likely Schedule B and Schedule E entries (and more!) resulting. I have a couple of clients with such scenarios, and I always have to chase down the related K-1s for those separate investments. (Many are retrievable at a web site for the specific investment.) If he has Master Limited or Publicly Traded Partnerships and/or anything related to passive loss issues, you could have a genuine mess to resolve. We all know the GIGO issues even with reasonably good tax software such as TurboTax.

As for the 5498, what you are looking for is a document that will show an amount in the "IRA Contribution" box. The absence of such is another pretty fair indication that nothing "new" actually went into the IRA account. The FMV information is common and may have little, if any, relevance to the tax return noted. Exception would be if, in the past, non-deductible (differs from "unallowable") IRA contributions were made and would first be entered on lines 1 and 2 of Form 8606 which would then calculate the taxable amount.

As for the Form 1099-R for any retirement distribution, it is not unusual for the "taxable" amount to be blank. Clients often have to pay us to come up with that number.

Finally, I cannot think of anything related to K-1 income or IRA contribution/distribution where "return of capital" would have any relevance.

Not to beat a dead horse, but I have grave doubts that anything from a K-1 could mysteriously end up in an IRA account (unless the asset was already owned by the IRA account) as a new "contribution". As noted, you said the Forms 5498 showed no new funds deposited. If somehow the investment firm made a "bad" contribution to his IRA accounts, as JohnH mentioned that is not a tax issue but an administrative issue that needs to be resolved.

Is there a possibility this "older gentleman" might not have a full grasp of what his investments actually involve??????

My prediction: 1) IRA distributions are valid, and in all likelihood fully taxable unless valid historical information for Form 8606 exists and 2) the K-1 income is likely personal income that was not properly reported to the IRS and 3) there may be NO legitimate new contributions (reductions in AGI) attributable to any IRA activity.

Good luck. Keep us posted!

FE

[Burke]

I would want to see the actual K-1's. Many are within IRA's now and they send them to the TP. However, they are issued to the custodian, and they are in the custodial IRA's EIN! Could this be what happened? I have to deal with these every year now. I am seeing a lot of issues with K-1's this year. It appears it is a new area of concentration with the IRS and its matching programs.

[manyhappyreturns]

New info from TP

Talked to TP this morning and got him pretty riled up with my questions. He said he had spoken with a "tax lawyer" at the IRS who told him the $4,469 in K-1 income that Fidelity Investments deposited in his IRA needed to be withdrawn (because it was an excess contribution) by the end of the tax year and that it would not be taxed as an IRA distribution because it was already taxed as income (that's what he meant by "return of capital"). Actually, it WILL be taxed as income on his 1040X. He originally filed declaring the entire $64,000 in IRA distrubutions as taxable, and that is the amount shown on his 1099R in Box 2, but now he's saying that the $4,469 should be considered part of that distribution and that part considered non-taxable. He didn't even know until he got the IRS letter a month ago that the K-1 income went into the IRA, but now he's saying it should be considered part of his distributions and exempted from tax.

Maybe he should try to get a corrected 1099R from Fidelity??? I doubt they would go for it.

He couldn't answer my question about his cost basis. In fact, he didn't appear to understand what I meant. He just kept saying the K-1 income was "return of capital" for that one year and I should somehow magically get him out of paying taxes on it. I was having trouble getting a word in, because he kept saying the same thing over and over. I'm going to meet him at my office this aft because he told me he can show me the figures on his spreadsheets. So, he might get mad and take back all his paperwork and leave, which is okay with me. He kept saying that he came to see me because he couldn't get Turbo Tax to give him the answers he wanted. Well, maybe I can't either.

[JohnH]

This guy sounds like a major pain. Turbo-Tax do-it yourselfer, doesn't know the difference between a tax attorney and IRS customer service, talks more than he listens. He already has 3 stikes against him in my book.

If he came to my office I'd probably tell him I'll give him 15 minutes at no charge while I look over his mess and then we go on the clock at the full hourly rate. From that point forward he can talk as much as he wants, but the bill will be mounting up. Chances are he would take his stuff and go, which would be fine by me. I'd also ask him to give my business card back to me as he went out the door.

[FEDUKE404]

Enough is enough

Talked to TP this morning and got him pretty riled up with my questions. He said he had spoken with a "tax lawyer" at the IRS who told him the $4,469 in K-1 income that Fidelity Investments deposited in his IRA needed to be withdrawn (because it was an excess contribution) by the end of the tax year and that it would not be taxed as an IRA distribution because it was already taxed as income (that's what he meant by "return of capital"). Actually, it WILL be taxed as income on his 1040X. He originally filed declaring the entire $64,000 in IRA distrubutions as taxable, and that is the amount shown on his 1099R in Box 2, but now he's saying that the $4,469 should be considered part of that distribution and that part considered non-taxable. He didn't even know until he got the IRS letter a month ago that the K-1 income went into the IRA, but now he's saying it should be considered part of his distributions and exempted from tax.

Maybe he should try to get a corrected 1099R from Fidelity??? I doubt they would go for it.

He couldn't answer my question about his cost basis. In fact, he didn't appear to understand what I meant. He just kept saying the K-1 income was "return of capital" for that one year and I should somehow magically get him out of paying taxes on it. I was having trouble getting a word in, because he kept saying the same thing over and over. I'm going to meet him at my office this aft because he told me he can show me the figures on his spreadsheets. So, he might get mad and take back all his paperwork and leave, which is okay with me. He kept saying that he came to see me because he couldn't get Turbo Tax to give him the answers he wanted. Well, maybe I can't either.

This guy sounds clueless....

FIRST ask him to show you a Form 5498 which shows a "contribution" was made to his IRA. (Doubt if such exists...)

SECOND confirm that Fidelity DID (perhaps) put NEW funds into an IRA. (Doubt if that happened...)

THIRD have the guy show you ALL of the K-1s for the year in question. (Doubt if "IRA" account...IRA account EIN and not his SSN...will appear on those documents...)

BTW: The guy is obviously totally confused as to what constitutes a "return of capital" and/or how such is totally irrelevant within any IRA account!

Oh yes: You never answered as to whether the IRS is now looking at K-1s for activity within an IRA account. (I reiterate the issue of EIN vs SSN on those K-1s!) My guess is even the IRS is not that desperate!

For my 2¢ worth, my wager is he simply has taxable (unrelated to any IRAs !!) unreported income that was originally disclosed to him on those K-1s. Hence the CP2000 notice (have you actually seen it?)

I do hope you are keeping track of billable hours for this PITA!! (Otherwise demonstrable as http://www.youtube.com/watch?v=V2f-MZ2HRHQ )

FE

[luke]

Fed

I think I'll have that Strother Martin video run on a "loop" in my reception area this tax season!!

[manyhappyreturns]

more info

The K-1s all show client's SSN as recipient, and also all of it is passive income. Therefore he was not even allowed to contribute to the IRA in the first place. He knows that because the "tax lawyer at the IRS" told him that. But he also said the "tax lawyer" told him to prepare an 8606 to report the K-1 income as a non-deductible contribution and to report that same amount also as the non-taxable part of the distribution he took, which he had previously reported as fully taxable. I wouldn't be totally surprised if someone at the IRS actually told him that, but the person may not have totally understood the situation. I have a lot of trouble getting IRS personnel to answer my questions, because they mostly just quote tax publications that I've already read, and they can't read between the lines anymore than I can. They often don't understand what I'm asking and keep going back to telling me things I already know.

He called me back a little while ago and for some reason it went straight to voicemail (which I'm glad about). His message was that he looked up what I meant by cost basis -- apparently a new term for him -- and he said that K-1 amount in question was his cost basis, and when you take that amount and divide it by the amount of the $64,000 distribution, it comes out 7%, which is the amount that should be returned tax free. I told him earlier that they figure the taxable amount based on the entire FMV of the IRA, but he is thinking it should be figured year by year and that he should get his nondeductible contribution back tax-free because it's "return of capital."

He ended the voicemail with "Sounds pretty simple to me. See you at 2pm." This is going to be an interesting meeting.