For perhaps the first time in tax preparation history, traditional and Roth individual retirement accounts (IRAs) must be screened for so-called “wash sales” — thanks to Revenue Ruling 2008-5, Internal Revenue Bulletin 2008-3. The ruling has no effective date.
Practitioners can accomplish this screening by including a question on a tax organizer to be completed by the taxpayer, or by way of income tax preparation checklists. Failure to catch wash sales involving traditional or Roth IRAs would have the same consequences as failing to catch any other wash sale: The Internal Revenue Service would regard it as an omission.
IRA owners will find it a shock that anything occurring inside a traditional or Roth IRA will increase their income taxes. But that's precisely what will happen if a deduction arising from a loss sale is disallowed under the new ruling.
The wash sale rules of Internal Revenue Code Section 1091 generally deny an income tax deduction for losses on sales of securities if substantially identical securities are acquired by the taxpayer within a period running from 30 days before through 30 days after the loss was incurred. The IRS said wash sale rules apply when the taxpayer causes such an acquisition to occur inside an IRA or Roth IRA. It is because the taxpayer has control over the IRA or Roth IRA that the wash sale rules apply, according to the ruling.
Even a contract or option can trigger the rules. But there's an exception: Dealers in stock or securities may claim the loss if it's sustained in a transaction made in the ordinary course of business.
An income tax basis adjustment is made for the difference between the selling price of the securities sold and the acquisition price of the securities acquired. The difference is added to or subtracted from the basis of the sold shares.
Let's say Jean sold her 1,000 shares in SpinCycle Corp. for $75,000 on Dec. 20, 2007. Jean's basis for determining gain or loss was $83,000. So, Jean has sustained a loss of $8,000. Jean then buys the same number of SpinCycle Corp. shares for her traditional, self-directed IRA on Jan. 4, 2008, at a cost of $77,000. According to the ruling, Jean may not deduct her loss, nor may she increase her income tax basis in her IRA. The same rule applies if Jean had bought the new shares in her Roth IRA instead of her traditional IRA.
The denial of the $2,000 basis increase in Jean's IRA puts her in a worse position than if she had bought the replacement shares outside the IRA.
Hunting for Authority
To support its conclusion, the IRS reached back to a very old court case — and made some essential mistakes.
The IRS pointed to Security First National Bank of Los Angeles.1 In that case, Henry E. Huntington formed an inter vivos trust for the fledgling Henry E. Huntington Library and Art Gallery. He reserved to himself and his wife dominion and control over the trust corpus for life. Huntington was also the sole shareholder of Huntington Land and Improvement Co.
On the same day he sold bonds at a loss from his personal account, he caused Huntington Land and Improvement Co. to exchange identical bonds it then owned for land held by the trust. Thus, the trust over which Huntington and his wife held dominion and control acquired the bonds, which were identical to the ones he himself had sold. The court held this was a wash sale under then IRC Section 214(a)(5) (predecessor of present day Section 1091) because “[a]lthough title to the bonds was acquired by the trust, actual command over the property was still in the [taxpayer].”2 In fact, Huntington could have re-vested title of the bonds in himself under the terms of the trust.
The ruling quotes Security First National Bank of Los Angeles: “The [taxpayer] did not personally reacquire substantially identical property and, strictly construed, the language of section 214(a)(5), above referred to, might not apply. However, the rule of strict construction should not be unduly pressed to permit easy evasion of a taxing statute. Carbon Steel Co. v. Lewellyn, 251 U.S. 501. Unless the respondent is right, a trust like this one could be used deliberately to accomplish the very thing which Congress intended to frustrate… Although title to the bonds was acquired by the trust, actual command over the property was still in the [taxpayer] … The difference between acquisition by him personally and acquisition by the trust amounts only to a refinement of title and may be disregarded so far as section 214(a)(5) is concerned.”3
The ruling missed important background in Security First National Bank of Los Angeles. There, the IRS argued, and the court agreed, that grantor trust rules as they existed in the 1926 Tax Act applied so as to tax to Huntington the income of the trust. When the court went on to address the alleged wash sale, it said: “The trust was not a taxpayer. The practical effect of the creation of the trust was to assign income. [Cite omitted.] All of the income of the trust was still taxable to the decedent. His gifts to the trust were so lacking in substance that the gift tax of the Revenue Act of 1924 would not have reached them.”4
Thus, the case the ruling cites as authority for its holding is distinguishable on its facts: the trust in Security First National Bank of Los Angeles was a grantor trust; an IRA is not. The predecessor to present-day grantor trust rules was the basis for the IRS commissioner's argument and the court's holding with respect to the wash sale rules. But tax-exempt trusts, including IRAs, are not treated as grantor trusts for any purpose by statute or regulations. In short, the ruling seeks to attribute ownership of property for income tax purposes outside the grantor trust rules, and the case cited does not support that conclusion.
Yet, the ruling flatly states that its conclusion applies “even though an individual retirement account is a tax-exempt trust.”
The ruling also fails to clearly distinguish self-directed IRAs from those for which the taxpayer can't direct investment decisions. Although the facts of the ruling involve only a person who causes the IRA to acquire the forbidden securities, the ruling does not make it clear whether its holding might or might not reach:
accounts established by employers and certain associations of employees under IRC Section 408(c);
securities that might be acquired in a rollover, such as from an employer-sponsored plan;
simplified employee pensions under IRC Section 408(k);
simple retirement accounts under IRC Section 408(p);
deemed IRAs under qualified employer plans under IRC Section 408(q); and
decedent's IRAs held in an IRA trust for a beneficiary, where the beneficiary has no control over investment decisions.
That's a lot to ignore. Taxpayers may wish to take the position that the ruling is limited to its facts, and that the wash sale rules don't apply when the taxpayer has no control over the investments in the IRA or Roth IRA.
Also ignored are types of qualified retirement plans for which the taxpayer controls investments. These could include defined contribution Keogh plans and single-participant plans that aren't covered by the Employee Retirement Income Security Act. After all, the investments in such plans are controlled by the taxpayer, just as in the IRA described in the ruling. But the IRS didn't venture into qualified plan territory. Their failure to do so calls into question why IRAs are being singled out.
A haunting afterthought remains: The ruling makes a point of sidestepping the possibility of running afoul of prohibited transaction tax provisions of Section 4975. It's difficult to see how this provision could apply to the facts in the ruling.
Too bad revenue rulings aren't subject to public comment before publication, especially now that there's a new penalty on practitioners if a tax return position isn't more likely than not to prevail. Substantial authority, which includes revenue rulings, must be taken into account. In determining whether an IRA transaction is more likely than not to be attributed to its owner, the IRS has blurred the lines of the grantor trust rules — which seems contrary to sound administration of our tax laws.
This is one ruling the IRS may want to revisit. It needs some cleaning up.
- Security First National Bank of Los Angeles, 28 BTA 289 (1933).
- Ibid. (Emphasis added.)
Michael J. Jones is a partner in Monterey, Calif.'s Thompson Jones LLP