Keebler & Ward on Taproot v. Commissioner: Roth IRA Not Eligible Shareholder of S Corporation

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Traditional IRAs are not eligible S corporation shareholders under Rev. Rul 92-73 on the theory that the beneficiary of a traditional IRA is not taxed currently on the IRA’s share of the S corporation’s income. But what about Roth IRAs?

In Employee Benefits and Retirement Planning Newsletter #506 Bob Keebler provided LISI members with his analysis of the initial Tax Court decision in Taproot, that at the time supplied the answer to the fascinating question set out above. Now, Bob returns with Michelle Ward, and together they comment on the 9th Circuit’s affirmation of the Tax Court’s decision.


In Taproot, the Ninth Circuit Court of Appeals upheld the U.S. Tax Court’s finding that a Roth IRA is not an eligible S-corporation shareholder.


Paul Di Mundo incorporated Taproot Administrative Services, Inc. in the state of Nevada in 2002. Taproot elected S corporation status effective as of the date of incorporation and filed its 2003 tax return on a U.S. Income Tax Return for an S Corporation.

In early 2003, Taproot issued all outstanding shares of its stock to a custodial Roth IRA account held at the First Trust Co. for the benefit of Di Mundo. The custodial Roth IRA account remained Taproot’s sole shareholder during the 2003 tax year.

In 2007, the Commissioner of the Internal Revenue Service issued a notice of deficiency to Taproot for the 2003 tax year. Among other findings, the Commissioner determined that a Roth IRA did not qualify as an eligible shareholder of an S corporation. Consequently, Taproot was deemed taxable as a C corporation for the 2003 tax year.


Taproot argued that the individual beneficiary of a custodial account also qualifying as a Roth IRA should be considered the shareholder for purposes of the S corporation statute.

Treas. Reg. Sec. 1.1361-1(e)(1) provides that “[t]he person for whom stock of a corporation is held by a nominee, guardian, custodian, or an agent is considered to be the shareholder of the corporation for purposes of [the S corporation statute].” Taproot contended that as the sole beneficiary of the DiMundo Roth IRA, DiMundo should be considered the shareholder and, thus a qualifying individual for the purposes of the statute.

IRC Sec. 1361(c)(2)(A)(i) also extends shareholder eligibility to any grantor trust “all of which is treated…as owned by an individual who is a citizen or resident of the United States.” Taproot therefore also argued that a Roth IRA should be classified as a grantor trust.

In Rev. Rul. 92-73, the IRS ruled that an IRA is not a permitted shareholder of an S corporation under section 1361. The IRS reached similar conclusions regarding an IRA’s eligibility as an S corporation shareholder in a least 42 PLRs (see, e.g., PLRs 200915020, 200931039 and 200940013). While the Court acknowledged that such rulings were not binding precedent, it also noted that they can be used as evidence of an administrative practice of the IRS.

The Tax Court, along with noting the functional differences between IRAs and grantor trusts, found Rev. Rul. 92-73 to “sensibly distinguish[ ] IRAs from grantor trusts.” In making that determination, the Tax Court relied in part on the rationale of Revenue Ruling 92-73, stating that:

[T]raditional IRAs are not eligible S corporation shareholders because the beneficiary of a traditional IRA is not taxed currently on the IRA’s share of the S corporation’s income whereas the beneficiaries of the permissible S corporation shareholder trusts listed in section 1361(c)(2)(A) are taxed currently on the trust’s share of such income.

On appeal, Taproot maintained that the Di Mundo Roth IRA functioned merely as the form of Di Mundo’s individual investment account and that the plain language of Treas. Reg. Sec. 1.1361-1(e)(1) explicitly authorizes those IRAs and Roth IRAs created as custodial accounts to be shareholders of S corporations.

Taproot first claimed that both forms of IRAs and Roth IRAs—trusts and custodial accounts—lack the essential characteristics of a separate taxpayer and should therefore be treated as indistinguishable from the individual owners. The Court, however, found that Taproot did not provide persuasive reasoning or convincing authority for this conclusion and found the reasoning in Rev. Rul. 92-73 to support the opposite result. The Court found that the distinguishing feature is the deferred income tax treatment, which differentiates IRAs from beneficiaries listed in IRC Sec. 1361(c)(2)(A) who are taxed currently on the trust’s share of income.

The Tax Court also discussed the legislative intent behind the S corporation statute, finding the only available evidence suggested that Congress did not intend to allow IRAs to own S corporation stock. Although at the time Congress initially drafted the S corporations statute, both traditional and Roth IRAs had yet to be created, the Tax Court reasoned that “had Congress intended to render IRAs eligible S corporation shareholders, it could have done so explicitly,” as it did with the 2004 amendment allowing banks with IRA shareholders to elect S status in specific circumstances.

This was especially true in light of Congress’s 1999 directive to “the Comptroller General of the United States to conduct a study of possible revisions to the rules governing S corporations including “permitting shares of such corporations to be held in individual retirement accounts.” For these reasons, the Tax Court concluded that traditional and Roth IRAs were not eligible shareholders. On appeal, the Court found the legislative history of the S corporation statute favored limited eligibility and that if at any point Congress had intended IRA eligibility, it could have amended the statute. The Court pointed out that if IRAs and Roth IRAs qualified as eligible shareholders in 2003, then the subsequent 2004 amendment would have been completely unnecessary.


It is interesting to note that the Tax Court was also mindful that under Taproot’s theory of statutory construction, DiMundo would avoid virtually all taxation on his S corporation profits. This would enable S corporations to achieve an overwhelming benefit over C corporation competitors which are subject to two levels of taxation —one at the corporate level and another at the shareholder level.

In a lengthy dissent, however, Judge Halpern notes that “this underestimates the strengths of the Code’s other defenses against such shenanigans.” He noted that there are numerous limitations on what can go in and out of an IRA—income-contribution limits, deadlines for contributions, penalties on prohibited transactions, and penalties on excess contributions. Judge Halpern further noted that while custodial retirement accounts are generally exempt from tax on undistributed IRA income, they are still subject to the taxes imposed on Unrelated Business Income Tax. In general, the Unrelated Business Income Tax subjects the business earnings of tax-exempt organizations to taxation.

The majority of the Tax Court, however, expressed its skepticism that the Unrelated Business Income Tax could adequately mitigate this tax advantage. Although Taproot contended that the Unrelated Business Income Tax negates the Tax Court’s policy concerns, the Appeals Court agreed with the IRS that I.R.C. Sec. 512 generally excludes passive investment income, such as interest income, from application of the UBIT and thus, in this case, the interest income at issue would not be subject to the UBIT.



CITE AS: LISI Employee Benefits and Retirement Planning Newsletter #603 (April 17, 2012) at Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.

CITES: Taproot Administrative Services v. Commissioner, Case No. 10-70892; Revenue Ruling 66-266, 1966-2 C.B. 356; Revenue Ruling 92-73, 1992-2 C.B. 224

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