Tracking Basis with IRS Form 8606
Like other accounts, distributions from IRAs of basis comes out tax-free. In this setting, basis would include both nondeductible IRA contributions and after-tax funds rolled over from company plans.
While after-tax funds in an employer plan can be rolled over to a traditional IRA, it doesn’t occur very often since the release of IRS Notice 2014-54. In that guidance, the IRS approved the separation of pre-tax and after-tax monies from an employer plan distribution. That allows people to roll the pre-tax portion over to a traditional IRA and convert the after-tax basis to a Roth IRA at a much lower tax rate, and potentially tax-free.
Basis is tracked on Form 8606. There’s a $50 IRS penalty for not filing the Form, and a $100 penalty for overstating the basis. However, that’s not the biggest issue since the penalty can be waived for reasonable cause. The larger issue is that if basis isn’t tracked, it ends up being taxed twice! While it’s easier for IRA owners to track their basis, it becomes much more difficult for beneficiaries of inherited IRAs. That’s because basis is carried over, but without adequate records, a beneficiary will have no clue whether a contribution was made before or after-tax.
Therefore, advisors must immediately investigate the existence of basis when a client inherits an IRA. If adequate records on basis do not exist, advisors should review contribution records against personal tax returns to determine whether a deduction was in fact taken for a particular contribution. Any unreported basis should be reported on a Form 8606. Even though Form 8606 is normally submitted along with a timely-filed Form 1040, the IRS has indicated that it will process a stand-alone Form 8606, and even one filed beyond the normal 3-year statute of limitations for claiming a refund. Since we are talking about nondeductible contributions, an amended Form 1040 (i.e., IRS Form 1040-X) is not required.
Under the Tax Code, tracking basis is solely the responsibility of the taxpayer, and not the IRS or even the IRA custodian. Thankfully, the courts have forced the IRS to take a much broader approach to establishing basis than the Service had in mind. The IRS used to take the position that if Form 8606 is not on file, then basis in an IRA does not exist. In fact, the IRS took this position in a recent Tax Court case, entitled Shank v. Commissioner, T.C. Memo 2018-33, March 20, 2018).
In Shank, an IRA owner took a full distribution from his traditional IRA and reported none of it on that year’s Form 1040. Upon audit, he claimed the distribution was basis, despite the fact that he had never filed a Form 8606 or did not have any tax returns to show that a deduction wasn’t taken for certain contributions. Unsurprisingly, the IRS rejected this argument and assessed taxes on the full amount.
At trial, the Court forced the IRS to consider additional evidence, including testimony from the taxpayer, payroll records, and old IRA statements when determining whether basis in an IRA exists. After looking at all the evidence, the Court drew the following conclusions:
- The IRA was opened with an initial contribution and no rollover or subsequent contributions were made to the account.
- In the year of the initial contribution, the taxpayer’s income placed him above the phase-out limits. Therefore, he probably did not take a deduction for that contribution (making it basis).
- One of his previous statements recorded the investments as having an acquisition cost of $4,760 and a purchase date around the time the IRA was originally opened.
As a result, the Shank Court ruled that the taxpayer had basis in the IRA in the amount of $4,760. However, it wasn’t all roses for Mr. Shank. While he now had some basis in the IRA, that still left $22,985 in unreported income from the IRA distribution which was still subject to penalties, interest, and fines.
In the end, it’s the taxpayer’s responsibility to track IRA basis. But advisors can assist here by providing annual IRA basis information to clients or by keeping the information on file to assist tax preparers. This will not only benefit the taxpayer during his or her life, it will be vital information to any beneficiary.