Bright idea doesn't apply to S corporations

Paul DiMundo set up a corporation in 2002, had all of the shares issued to a custodial Roth IRA account and had the corporation elect to be taxed as an S corporation.

An S corporation is generally not subject to tax. Instead, the income of the S corporation is taxed directly to the shareholders.

If you were a shareholder of an S corporation, wouldn't it be a great idea to have your IRA own the shares of the S corporation?

The profits earned by the S corporation would pass to the IRA, an entity that is exempt from tax. Better yet, if you used a Roth IRA, you wouldn't even be taxed when you received distributions from the account.

Unfortunately, Treasury regulations prohibit IRAs, including Roth IRAs, from being shareholders in an S corporation. In DiMundo's situation, the tax year at issue was a year prior to when the prohibiting Treasury regulation went into effect.

Even in the absence of the regulation, the Tax Court and the 9th Circuit Court of Appeals concluded that a Roth IRA was an ineligible shareholder of an S corporation. As a result, DiMundo's corporation lost its status as an S corporation and was instead assessed corporate taxes on its profits (Taproot Administrative Services, Inc. v. Commissioner, CA-9, 109 AFTR 2d ¶ 2012-599, March 21, 2012).

It's worth noting that the tax law does not prevent the transfer of shares of stock to an IRA. However, if the shares are in a corporation that has the tax status of an S corporation, that status will be lost when the ineligible entity becomes a shareholder.

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