Excess IRA contributions increasing taxpayer's basis.

In a case of first impression, the Tax Court recently ruled in Campbell, 108 TC No. 5 (1997), that an excess contribution to an individual retirement account (IRA) that had previously been taxed increased the taxpayer's basis in his IRA. Therefore, when the excess contribution was distributed to him, it was not included in his gross income a second time.

The statutory scheme determining this issue is complex. Sec. 408(a)(1) prohibits contributions to an IRA in excess of $2,000 per individual per year unless the contribution is a rollover contribution. In general, Sec 4973(b) defines "excess contributions" as contributions in excess of $2,000 per individual per year. Whether part or all of the $2,000 contribution is IRA IRA deductible depends on the taxpayer's income and participation in a qualified retirement plan. Prior to 1987, nondeductible contributions were not allowed and a taxpayer's basis in an IRA was zero. The 1986 Tax Reform Act (TRA) added Sec. 408(o), which permitted nondeductible contributions up to $2,000 per individual per year. Also, the TRA changed the rules on the taxation of IRA distributions.

For IRA distributions made after 1986, Sec. 408(d)(1) specifies that they are generally included in gross income as determined under Sec. 72. Sec. 408(d)(4) provides an exception to this rule for contributions to an IRA during a tax year that are distributed by the due date of the return (including extensions) for that year; such amounts are not included in gross income. Also, Sec. 408(d)(5) provides another exception for certain excess contributions to an IRA distributed after the due date of the return, if such contributions do not exceed $2,250. Finally, Sec. 408(d)(3) contains an exception for certain distributions that are rolled over.

In general, Sec. 402(a) specifies that distributions from qualified retirement plans are also included in gross income as determined under Sec. 72; there is an exception for certain rollovers made within 60 days of the distribution. However, Sec. 402(a)(5)(D) and (e)(4)(A) extended this exception to partial distributions only if the employee separated from the service of the employer. This requirement was repealed for distributions made after 1992.

Sec. 72(e) applies to IRA and qualified retirement plan distributions not received as annuities. Sec. 72(e)(2)(B) requires the distributions to be includible in income to the extent allocable to income on the contract and excludible to the extent allocable to investment in the contract. Sec. 72(e)(8) specifies that the amount allocated to the investment in the contract is the ratio of the investment in the contract to the total account balance. Sec. 72(e)(6) defines "investment in the contract" as the consideration paid for the contract minus any excludible amounts received.

In Campbell, George Campbell, a Maryland state employee, transferred from the Maryland Retirement System to the Maryland Pension System. Both are qualified retirement plans. On Nov. 30, 1989, he received a transfer refund of $174,802, even though he remained a Maryland employee eligible for a monthly annuity on retirement. The $174,802 consisted of $11,696 in previously taxed contributions and $163,106 in taxable employer contributions and earnings. The transfer refund was a partial lump-sum distribution under former Sec. 402(a)(5)(D); thus, $163,106 was includible in Campbell's gross income.

Campbell did not include the $163,106 in gross income on his 1989 return. He deposited $82,900 into an IRA with Loyola Savings on Dec. 26, 1989, and $81,206 into an IRA with Delaware Charter Trust Co. on Jan. 2, 1990. (The $1,000 discrepancy was not explained in the case.) On Apr. 11, 1991, Campbell received a distribution of the $82,900 plus earnings from the Loyola IRA. In a letter dated Apr. 8, 1991, he requested that the Delaware Charter IRA be converted into a non-IRA account. Delaware Charter made the conversion on June 11, 1991. Also in 1991, Campbell filed an amended 1989 return to report the $163,106 taxable portion of the transfer refund in income.

Campbell conceded that the earnings on both IRAs were includible in his 1991 gross income. The IRS conceded that the Delaware Charter IRA distribution was deemed to have occurred prior to the due date of Campbell's 1990 return; therefore, it was excludible under Sec. 408(d)(4). However, the Service claimed that the $82,900 distribution from the Loyola IRA was taxable under Sec. 408(d)(1). Campbell argued that the "consideration paid for the contract" under Sec. 72(e)(6) gave him a basis in the excess contribution that was deposited into the Loyola IRA. The IRS maintained that Campbell's basis in the Loyola IRA was zero and that Sec. 72(e)(6) applies only to nondeductible IRA contributions under Sec. 408(o).

The Tax Court ruled that the excess contribution was "consideration paid for the contract" under the plain meaning of Sec. 72(e)(6). Therefore, applying the exclusion ratio under Sec. 72(e)(8), the distribution of the excess contribution was excludible. The court found no unequivocal evidence of a contrary intent in the legislative history of the relevant statutes. Although the legislative history of the Employee Retirement Income Security Act of 1974 clearly indicated that a distribution such as Campbell received would have been taxable if it occurred prior to 1987, the legislative history of the TRA does not consider the distribution of excess contributions. Finally, the Tax Court pointed out that double taxation is to be avoided unless explicitly intended by Congress.

Campbell applies to any taxpayer receiving a distribution of an excess contribution that exceeds $2,250 and occurs after the due date of the return for the year the excess contribution was made. Typically, these excess contributions are amounts that the taxpayer erroneously believes qualify for rollover treatment. Because they are ineligible. they are taxable and constitute excess contributions. Rollovers of distributions from qualified retirement plans under Sec. 402(c) and from IRAs under Sec. 408(d)(3) that are ineligible include the following: excess amounts, amounts after the 60-day deadline, certain periodic payments and required distributions. Also ineligible are rollovers of distributions from inherited IRAs, unless the surviving spouse is the heir.

From Peter C. Barton, MBA, CPA, J.D., Professor of Accounting, University of Wisconsin-Whitewater, Whitewater, Wisc.