This is predicated on the idea that if business profits are funneled through the Roth, they will be tax free, said CPA Ed Slott, founder of Ed Slott and Company in Rockville Centre, New York.
Under normal circumstances, withdrawals from a Roth IRA are generally tax free, but that's because you paid income taxes on what you contributed.
Roth IRA tax evasion schemes tend to fall flat because the business owner ends up over-funding the account beyond the annual contribution limit ($5,500 in 2017, plus $1,000 if you're over age 50), which leaves him or her on the hook for taxes and penalties.
Ed Slott's five warning signs about tax schemes
Multiple entities: A tax plan that requires you to set up multiple partnerships to cover up the transaction is probably not going to pass muster with the IRS.
Long professional opinions: A proposed transaction that can't be explained in a paragraph or two should be avoided. If it's too long, it's going to be harder to understand.
Secret formula: Your tax guru is so clever that the investment strategy involved must be kept secret from you. Run away from any deal that requires you to sign a confidentiality agreement stating you won't discuss the transaction.
Unrealistic claims: Be suspicious of ads that tout guaranteed investment returns or that you'll never lose money.
The IRS "approves" this investment: This is blatantly false, as the IRS has a publication stating it does not approve IRA investments.
Be prepared to lose in Tax Court if you challenge the IRS.
In one notable case in 2008, an investor paid a $120,000 fee for an elaborate scheme that resulted in the transfer of about $1.3 million to a Roth IRA without any taxes paid.
The Tax Court ruled in favor of the IRS. The investor "should have realized that the deal was too good to be true," the Tax Court said.
"There is something about taxes that turns the brains of smart and sophisticated people into mush," Slott said. "These are people who won't spend 2 more cents on coffee, but they'll spend thousands on something that's supposedly tax free."