The Tax Court held that the taxpayers’ guarantees of a loan made to a company owned by the taxpayers’ individual retirement accounts (IRAs) were prohibited transactions that caused the accounts to cease to be IRAs.
In 2001, Darrell Fleck and Lawrence Peek (the taxpayers) decided to buy Abbot Fire & Safety Inc. (AFS). On the advice of an accountant, the taxpayers chose to use IRAs to purchase the company. Each taxpayer established a self-directed traditional IRA to hold his share of the company’s stock. They then formed FP Co. and directed the new IRAs to use rolled-over cash to purchase 100% of FP Co.’s newly issued stock. FP Co. subsequently acquired the assets of AFS, using the funds from the IRAs’ purchases of its stock and a bank loan and notes from FP Co. to the broker and the sellers. The taxpayers personally guaranteed FP Co.’s bank loan.
In 2003 and 2004, the taxpayers rolled over the FP Co. stock from the traditional IRAs to Roth IRAs, including in their income the value of the stock rolled over in those years. In 2006 after the FP Co. stock had significantly appreciated in value, they directed their Roth IRAs to sell all of the FP Co. stock, and they received payments for the stock in 2006 and 2007. The taxpayers did not report the gain from the sale on their respective individual income tax returns for 2006 and 2007.
The IRS disagreed with how the taxpayers reported the results of this series of transactions. The IRS contended that the taxpayers’ personal guarantees of the FP Co. loan were prohibited transactions under Sec. 4975(c)(1)(B), which prohibits a direct or indirect lending of money between a retirement plan and a disqualified person. Under Sec. 408(e)(2)(A), because the loan guarantees were prohibited transactions, the taxpayers’ original IRAs ceased to qualify as IRAs, resulting in a distribution of the assets in the IRAs to the taxpayers. From that point forward, the IRS treated the FP Co. stock as personally owned by the taxpayers. The IRS adjusted each taxpayer’s income for 2006 and 2007 to include capital gain from the sale of his share of the FP Co. stock.
The taxpayers challenged the IRS’s determination in Tax Court. While the taxpayers’ acknowledged that their loan guarantees were indirect loans and that they were disqualified persons for purposes of Sec. 4975(c)(1)(B), they argued that the guarantees were not loans between the plans (i.e., the IRAs) and disqualified persons. Instead, the guarantees were between disqualified persons and FP Co., which was an entity other than the plans. Therefore, the guarantees were not prohibited transactions, the IRAs did not cease to qualify as IRAs in 2001, the conversions of the IRAs to Roth IRAs were valid, and the sale of the FP Co. stock was a sale by the Roth IRAs, not by the taxpayers.
The Tax Court’s Decision
The Tax Court held that the loan guarantees were Sec. 4975(c)(1)(B) prohibited transactions and the original IRAs and the successor Roth IRAs did not qualify as IRAs during the period they were in force, including the time when the FP Co. stock was sold. Because the Roth IRAs did not qualify as IRAs at the time of the sale, the court further held that the taxpayers owned the stock personally and the sales resulted in capital gain income for the taxpayers.
The Tax Court found that the taxpayers misinterpreted the meaning of “any direct or indirect” as applying only to the types of extension of credit that are prohibited under Sec. 4975(c)(1)(B), serving only to widen the scope of the prohibition to cover loan equivalents such as loan guarantees. Citing the Supreme Court’s opinion in Keystone Consolidated Indus., Inc. , 508 U.S. 152 (1993), the Tax Court found that “any direct or indirect” should be interpreted more broadly to also refer to any loans that are made directly or indirectly to the IRA. Following the taxpayers’ limited interpretation, the court explained, would allow an IRA easily and abusively to circumvent the loan prohibition by simply creating a shell corporation and having the desired loan made to the corporation instead of directly to the IRA. The court stated that this was a type of evasion Congress sought to prevent by using the word “indirect” in the statute. Accordingly, it did not matter that the taxpayers made their loan guarantees with FP Co., and not directly with the IRAs.
The Tax Court also explained that each of the taxpayers’ original IRAs ceased to qualify as IRAs in 2001, and since the loan guarantees continued in force when the taxpayers set up their Roth accounts in 2003 and 2004, those accounts ceased to qualify as Roth IRAs as soon as the taxpayers funded them with the FP Co. stock. Thus, the taxpayers personally owned the FP Co. stock when it was sold, and they were liable for tax on the gains from the sale. In a footnote in its opinion, the Tax Court noted that since the guarantees remained in force from 2001 until the FP Co. stock was sold, it did not address the issue of whether a taxpayer could “reform or resuscitate” an IRA that ceased to qualify as an IRA under Sec. 408(e)(1).
Further proving that in tax affairs ignorance is not always bliss, the Tax Court also held the taxpayers liable for accuracy-related penalties due to negligence or disregard of rules or regulations. Although the accountant who had sold the taxpayers on the plan to buy AFS through IRAs did not tell them that a loan guarantee with FP Co. would be a prohibited transaction with respect to the IRAs, the opinion letter from the accountant clearly stated that they could not engage in transactions with the IRAs that the IRS would consider to be prohibited transactions under Sec. 4975. Given that the taxpayers did not ever tell the accountant about the loan guarantees, this was enough for the court to find negligence on the taxpayers’ part.
Peek, 140 T.C. No.12 (2013)