Ellis, the Case of a Misdirected IRA

Editor: Mindy Tyson Weber, CPA, M.Tax.

Employee Benefits & Pensions

A simple internet search regarding how to use IRA funds as startup capital will generate many links to articles in the financial press, as well as to companies offering services to IRA owners interested in using IRA funds as a source of initial capital. However, not many of these articles or websites advise potential entrepreneurs of the tax complexities of investing retirement funds in such a manner.

IRA Investment Restrictions and Requirements

There are relatively few restrictions on the types of permissible IRA investments. Life insurance and certain collectibles are the only prohibited investments. In addition, an IRA may not, with limited exceptions, commingle its assets with other property. The other key requirements include:

1. All contributions (other than rollover contributions) must be in cash;
2. The trustee or custodian must be a bank or an IRS-approved nonbank custodian (in other words, while IRA owners can self-direct their IRA, they cannot appoint themselves trustee of the IRA);
3. An IRA owner cannot pledge his account as security for a loan; and
4. The trustee or custodian must annually report the activities of the IRA to the IRS.

These very limited exceptions aside, an IRA owner is free to choose from the whole world of investment opportunities. That has led many IRA owners and their advisers to conclude that it is permissible for IRA owners to use their IRA to make an equity investment in a business in which they will be involved.

Prohibited Transaction Considerations

When using IRA funds to invest in a business, an IRA owner needs to be aware of the Code’s prohibited transaction rules. Sec. 4975 prohibits certain transactions between a plan and disqualified persons with respect to the plan. Sec. 4975(e)(1) defines a plan as including an IRA described in Sec. 408(a).

Prohibited transactions defined: The Code prohibits direct transactions and what are referred to as self-dealing transactions. Specifically, Sec. 4975(c)(1) prohibits any direct or indirect sale or exchange, or leasing, of any property between a plan and a disqualified person; any lending of money or other extension of credit between a plan and a disqualified person; any transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; and any act by a disqualified person who is a fiduciary whereby he or she deals with the income or assets of a plan in the fiduciary’s own interest or for his or her own account.

Disqualified persons: With respect to an IRA, the long list of disqualified persons (Sec. 4975(e)(2)) includes any fiduciary to the plan (when acting outside his or her official capacity), service providers to the plan (when acting outside of their official capacity); any family members of any fiduciary or service provider to the plan; and any business in which a fiduciary or service provider has a 50%-or-more ownership stake (direct or indirect). In other words, virtually all parties involved in an IRA relationship, their family members, and certain organizations with which the IRA owner has an affiliation are disqualified persons.

Tax consequences: Sec. 4975 imposes a 15% excise tax on the amount involved in a prohibited transaction, and if the transaction is not reversed within a certain period, an additional 100% excise tax applies. However, in the case of an IRA, if the IRA owner caused or participated in the prohibited transaction, there is no excise tax. Instead, under Sec. 408(e), the IRA loses its tax-favored status, and the assets of the IRA are deemed distributed as of the first day of the year in which the prohibited transaction occurred. The deemed distribution results in the IRA owner’s having to include the amount distributed (less any basis) in income.

The Ellis case

In Ellis, T.C. Memo. 2013-245, the taxpayer learned the particularly dire tax consequences associated with a self-directed IRA investment gone awry. The taxpayer directed his IRA to offer to take a 98% stake in CST, a newly formed Missouri limited liability company (LLC). An individual unrelated to the IRA owner purchased the remaining 2% stake in CST. The taxpayer then funded this IRA with funds rolled over from his prior employer’s Sec. 401(k) plan, and the IRA, in turn, transferred the funds to CST.

During the initial organizational process, CST made a check-the-box election to be taxed as a corporation. In addition, CST appointed the taxpayer as its general manager. In 2005 and 2006, respectively, CST paid the taxpayer $9,754 and $29,263 as compensation for his general manager services.

Shortly after the formation of CST, the taxpayer individually purchased a 50% interest in CDJ LLC, also a Missouri LLC. The taxpayer’s spouse purchased a 12.5% stake in CDJ, and his three children purchased equal shares of the remaining 37.5% of CDJ. Because CDJ did not make an election to be taxed as a corporation, it was taxable as a partnership.

CDJ was formed to purchase and lease commercial real estate. On Jan. 1, 2006, CDJ entered into an agreement with CST to lease certain commercial property to CST. In 2006, pursuant to the lease, CST paid CDJ rent of $21,800.

The notice of deficiency: In 2011, the IRS issued a notice of deficiency asserting that the taxpayer owed $135,936 in 2005 or, alternatively, $133,067 in 2006. The IRS also assessed Sec. 6662 accuracy-related penalties of $27,187 for 2005 or, alternatively, $26,613 for 2006. The IRS deemed the distribution from the IRA (in whichever year it occurred) a premature distribution subject to the additional tax under Sec. 72(t) for early distributions from a qualified retirement plan. The IRS issued alternative notices of deficiency for the 2005 and 2006 tax years based on its position (discussed below) that if a prohibited transaction did not occur in 2005, then one certainly occurred in 2006.

IRS position: The IRS contended that a prohibited transaction occurred at one of the following points: (1) when the taxpayer caused his IRA to engage in the sale and exchange of membership interests in CST in tax year 2005; (2) when the taxpayer caused CST, an entity owned by his IRA, to pay him compensation in tax year 2005; (3) when the taxpayer caused CST, an entity owned by his IRA, to pay him compensation in tax year 2006; or (4) when the taxpayer caused CST, an entity owned by his IRA, to enter into a lease agreement with CDJ, an entity owned by him, his wife, and their children, in tax year 2006.

The court’s analysis: In reviewing the IRS’s determination, the Tax Court first had to decide whether the taxpayer was a disqualified person. In doing so, the court noted that Sec. 4975(e)(2)(A) defines “disqualified person” to include a plan fiduciary, and Sec. 4975(e)(3)(A) defines “fiduciary,” in part, to include any person who exercises any discretionary authority or discretionary control with respect to management of such plan or exercises any authority or control regarding management or disposition of the plan assets. The court found that the taxpayer clearly had exercised investment discretion over the IRA assets. Thus, he was a fiduciary with respect to his IRA and, as such, a disqualified person.

The creation of CST was not a prohibited transaction: In evaluating whether the creation of CST represented a prohibited transaction, the court took note of its determination in Swanson, 106 T.C. 76 (1996), that a corporation without shares or shareholders does not fit within the definition of a disqualified person under Sec. 4975(e)(2)(G). The court found that an LLC that elects to be treated as a corporation but does not yet have members or membership interests is sufficiently analogous to a corporation without shares or shareholders. Thus, the court held that, at the time of CST’s organization, CST was not a disqualified person with respect to the taxpayer’s IRA. Accordingly, the taxpayer did not engage in a prohibited transaction when he caused his IRA to invest in CST.

Compensation paid to the taxpayer by CST was a prohibited transaction: The court did not accept the taxpayer’s argument that he did not engage in a prohibited transaction when he caused CST to pay him compensation, because the amounts it paid to him did not consist of plan income or assets of his IRA, but merely the income or assets of a company in which his IRA had invested. In essence, the court in certain respects ignored the separate legal existence of CST and instead focused on the facts that the IRA owned 98% of CST and the taxpayer was CST’s general manager. The court determined that CST and the taxpayer’s IRA were substantially the same entity. Therefore, by causing CST to pay him compensation, the taxpayer engaged in the transfer of plan income or assets for his own benefit in violation of Sec. 4975(c)(1)(D). Furthermore, in authorizing and effecting this transfer, the taxpayer dealt with the income or assets of his IRA for his own interest or for his own account, in violation of Sec. 4975(c)(1)(E).

The taxpayer also argued that the payment of compensation by CST should not be classified as a prohibited transaction because Sec. 4975(d)(10) exempts reasonable compensation received by a disqualified person for services rendered in connection with the performance of his or her duties under the plan. This exemption permits trustees and investment providers to receive compensation for their services to qualified plans. However, the court found that CST paid the taxpayer for his role as general manager of CST, not for investment management of the IRA. Thus, the exemption did not apply.

Tax consequences: As a result of these findings by the court, the IRA lost its tax-favored status as of the first day of 2005. Thus, under Secs. 408(e)(2) and 408(d)(1), the entire amount rolled over from the taxpayer’s Sec. 401(k) account was taxable income to the taxpayer in 2005. Because the court also determined that the amount deemed distributed from the IRA in 2005 was a premature distribution under Sec. 72(t)(1), the 10% additional tax also applied.

The court also upheld the IRS’s imposition of a Sec. 6662(a) accuracy-related penalty. Sec. 6664(c)(1) can provide a waiver of the Sec. 6662 penalty if taxpayers can establish that they acted with reasonable cause and in good faith. However, the taxpayer and the IRS had stipulated that he did not have reasonable cause. Thus, the court had to find the taxpayer liable for the Sec. 6662(a) accuracy-
related penalty for tax year 2005.

Issues not addressed by the court: As the court found that a prohibited transaction occurred in 2005, it did not address the IRS’s contention that prohibited transactions occurred in 2006. Those contentions became moot, as a prohibited transaction can occur only when there is a transaction between a plan and a disqualified person. In 2006, the trust account was no longer a tax-exempt IRA, and the taxpayer was no longer a disqualified person.

The court followed its decision in Swanson in determining that the organization of CST and the funding of the business with the rollover proceeds was not a prohibited transaction. It was the payment of compensation in 2005 to the taxpayer for his efforts as the manager of the LLC that triggered the prohibited transaction.

What if no compensation had been paid in 2005 and 2006? In that case, no prohibited transaction would have occurred in 2005, and the IRS would have had to prevail on other grounds in 2006. However, if the court determined (as the IRS contended) that the taxpayer used his influence as CST’s manager to cause CST to enter into a lease with CDJ (an entity 100% owned by his family), the court would have had a basis to find that a prohibited transaction occurred in 2006. The lease agreement could be categorized as a use of plan income or assets for the taxpayer’s own benefit in violation of Sec. 4975(c)(1)(D), or the taxpayer could be viewed as a fiduciary using the income or assets of the IRA for his own interest or for his own account in violation of Sec. 4975(c)(1)(E).

A Different Approach Might Have Saved the Taxpayer

It appears that most advisers structure transactions where taxpayers use retirement funds to purchase a business using a qualified profit sharing or Sec. 401(k) plan as the acquisition vehicle, as opposed to an IRA. This approach is often referred to as a rollover-as-business startup (ROBS), and it relies on the exemptions in Sec. 4975(d)(13) and ERISA Section 408(e),which both provide an exemption from the prohibited transaction rules for acquisitions or sales of qualifying employer securities (provided the acquisition or sale is for adequate consideration).

Note: This exemption is the basis that employee stock ownership plans (ESOPs) and other employer-sponsored qualified plans use for investing in employer securities.

However, taxpayers considering using a qualified plan as a rollover recipient should note that the IRS has drafted examination guidelines for ROBS transactions involving qualified plans (see the memorandum). One issue the IRS might raise with a ROBS arrangement using a qualified plan is that the initial transaction was a prohibited transaction due to a deficient valuation of the stock. The IRS will expect the taxpayer initiating such a transaction to do so with the same care and prudence it requires of an existing operating company that is establishing an ESOP. The professional fees for properly prepared initial valuations are a difficult hurdle for a small business to overcome, and the valuation issue gives the IRS the most leeway to seek to impose a prohibited transaction tax.

Conclusion

For the reasons the court addressed in Ellis and the other concerns set forth above, using an IRA is not a suitable way to establish a business for which the IRA’s owner intends to provide services.

EditorNotes

Mindy Tyson Weber is a senior director, Washington National Tax, for McGladrey LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or mindy.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with McGladrey LLP.