By Anthony Diosdi
Many Individual Retirement Account (“IRA”) beneficiaries would like more control over the investments of their IRAs. Some IRA beneficiaries want to form investment vehicles to acquire such assets as cryptocurrencies that are rapidly increasing in value. A number of trust companies claim that the United States Tax Court case of Swanson v. Commissioner, 106 T.C. 76 (1996) authorizes the use of an IRA owned grantor trust at the direction of the IRA account holder as a trustee to act as an investment vehicle.
This article will discuss whether an IRA grantor trust in which the IRA account holder is a trustee violates the meaning of Section 4975(c)(1)(D) and (E).
An Overview of Internal Revenue Code Section 4975
The growth of 401(k) plans and other defined contribution plans (as opposed to traditional defined pension plans) has generated additional opportunities for employees and retirees to use IRAs. to postpone taxation of the account balance in such a plan, the individual must rollover some or all of the account balance to an IRA or other qualified plan. This has resulted in the growth of “self-directed” IRAs. Since 1974, the IRS has permitted individuals to totally “self-directed” investments made within their IRAs. Self-directed IRAs are held by a trustee or custodian. They permit investment in a broader range of investments than is permitted by traditional IRAs.
Although a self-directed IRA allows individuals to invest in numerous illiquid assets, investments in some assets are prohibited. These include but may not be limited to collectibles, including artwork, stamps and jewelry, antiques, and rugs. In addition, an individual cannot use an IRA to invest in real estate that he or she will personally use. A key term under the special term under the special rules governing self-directed IRAs is “prohibited transactions.” If a self-directed IRA engages in a “prohibited transaction,” the “self-directed” IRA will lose its tax exempt status. Because of the importance of the ‘prohibited transaction’ concept, the next subsection of our opinion will discuss this concept in great detail.
Internal Revenue Code Section 408(a) provides the technical statutory definition of a “prohibited transaction” with respect to self-directed IRAs. The prohibited transaction rule included in Section 408 of the Internal Revenue Code provides that an IRA loses its status as an IRA if the owner of the account, or the beneficiary of the account, engages in a prohibited transaction with an account. A prohibited transaction committed by an owner or beneficiary essentially “disqualifies” an IRA, and the account is no longer exempt from income tax. The income tax regulations under Internal Revenue Code Section 408 draw a distinction between a prohibited transaction committed by the owner (or beneficiary) of the account and any other person. For this purpose, a ‘prohibited transaction’ is determined under the rules of Internal Revenue Code Section 4975. As noted above, the sanction for a prohibited transaction by the owner or beneficiary of an IRA is disqualification of the account. That is, the IRA is treated as if all of its assets were distributed to its owner as of the first day of the year during which the transaction occurs and the IRA ceased to exist as of that day. For a traditional IRA, this would impose income tax on the account and potentially an additional 10 percent for premature distribution. For a Roth IRA, the account would permanently lose its exempt status and possibly incur early distribution penalties. The IRS can also assess an additional 20 percent tax under Internal Revenue Code Section 6662 for premature distributions from traditional and Roth IRAs. The sanctions for a prohibited transaction by another person (defined in Section 4975 as a “disqualified person”) are the excise taxes imposed by Section 4975. The excise taxes are imposed in two tiers. First, there is a tax of 15 percent of the amount involved (generally, the transaction value). Second, if the transaction is not “corrected” (generally, undoing the transaction) there is a tax of 100 percent of the amount involved.
In order for a prohibited transaction to occur, there must be a transaction involving a “disqualified person” with respect to a “plan.” For example, a sale or exchange of assets is among the types of transactions prohibited between the plan and a disqualified person. The Internal Revenue Code defines the term “plan” to include an IRA. The Internal Revenue Code defines “disqualified person,” to include, in part:
1) A fiduciary;
2) A person providing services to the plan;
3) An employer of any of whose employees are covered by the plan;
4) An owner, direct or indirect of 50 percent or more of: i) the combined voting power of all classes of stock entitled to vote or the total value of the shares of all classes of a corporation; ii) the capital interest or profits interest of a partnership; iii) a beneficial interest of a trust or unincorporated enterprise which is an employer or an employee organization;
5) A member of the family including spouse, ancestor, lineal descendant and any spouse of a lineal descendant;
6) A corporation, partnership, or trust or estate of which is 50 percent or more of the combined voting power of all classes of stock entitled to vote of the total value of the shares of all classes of stock of such corporation.
7) The beneficial interest of such trust or estate which is owned directly or indirectly by a disqualified person(s);
8) An officer, director, or ten percent or more shareholder, or a highly compensated employee.
A “prohibited transaction” with respect to a self-directed IRA includes:
1) Sale or exchange, or leasing, of any property between a plan and a disqualified person:
2) Lending of money or other extension of credit between a plan and a disqualified person:
3) Furnishing of goods, services, or facilities between a plan and a disqualified person:
4) Transfer to, or use by or for the benefit of, a disqualified person the income or assets of a plan;
5) Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
6) Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
The Internal Revenue Code defines the term “fiduciary,” in part, to include any person who exercises any discretionary authority or discretionary control respecting management of such plan, or exercises any authority or control regarding management or disposition of its assets. Where none of the relationships described in the Internal Revenue Code are found to exist, an entity would not be a disqualified person with respect to a plan.
As noted, the Internal Revenue Code prohibits any direct or indirect sale, or exchange or leasing of any property between a plan and a disqualified person. The Internal Revenue Code also prohibits any direct transfer to, or use by or for the benefit of, a disqualified person the income or assets of a plan in his or her own interest or for his or her own account. The relevant regulations characterize such transactions as involving the use of authority by fiduciaries to cause plans to enter into transactions when those fiduciaries have interests which may affect the exercise of their best judgment as fiduciaries, i.e., a conflict of interest.
For example, a Bankruptcy Court in In re Williams, 2011 WL 10653865 (Banr. E.D.Cal.2011) determined a prohibited transaction under Internal Revenue Code Section 4947 disqualified a “self-directed” IRA where the IRA made payments to the beneficiary for services rendered. The Williams case involved a self-directed IRA that owned real property. Significantly, the Williams court determined that payment by the “self-directed” IRA to the beneficiary for work and services was a prohibited transaction under Internal Revenue Code Section 4975(c)(1)(C). In another case, an individual, who had caused his self-directed IRA to invest a substantial majority of its value in his used car business with the understanding that he would receive compensation for his services as the business’s general manager, engaged in a prohibited transaction with respect to his IRA when he directed his business to pay him a salary.
The Impact of Swanson v. Commissioner
The United States Tax Court in Swanson v. Commissioner, 106 T.C. 76 (1996), examined whether certain transactions were prohibited by Sections 4975(c)(1)(A) and (E) of the Internal Revenue Code. In Swanson, a taxpayer James Swanson, arranged for the organization of Swanson Worldwide, a domestic international sales corporation, and the formation of the IRA. Swanson was the IRA’s account holder and retained the power to direct the investment of the IRA. Swanson served as the initial director of Worldwide and, later, as its President. At the direction of Swanson, the custodian of his IRA caused the IRA to subscribe to 2,500 shares of Worldwide’s original issue stock. Those shares of original issue stock were issued to Swanson’s IRA which became Worldwide’s sole shareholder. Worldwide received commissions from another company owned by Swanson. At the direction of Swanson, Worldwide paid dividends to its sole member IRA.
The Tax Court in Swanson first discussed whether the acquisition of Worldwide’s stock by Swanson’s IRA was prohibited by Section 4975(c)(1)(A) of the Internal Revenue Code. As noted above, Section 4975(c)(1)(A) of the Internal Revenue Code prohibits the sale, exchange or leasing of any property between an IRA and an entity or individual that is a “disqualified person” with regard to the IRA. Thus, if Worldwide was a disqualified person with regard to Swanson’s IRA, the acquisition of Worldwide’s stock by Swanson’s IRA would be a prohibited transaction. The Tax Court noted, however, that at the time of the acquisition, Worldwide had no shares or shareholders and, therefore, could not be a disqualified person with regard to Swanson’s IRA. Accordingly, the acquisition of Worldwide’s stock by Swanson’s IRA was not a prohibited transaction within the meaning of Section 4975(c)(1)(A) of the Internal Revenue Code.
The Tax Court next discussed whether the payment of dividends by Worldwide to Swanson’s IRA, at the direction of Swanson, constituted a prohibited transaction under Section 4975(c)(1)(E) of the Internal Revenue Code. As indicated above, Section 4975(c)(1)(E) prohibits any act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account. The Tax Court stated that “Section 4975(c)(1)(E) addresses itself only to acts of disqualified person who, as fiduciaries, deal directly or indirectly with the income or assets of a plan for their own benefit or account. Here, there was no such direct or indirect dealing with the income or assets of a plan, as the dividends paid by Worldwide did not become income of IRA #1 (Swanson’s IRA) until unqualified made subject to the demand of IRA #2 (Swanson’s IRA). Further, the Tax Court said that “the only direct or indirect benefits that Swanson realized from the payments of dividends by Worldwide related solely to his status as participant of IRA #1. In this regard, Swanson benefits only insofar as IRA #1 accumulated assets for future distribution. Accordingly, based on Section 4975(d)(9) of the Internal Revenue Code, the Tax Court concluded that there was no support for the contention that the payment of dividends by Worldwide to Swanson’s IRA constituted an act prohibited by Section 4975(c)(1)(E) of the Internal Revenue Code.
Subsequent to the Swanson decision, a number of trust companies facilitated the creation of IRA grantor trusts. In the Swanson case, no prohibited transaction was deemed to occur as the result of the issuance of the corporate entity’s shares to the IRA because the corporate entity was not a disqualified person of the IRA at the time of issuance. These trust companies assumed that an IRA grantor trust could also be considered a disqualified person of an IRA at the time an IRA is deemed to issue certificates in the trust. They believed that the simultaneous creation of an IRA grantor trust and deemed issuance of certificates to the IRA would not, in and of itself, cause an IRA grantor trust to be a disqualified person of an IRA. Assuming that an IRA grantor trust is not a disqualified person of an IRA and that the principles and holdings of the Swanson case otherwise apply to an IRA grantor trust, a number of financial companies believe that the formation of an IRA grantor trust with an IRA as its initial and sole beneficiary should not be a prohibitive transaction within the meaning of Section 4975(c)(1)(A), and distributions made to an IRA by an IRA grantor trust at the direction of the IRA account holder as a non-compensated trustee of an IRA grantor trust will not be a prohibited transaction within the meaning of Section 4975(c)(1)(D) and (E).
The reasoning discussed above is flaws. Currently, no guidance exists as to whether an IRA grantor trust will be considered a disqualified person of an IRA at the time an IRA is deemed to issue certificates in the trust. Even if somehow it can be established that an IRA grantor trust is not a not a disqualified person of an IRA under the principles of Swanson, the Tax Court holding never authorized an IRA owner to be a trustee (which is a fiduciary position) of an IRA owned entity. The decision only allows an IRA owner to be the president of an IRA owned entity. While the case indicates that being president is not prohibitive, neither the Internal Revenue Code, its regulations, nor case law address what “serves,” if any, that a president can provide an IRA owned entity.
IRA beneficiaries that become trustees of IRA owned entities do so at their own peril. If an account holder would like to establish an investment vehicle, utilizing an LLC structure instead of a grantor trust is less risky. Although an IRA account holder may serve as the president of such a structure, the decision making and services allocated to a president account holder should be limited to the parameters allowed by Section 4975.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides domestic and international tax advice to individuals, closely held entities, and publicly traded corporations. Anthony Diosdi also has substantial experience in expatriation tax and treaty planning. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.