By Lynn K. Ching
An Individual Retirement Account (IRA), whether it be a traditional IRA, a Roth IRA or a Self Directed IRA is a tax-advantaged plan under the Internal Revenue Code (IRC), intended to encourage individuals to save for retirement. Self Directed IRAs are held by a trustee or custodian that permits investment in a broader set of assets than is permitted by traditional IRA custodians.
To ensure that the IRA’s tax-preferenced assets are kept separate from the other assets of the IRA owner, the Internal Revenue Code contains a series of “prohibited transaction” rules intended to prevent the IRA owner from using the account to enrich themselves, their family members, or entities in which they retain an interest (“disqualified persons”).
In general, IRC 4975 prohibits any direct or indirect:
1. Sale or exchange or leasing, of property between an IRA and any “disqualified person”;
2. Lending of money or ther extension of credit between an IRA and any disqualified person;
3. Furnishing of goods, services or facilities between and IRA and any disqualified person;
4. Transfer of IRA assets to, or use of IRA assets by or for the benefit of any disqualified person;
5. Act by a fiduciary (which includes the IRA owner) that involves fiduciary “dealing” with the assets of an IRS in his own interest or for his own account (self-dealing).
The prohibited transaction rules cause adverse tax consequences for the IRA if it engages in such prohibited transactions with any “disqualified person”. See IRC 4975 (e)(2).
IRA Owner’s Self Dealing With Related LLC
In In Re Barry K and Dana M Kellerman (538 B.R. 776 (2015), Barry Kellerman and his wife each owned a 50% interest in Panther Mountain LLC. Barry Kellerman caused his Self Directed IRA to enter into a partnership agreement with the LLC to purchase and develop four acres of land.
Pursuant to IRC 4975, the Court determined that the Self Directed IRA engaged in prohibited transactions with disqualified persons (i.e. the LLC and the IRA owner) that caused it to lose its tax exempt status.
First, the court found that the LLC used the IRA as a lending source for the purchase price and development of the four-acre tract of land in violation of subsection IRC 4975(c)(1)(B) (lending of money or other extension of credit between an IRA and a disqualified person). Secondly, the court found that Barry Kellerman transferred or used the IRA’s assets for the benefit of disqualified persons in violation of IRC 4975(c)(1)(D). The court also found that Barry Kellerman dealt with the income of the assets of the IRA as a fiduciary for his own interest in violation of IRC 4975(c)(1)(E).
Liability for Indirect Transactions under IRC 4975 and IRC 408 –
The following illustrates the long reach of prohibited transactions under IRC 4975 when dealing with an IRA.
In Peek v. Commissioner of Internal Revenue (140 T.C. 12), the Tax Court addressed liability for a loan guarantee between disqualified persons (the IRA owners) and an entity other than the IRA, i.e., FP Corp, an entity owned by the IRA’s, rather than the IRA’s themselves.
In 2001 taxpayers (Mr. Fleck and Mr. Peek) established Self Directed IRAs. Mr. Fleck and Mr. Peek also formed FP Corp. and directed their new IRAs to use rolled-over cash to purchase 100% of FP Corp.’s newly issued stock. Fleck and Peek then used FP Corp. to acquire the assets of AFS Corp. Messrs. Fleck and Peek personally guaranteed loans of FP Corp. that arose out of the asset purchase.
In 2003 and 2004 Fleck and Peek undertook to roll over the FP Corp. stock from their Self-Directed IRAs to Roth IRAs, including in their income – the value of the stock rolled over in those years. In 2006 after the FP Corp. stock had significantly appreciated in value, Messrs. Fleck and Peek directed their Roth IRAs to sell all of the FP Corp stock to Xpect First Aid Co. Their personal guaranties on the loans of FP Corp. persisted up to the stock sale in 2006.
Following the sale, neither the Fleck Roth IRA nor the Peek Roth IRA owned any interest in FP Corp, and neither Mr. Fleck nor Mr. Peek had any involvement with FP Corp or Xpect First Aid Co.
The IRS argued that Fleck and Peek’s personal guaranties of the FP Corp. loan were prohibited transactions under IRC 4975 (i.e. lending of money between a disqualified person and an IRA), and, as a result, they are liable for the capital gains realized from the sale of FP stock in 2006. Messrs. Fleck and Peck took the position that the IRC 4975 prohibition only applies when a loan guaranty is between an IRA and a disqualified person, and not with an entity owned by the IRA.
Held: The Tax court held that each of the taxpayer’s personal guaranties of the FP Corp. loan was an indirect extension of credit to the (Self-Directed) IRAs, which is a prohibited transaction under IRC 4975. Under IRC 408 (e), each original account that held the FP Corp. stock ceased to be IRAs as of 2001.
Further, in 2003 and 2004 when Mr. Fleck and Mr. Peek established Roth IRAs, those accounts ceased to be Roth IRAs when they funded the accounts with FP Corp stock, because the prohibited transactions continued as to those accounts. See IRC 408A(a). For the same reasons, the accounts holding the FP Corp stock when the stock was sold in 2006 were not Roth IRAs, and the gains from the sale realized in 2006 and 2007 were not exempt from tax.
To ensure that an IRA, including a Self-Directed IRA, retains its tax exempt status, owners and other fiduciaries of Self-Directed IRAs should take care not to engage in direct or indirect (prohibited) transactions in violation of IRC 4975.
Lynn K. Ching is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Lynn may be reached at (415) 318-3990 or by email at 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.