Advanced Underwriting Consultants

Ask the Experts – November 5

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers.  Here’s the question of the day.

Question: My client is thinking about investing in a self-directed IRA to help him fund his business needs.  Is that a good idea?

Answer: Using IRA money to capitalize a closely held business can lead to all sorts of potential problems.

In the recent decision, Ellis v. Commissioner, T.C. Memo. 2013-245 (10/29/13), the Tax Court gave us a little more insight on self-directed IRAs.

Here are the basic facts of the case: the taxpayer retired with about $300,000 in his section 401(k) retirement plan, which he subsequently rolled over into a newly created self-directed IRA.

The taxpayer then created an LLC to engage in the business of used car sales. The taxpayer was the manager and not a shareholder of the LLC. He chose to have the LLC taxed as a corporation and directed his IRA transfer the $300,000 into the LLC. The LLC was the IRA’s sole investment, and the IRA was the LLC’s sole investor. As the LLC began its operation, the taxpayer received payment for his services as manager of business.  The IRS challenged the validity of the transaction.

First, the IRS claimed that the transfer of his IRA funds to the LLC was a prohibited transaction. Its theory was that the LLC was a “disqualified person” at the time the IRA funded the LLC’s because the taxpayer, a fiduciary (and therefore disqualified person) controlled the LLC. The IRS claimed that the LLC was constructively owned by the taxpayer, resulting in the LLC being a disqualified person.

The Tax Court disagreed with the IRS, reasoning that even though the taxpayer acted as a fiduciary to the IRA (and was therefore a disqualified person under section 4975), the LLC itself was not a disqualified person at the time of the transfer because it was operating as a “corporation without shares or shareholders.”

Second, the IRS claimed that the taxpayer had engaged in a prohibited transaction by receiving payment from the LLC. The court agreed with the IRS on this issue.

Although the LLC (and not the IRA) was officially paying the taxpayer’s salary, the Tax Court concluded that since the IRA was the sole owner of the LLC, and that the LLC was the IRA’s only investment, the taxpayer (a disqualified person) was essentially being paid by his IRA—which is a prohibited transaction.

Since the IRA engaged in a prohibited transaction, it no longer qualified as an IRA, and therefore is deemed to have distributed all of its assets at the time of the prohibited transaction. See Code Section 408(e)(2)(A). The taxpayer incurred (1) income taxes on the entire $300,000 deemed distribution, (2) the 10-percent early distribution penalty (Section 72(t)), and (3) the 20-percent accuracy-related penalty (Section 6662(a), (b)).

Self-directed IRAs are still a subject of uncertainty, so a client should be advised to proceed with care because the penalties to engaging in a prohibited transaction, as evidenced by Ellis, can be substantial.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.