As the number of retirees’ individual retirement account rollovers swells, so will the number of self-directed IRAs. Of the vast menu of nontraditional investments available for IRAs to invest in, perhaps the most risky is an operating business, especially one in which the IRA owner may wish to take an active role. Doing so can kill the IRA. Advisors should warn clients of the dangers.
In a recent case, the Tax Court treated the IRAs of James E. Thiessen and Judith T. Thiessen as distributing all assets to them and terminating as of Jan. 1, 2003. This result occurred because the Thiessens provided personal guarantees for loans made by Polk Investments, Inc. (Polk) to a newly formed corporation that was wholly owned by their IRAs, resulting in prohibited transactions.
Post-Retirement Career Sought
After retiring from their jobs at Kroger Co., James sought to acquire a metal fabrication business and found one, operating as Ancona Job Shop. Ancona was an unincorporated division of Polk. The brokerage firm, A.J. Hoyal & Co., Inc. (AJH) had located Ancona for James and informed him that he could roll over retirement funds from his Kroger retirement plan account to a rollover IRA. The IRA could then form a corporation to purchase Ancona’s assets.
At the suggestion of a friend and former Kroger colleague who had done the same thing, the Thiessens met with Christian Blees, CPA, asking for his help with the transaction.
Thomas James (Thomas), an attorney with no prior ties to Christian or AJH, was engaged to help handle the negotiations and structure the purchase, but Christian had no involvement in drafting the sale contract or in structuring the financing arrangement. However, Christian did help the Thiessens form a C corporation, Elsara Enterprises, Inc. (Elsara) on May 29, 2003, which would eventually acquire Ancona. The Thiessens were its only shareholders and officers.
James rolled over, by direct transfer, $384,855.80 from his Kroger retirement to his newly-formed IRA. Judith did likewise with $47,220.61. Each spouse directed purchases of Elsara stock by their respective IRAs.
To encourage Polk to take an interest in Elsara’s success, a member of AJH suggested that the transaction be structured to include a promissory note due to Polk.
Consideration for the purchase included:
Pro-rated 2003 property taxes $212.94
Earnest money deposit (cash) 60,000.00
Other cash payment 341,764.56
Promissory note to seller 200,000.00
Purchase price $601,977.50
The promissory note was secured by “[a]ll items of value used in the operation of the business known as Ancona Job Shop.” In addition, both James and Judith personally guaranteed the note’s repayment in writing.
The IRS asserted, and the court found, that their personal guarantees were fatal to their IRAs.
Prohibited Transaction From Indirect Extension of Credit
Internal Revenue Code Section 4975 imposes a tax on any of six types of prohibited transaction generally enumerated in IRC Section 4975(c). But, when an IRA or Roth IRA is involved, instead of imposing a tax, the IRA is terminated as of the first day of the year when any prohibited transaction occurs.1 As a result of such termination, all property held in the IRA is deemed distributed as of the beginning of the calendar year when any prohibited transaction occurs.
Lending of money or other extension of credit between an IRA and a “disqualified person” is a prohibited transaction.2 A disqualified person includes a fiduciary and a member of a disqualified person’s family.3 When, as in the Theissens’ case, an IRA owner directs how IRA funds are invested, the IRA owner is classified as a fiduciary.4
Because the Theissens guaranteed the loan owed by Elsara to Polk, thereby indirectly extending credit to their IRAs, and because they did so when they were fiduciaries with respect to their IRAs, each of their IRAs engaged in a prohibited transaction.
Statute of Limitations Extended to Six Years
The Theissens claimed that the three-year statute of limitations had run out on their 2003 income tax returns, so that the government could no longer assess the tax. Apparently, there was no dispute that the amounts at issue exceeded 25 percent of gross income, the level at which the statute of limitations is extended to six years. But, any amount “disclosed in the return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature and amount of such item” isn’t taken into account for purposes of the 25 percent test.
The Theissens argued that the disclosure exception applied because the amounts of their distributions were reported in their joint return as rollovers. But, because the Theisens’ joint return nowhere mentioned the loan guarantees, the court found that the requirements of the adequate disclosure exception weren’t met. The statute of limitations on assessments and collections was therefore extended from three years to six years.
No Easy Answers
Possibly, better teamwork on the part of the Theissens’ professionals might have prevented this tragedy. For example, might a final document review by Christian have revealed the problem that the personal guarantees presented?
Even if that were so, another trap awaited: Payment of compensation by Elsara to either James or Judith would also be a prohibited transaction. That’s what occurred in Ellis, et ux v. Commissioner,5 in which a used car business was operated by a limited liability company (LLC) taxable as a C corporation. Terry Ellis caused his IRA to acquire all but a small minority of the LLC, then became its general manager. Payment of compensation to Terry was found to be a prohibited transaction under IRC Section 4975(c)(1)(C).
1. Internal Revenue Code Section 408(e)(2)(A) causes an individual retirement account to terminate as of the first day of the year when an IRC Section 4975 prohibited transaction occurs. Section 4975(c)(3) exempts the IRA owner and the IRA from the excise tax imposed by Section 4975 when the account ceases to be an IRA by reason of the application of Section 408(e)(2)(A) or if Section 408(e)(4) applies to such account.
2. IRC Section 4975 (c)(1)(B).
3. IRC Section 4975(e)(2)(A) and (F).
4. IRC Section 4975(e)(3)(A).
5. Ellis, et ux v. Commissioner, T.C. Memo. 2013-245 (2013).