The recent case of Lawrence F. Peek, et ux., et al., v. Commissioner, 140 T.C. No. 12, gives us insights into how the Internal Revenue Service and the Tax Court view, and attack, prohibited transactions (PTs) involving an individual retirement account.
Lawrence Peek and Darrell Fleck used their IRAs to buy and grow a business, Abbott Fire & Safety (AFS). The IRS contended that, in the course of acquiring and operating this business, Lawrence and Darrell committed “prohibited transactions” that caused their IRAs to be disqualified. The Tax Court agreed with that assertion and concluded that the partners should, therefore, be taxed personally on the gain realized when the business was sold by the disqualified IRAs.
Let’s look at the paths the IRS and the court took to reach these conclusions, and what alternative roads they or the taxpayers might have taken.
Facts
Lawrence and Darrell were business acquaintances. However, they weren’t related to each other by blood or marriage, nor is it mentioned that they had any ongoing business relationship other than their co-ownership of AFS through their IRAs.
The two men created IRAs. These IRAs were apparently properly created and funded (with rollovers or transfers from other retirement plans), so at the “starting gate” each man had a “legitimate” IRA containing cash. The IRAs together formed FP Company (FP), each IRA contributing $309,000 cash in exchange for 50 percent of FP’s stock. Again, so far so good—no PT yet.
In September 2001, FP acquired from sellers the assets of an operating business, AFS. It paid the $1.1 million purchase price with $850,000 of cash (which came from a $450,000 loan to FP Company from a credit union, plus $400,000 of the cash then held in FP), a $50,000 promissory note from FP Company to the broker and a $200,000 note from FP Company to the sellers. The $200,000 note (representing a little less than 20 percent of the total purchase price) was secured by personal guarantees from Lawrence and Darrell. Those guarantees were in turn secured by mortgages on their personal residences. This $200,000 loan and its personal guarantees, “remained in effect until the sale ... of FP Company in 2006.”
In 2003 and 2004, Lawrence and Darrell converted their IRAs to Roth IRAs. In 2006, the Roth IRAs sold FP Company for over $3.3 million.
Loan Guarantees Were PTs
The Tax Court held that the loan guarantees were PTs under Internal Revenue Code Section 4875(c)(1)(B)1 (extension of credit between the plan and a disqualified person), and therefore the IRAs were disqualified. Lawrence and Darrell were taxable personally on the gain realized when their Roth IRAs sold FP. The court ruled that, in view of this holding, it didn’t need to consider other PT arguments made by the IRS regarding the payment of compensation to Lawrence and Darrell by FP Company and payment of rental income to Darrell’s wife by FP or the IRS’ claim of a IRC Section 4973 excise tax for excess IRA contributions.
IRAs and PTs
Although it’s clear under the law that the prohibited transaction rules apply to IRAs2, it’s not always clear exactly HOW the rules apply to IRAs. The statute (IRC Section 4975) is short and appears comprehensive, but it actually contains numerous gaps and ambiguities. There are several building blocks that must be lined up to create a PT . . . and once you successfully “build” the PT, it’s not clear what the punishment is!
How IRA owners are subject to the PT rules. Here’s an example of a statutory gap. IRC Section 408(e)(2)(A) provides that “If . . . the individual for whose benefit any individual retirement account is established...or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account . . . ” One of the transactions prohibited by Section 4975 is the (direct or indirect) “lending of money or other extension of credit between a plan and a disqualified person.”3 A disqualified person (DQP) includes a “fiduciary” of the plan. A fiduciary includes, among other categories, someone who “exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets.”4
Note that the IRA owner qua owner isn’t listed as a DQP. Yet, it’s the IRA owner (or beneficiary) who’s punished by IRA disqualification for engaging in a transaction otherwise prohibited by Section 4975. This dichotomy between punishment and transgression can be bridged by concluding that the IRA owner is punished only if, in his capacity as fiduciary, he violates Section 4975. Others would conclude that the gap can’t be bridged and this simply represents a mistake in the statute. But this particular glitch didn’t matter in Peek because Lawrence was clearly both the owner (individual for whose benefit the IRA was established) and fiduciary of his IRA, as Darrell was as to his. So IRC Section 408(e)(2) tells us that if the owner (as fiduciary) commits a PT with his IRA, the punishment is disqualification.
Let’s follow the process of establishing that a PT occurred here and (if it did) exactly how the IRA owner is punished.
Establishing the elements of a PT for Lawrence and Darrell. The prohibited transaction winningly asserted by the IRS in this case was the “extension of credit between a plan and a disqualified person.”
Was there an extension of credit? It’s well established that a loan guarantee is an “extension of credit” within the meaning of Section 4975(c)(1)(B).
In Arthur S. Janpol,5 an auto dealership had a profit-sharing plan. The plan engaged in the business of financing auto sales for the dealership in the 1970s and 1980s. Arthur Janpol and Donald Berlin were the sole stockholders, as well as directors and officers, of the dealership, and were participants in the plan (the sole participants, after 1987). To finance its lending operation, the plan borrowed substantial amounts from Arthur and Donald. When the dealership was sold in 1986, the plan stayed in existence and started financing auto sales for other dealerships. For that purpose, it borrowed $5 million (later increased to $10 million) from a bank, with the loan personally guaranteed at various points by Arthur and Donald.
Janpol stands mainly for the principle that the prohibition in Section 4975 of loans “between” a plan and a party in interest includes loans from the party in interest6 to the plan, not just loans from the plan to the party in interest.
Because Janpol involved loan guarantees as well as loans, it also stands for the rule that “an individual who guarantees repayment of a loan extended by a third party to a debtor is, although indirectly, extending credit to the debtor.” The opinion points out that the term “extension of credit” is intended to broaden the statute to cover not only direct transactions, such as a loan, but also indirect transactions such as establishing a line of credit (even if it’s never drawn upon) or guaranteeing a loan (even if the guarantee is never activated). “The guarantee is, in effect, also a contract to make a loan to the” plan.
Peek is similar to Janpol, in that the IRA owners indirectly lent to their IRA-owned business by personally guaranteeing its loans, though (unlike in Janpol) Lawrence and Darrell didn’t also make direct loans to their retirement plans.
The legislative history of the Employee Retirement Income Security Act (ERISA)(which added Section 4975 to the IRC in 1974) confirms that “The conference substitute also generally prohibits the direct or indirect lending of money or other extension of credit between a plan and parties-in-interest. For example a prohibited transaction generally will occur if a loan to a plan is guaranteed by a party-in-interest…,” unless it falls within certain statutory exceptions for employee stock ownership plans (ESOPs).7
The personal loan guarantees given by Lawrence and Darrell, secured by mortgages on their homes, would, accordingly, be considered an “extension of credit,” especially since (the opinion implies) FP couldn’t have completed the purchase of AFS without these guarantees.
Although the leading case, Janpol, involved actual loans to an operating business, as well as personal guarantees of the plan-owned business’ loans, the Department of Labor (DOL) extends the PT label willy-nilly to virtually any piece of paper that contains the word “guarantee,” regardless of whether there’s any actual loan being guaranteed or any actual credit extended. For example, the DOL ruled in Advisory Opinion 2009-03A (Oct. 27, 2009), www.dol.gov/ebsa/regs/aos/ao2009-03a.html, that a participant who signed a standard brokerage firm form granting the IRA provider a security interest in the participant’s non-IRA account at the same firm, to secure any liabilities to the firm that his proposed new IRA account at the firm might incur, was committing a PT, even if the IRA never had any such liabilities. Similarly, in Advisory Opinion 2011-09A (Oct. 20, 2011), www.dol.gov/ebsa/regs/aos/ao2011-09a.html, the DOL opined that an IRA owner who signed an agreement whereby a brokerage firm was given a security interest in the IRA assets to secure the participant’s potential future liabilities under a (taxable) futures trading account that the participant proposed to open at the same firm, would be engaging in a PT and that this PT wasn’t covered by a “class exemption” previously granted to extensions of credit in connection with routine plan operating costs.8
Was the extension of credit made to the plan? The IRC prohibits an extension of credit “between” the IRA owner/fiduciary and the IRA itself. Lawrence’s loan guarantee didn’t run from Lawrence to his IRA; it ran to FP, which was only 50 percent owned by Lawrence’s IRA. Ditto for Darrell’s guarantee.
The court didn’t discuss the implication of the partial ownership by each IRA; rather it concluded, simply, that an extension of credit to an entity owned by the IRA is an “indirect” loan to the IRA itself, and the statute prohibits both direct and indirect extensions of credit.
This hasty conclusion skips over a whole body of law known as the plan assets rule. Not every transaction between an IRA fiduciary and an entity partially owned by that IRA is a PT. For example, if Lawrence’s IRA had owned 10 shares of General Electric stock, and then Mr. Lawrence personally bought some GE bonds (thereby extending credit to an entity partially owned by his IRA), that wouldn’t be a PT.
Only if retirement plans own a significant equity interest in a non-publically-traded investment entity do the regulations generally “look through” the entity and treat the entity’s assets as plan assets subject to the PT and ERISA fiduciary rules.9 However, since a company is deemed to have “significant” retirement plan ownership if the entity is owned 25 percent or more by retirement plans, this line of argument doesn’t help Lawrence and Darrell, since each IRA’s 50 percent ownership would be considered “significant.”
Who was the DQP? As discussed above, Lawrence and Darrell, as fiduciaries, were clearly DQPs as to their respective IRAs.
Ok it’s a PT. Now what? The IRC is absolutely clear: If the IRA owner uses his IRA (or part of it) as security for a loan, the IRA (or the part used as security for a loan) is deemed distributed to him.10
In the case of any other type of prohibited transaction involving the IRA owner “or his beneficiary,” the IRA loses its income tax exemption entirely (even if only part of the IRA was involved in the PT). The entire account is deemed distributed as of the first day of the taxable year in which the PT occurred.11 Accordingly, the IRA owner must include in his income for that year the total value of the IRA as of Jan. 1 of such year as well as all income (for example, interest and dividends) the IRA earned for the rest of that year.
This sounds draconian, especially considering that the entire account is apparently “disqualified” even if the PT involved only a small portion of the IRA’s assets.12
But, in fact, the results and effects of this statutory disqualification are unclear, and it’s not surprising that the court sort of just made up its own remedy to punish Lawrence and Darrell. When you try to apply the PT “remedy” (disqualification) to a situation like this, you end up in a morass of contradictions and dead ends.
For example, if the Lawrence’s and Darrell’s IRAs were deemed distributed to them as of Jan. 1, 2001, as dictated by IRS regulations, then that would be a nonevent, because the IRAs didn’t even exist then (the IRAs were created in August 2001), so they had no value at all and the result would be taxable income of zero dollars in 2001 for this deemed distribution of nothing.
Suppose the regulation were interpreted to mean that Lawrence’s and Darrell’s IRAs were deemed distributed when they were created or when the loan guarantees were first put into place in August-September 2001. Such a deemed distribution would have resulted in taxable income to them of several hundred thousand dollars each. But the IRS notices of deficiency were issued in 2010, too late to attack a 2001 deemed distribution, assuming Lawrence and Darrell timely filed tax returns for 2001. So they “got away with” the deemed distribution in 2001. They can’t be punished, in 2010 for a PT that occurred in 2001, assuming they timely filed their 2001 income tax returns, even if the PT wasn’t reported on those returns!
Does the hypothetical deemed income they should have reported in 2001 give them a “basis” in the IRAs, equal to the taxable income that they should have (but didn’t) report in the year the accounts were disqualified? Presumably not; Lawrence and Darrell didn’t assert any basis.
The IRS’ position, stated in its notice of deficiencies, was that the FP Company stock was deemed to be owned personally by Lawrence and Darrell from 2001 on, because it was deemed distributed as a result of the PT in 2001. Therefore, they should personally be taxed on the gain from the sale in 2006. The court agreed with that analysis.
But, but, but: Assuming the traditional IRAs “ceased to exist” in 2001, and Lawrence and Darrell actually owned the FP stock personally even though they didn’t realize it . . . what are we to make of the Roth conversions in 2006? Those constituted NEW contributions to NEW IRAs, namely, each partner’s Roth IRA. Since those weren’t valid “rollovers,” they should have been treated as “regular” contributions to the Roth IRAs, attracting the 6 percent excise tax for excess IRA contributions.13 But the court dismissed whatever claims the IRS may have asserted in this case regarding the excess contributions penalty, apparently treating that as an alternative remedy, which became moot once the court chose the “personal sale” remedy.
The court emphasized that the loan guarantees weren’t “one and done” transactions . . . they remained in effect all the way from 2001 until the sale in 2006. Therefore, the original IRAs and the Roth IRAs were both disqualified due to PTs.
But what difference does it make whether the loans were “ongoing” or not? Suppose the loan guarantees had been mere temporary bridge financing and had been released in 2001? Would that somehow cause the IRAs to be “resurrected” for 2002 and later years and, therefore, cause the later Roth conversions to be valid? It’s not clear what conclusions the court draws from the “ongoing” nature of the loan guarantees. Perhaps that’s why the court treated the Roth conversions, not as excess contributions, but as entirely nugatory transactions.
Presumably their payment of income taxes on the “Roth conversions” they thought they carried out in 2006 should have given Lawrence and Darrell some basis in the “Roth IRAs” they thought they had, going forward? Lawrence and Darrell didn’t assert they had any basis, according to the court. This creates the possibility of paying income tax twice on the same money, once upon the “Roth conversion” and again when the FP stock was sold by the “Roth IRAs.”
The IRS’ other theories. The IRS apparently started its case against Lawrence and Darrell with the theory that the payment to them of compensation by the IRA-owned business (FP) constituted a prohibited transaction, as did (at least as to Darrell) the payment of rental income from FP Company to Darrell’s wife. This is a great unanswered question in the area of IRA-owned businesses. Generally, payment of reasonable compensation for services to the plan is an exception to the PT rules. But, that exception isn’t available for certain types of plans . . . and it’s not clear whether the PT exception is available for IRAs. The court wisely decided it didn’t need to get to this argument.
The IRS also apparently sought, in the alternative, to impose an excess contributions penalty on Lawrence and Darrell, presumably for making their “invalid” rollover to the Roth IRAs. This would have had to be an alternative argument. The IRS can’t have it both ways. If the IRA is invalid, there can’t be a penalty for making an excess contribution to it, since the penalty applies only to contributions to IRAs, and an IRA that’s been disqualified isn’t an IRA. So you can face disqualification because of a PT, or you can face an excess contributions penalty, but not both, apparently.
Lesson for Clients and Practitioners
Operating a business inside an IRA isn’t illegal, but it’s risky. Ordinary business transactions can easily become IRA-disqualifying PTs. The lack of clarity in the PT law as it applies to IRAs can sometimes be helpful in defending an accused client, though it didn’t help Lawrence and Darrell.
You can’t expect logic and consistency when the basic law is nonsense. Lawrence and Darrell gave secured personal guarantees for a $200,000 loan to their IRA-owned company extending over five years. But they apparently would have suffered the exact same punishment if they had lent $20 for an hour to pay for a filing fee at the loan closing!
If the client insists on using retirement assets to start a business, the route of investing through the startup company’s own ESOP is considerably safer, because there are clearer exemptions from the PT rules for qualified plans than for IRAs. The IRS calls that approach “rollovers as business startups,” and the IRS doesn’t really like it much, but so far they haven’t figured out exactly what’s wrong with it.
Endnotes:
1. Citations preceded by “Section” refer to sections of the Internal Revenue Code of 1986, as amended, or (if preceded by “Regs.”) to Treasury Regulations.
2. IRC Section 408(e)(2)(A) says that individual retirement account owners must not engage “in any transaction prohibited by section 4975.” IRC Section 4975 prohibits transactions between a “disqualified person” and a “plan,” and “plan” is defined to include an IRA. IRC Section 4975(e)(1)(B).
3. IRC Section 4975(c)(1)(B).
4. IRC Section 4975(e)(3)(A).
5. 101 TC 518 (1993).
6. When dealing with a qualified plan, the prohibitions apply to a “party-in-interest,” which is equivalent to the “disqualified person” prohibitions with respect to IRAs.
7. House Conference Report 93-1280, H.R. Conf. Rep. 93-1280 (1974); 1974-3 C.B. 415, 469.
8. The Internal Revenue Service has ruled a bit more leniently that it wouldn’t treat such a “boilerplate” cross-collateralization agreement as a prohibited transaction (PT) unless and until the provision was actually enforced against one account or the other. IRS Announcement 2011-81. For more discussion of the jurisdictional squabbles between the IRS and the Department of Labor concerning enforcement of the PT rules with respect to IRAs, see my forthcoming Special Report: IRAs and Prohibited Transactions, to be published at www.ataxplan.com.
9. 29 CFR Section 2510.3-101.
10. IRC Section 408(e)(4).
11. Section 408(e)(2); Treas. Regs. Section 1.408-4(d)(1).
12. Notwithstanding the clear wording of the statute to the effect that the entire account is deemed distributed, at least one case ruled that only the amount actually involved in the PT was deemed distributed, not the entire IRA, which makes much more sense. See Gerald M. Harris, T.C. Memo. 1994-22.
13. See IRC Section 4973(a), (f), as applied in the case of Robert K. and Joan L. Paschall v. Commissioner, Docket # 10478-08, 25825-08 (July 5, 2011).