In the latest United States Tax Court case involving an IRA owned entity managed by the IRA owners, the taxpayers have once again lost. In 2001 taxpayers Lawrence F. Peek and Darrell G. Fleck established traditional IRAs. Each IRA then purchased 50% of a newly formed corporation, FP Company, Inc. (FP Company) for $309,000. Mr. Peek and Mr. Fleck were appointed as corporate officers and directors of FP Company. FP Company then acquired the assets of Abbot Fire & Safety, Inc. (“AFS”) for $1,100,000, which included a $200,000 promissory note from FP Company to the sellers of AFS, with personal guaranties by Mr. Peek and Mr. Fleck. The $200,000 note to the sellers was secured by deeds of trust on Mr. Peek’s and Mr. Fleck’s personal residences. In 2003 and 2004, Mr. Peek and Mr. Fleck both converted their IRAs to Roth IRAs, paying the taxes on the fair market value of the shares at that time. In 2006 the Roth IRAs sold FP Company to Xpect First Aid Co., eventually receiving $1,668,192 for their stock.
The Tax Court ruled that 1) each of the personal guaranties of the FP Company loan is an indirect extension of credit to the IRAs, which is a prohibited transaction under Internal Revenue Code (“IRC”) §4975(c)(1)(B); 2) because the prohibited transaction terminated the IRAs under IRC §408(e), the gains realized on the sale of FP Company are included in the taxpayers’ personal income, and 3) the taxpayers are liable for the accuracy-related penalties under IRC §6662.
The IRS argued that Mr. Peek’s and Mr. Fleck’s personal guaranties of the $200,000 promissory note from FP Company to the sellers of AFS in 2001 were prohibited transactions under IRS §4975(c)(1)(B), which prohibits any direct or indirect lending of money or other extension of credit between a plan (including an IRA) and a disqualified person. Mr. Peek and Mr. Fleck were disqualified persons as to their IRAs as fiduciaries. Mr. Peek and Mr. Fleck countered that the guaranties were not prohibited transactions because they did not involve their IRAs directly – the personal guaranties were for debts of FP Company, not their IRAs. The Tax Court ruled, however, that to read the statute as Mr. Peek and Mr. Fleck would have liked “would rob it of its intended breadth.” The Supreme Court has observed that “when Congress used the phrase ‘any direct or indirect’ in section 4975(c)(1), it thereby employed ‘broad language’ and showed an obvious intention to ‘prohibit something more’ than would be reached without it.” As the IRS Commissioner pointed out, if the statute prohibited only a loan or loan guaranty between a disqualified person and the IRA itself, then the prohibition could be easily and abusively avoided simply by having the IRA create a shell subsidiary to which the disqualified person could then make a loan.
As far as the tax consequences of the prohibited transactions in this case, the Tax Court ruled that 1) the accounts that held the FP Company stock were not IRAs in 2006 when the stock was sold, 2) the accounts ceased to be IRAs in 2001 and therefore were not exempt from income tax, and 3) the tax consequence of their non-exemption was that Mr. Peek and Mr. Fleck were liable for tax on the capital gains realized in 2006 and 2007 from the sale of the FP Company stock. Because the guaranties remained in place and constituted a continuing prohibited transaction, the accounts that held the FP Company stock could not be IRAs in subsequent years, including the subsequently established Roth IRAs.
The Tax Court also ruled that Mr. Peek and Mr. Fleck were liable for a 20% accuracy related penalty because their tax underpayments were “substantial understatements” of income tax under §6662(b). Mr. Peek and Mr. Fleck relied upon a CPA, Mr. Christian Blees, to set up a strategy which Mr. Blees identified as the “IACC” plan. The IACC plan called for the participant to establish a self-directed IRA, transfer funds from an existing IRA or 401(k) plan into the self-directed IRA, set up a new corporation, sell shares in the new corporation to the self-directed IRA, and finally to use the funds from the sale of shares to purchase a business. In addition to describing the plan, the IACC documents included a discussion of prohibited transactions which would be detrimental to the IACC plan’s tax objectives, including a warning that all actions must be taken by the participant as an agent for the corporation and not by the participant personally. Given that Mr. Peek and Mr. Fleck had been given advice about the hazards of prohibited transactions and their personal involvement with the FP Company transactions, the Tax Court held that they were negligent and liable for the 20% accuracy-related penalty. Mr. Peek and Mr. Fleck were unable to convince the court that they acted with reasonable cause and in good faith because of their reliance on advice provided by Mr. Blees, the CPA, because Mr. Blees was a promoter and not a disinterested professional. A “promoter” is “an advisor who participated in structuring the transaction or is otherwise related to, has an interest in, or profits from the transaction.” Additionally, there is no indication that Mr. Peek and Mr. Fleck ever asked for advice from Mr. Blees about whether or not the personal guaranties would be prohibited transactions.
This case shows the danger of checkbook control IRA owned entities. Some people use this setup in an attempt to get around the prohibited transaction rules, which clearly does not work. In fact, arguably it could increase the likelihood of a prohibited transaction occurring within your IRA. Remember that the phrase “direct or indirect” is meant to be very broad, and simply interposing an entity in between your IRA and the transaction will not provide any insulation against the prohibited transaction rules. Relying on a promoter for advice as opposed to a disinterested professional will not help you avoid penalties, either.
Self-directed IRAs are indeed a very powerful tool for building your retirement wealth, but if you violate the prohibited transaction rules your IRA will be deemed distributed to you as of January 1 of the year in which the prohibited transaction occurs. As I always have said, use the law, but do not abuse the law.