Eventually, I hope IRA owners will learn that the middle letter in IRA stands for Retirement. The essence of the prohibited transaction rules is simple:  you may not invest your IRA in a way that gains you or any other disqualified person a current benefit, other than as a beneficiary of the IRA.  The latest Tax Court case of Ellis v. Commissioner (T.C. Memo 2013-245) shows once again the dangers of a checkbook control IRA-owned LLC where the IRA owner is the manager.

             In 2005 Mr. Terry L. Ellis had his attorney form CST Investments, LLC (“CST”).  Mr. Ellis was the general manager and signed the operating agreement on May 25, 2005 listing his IRA as a member with 98% ownership of CST and initial contributed capital of $319,500.  CST was formed to engage in the business of used vehicle sales.  On June 7, 2005, Mr. Ellis submitted an application to establish the IRA which he previously listed as a member of CST (yes, he did it backwards). Mr. Ellis elected to have the entity taxed as a corporation, presumably to avoid having his IRA owe Unrelated Business Income Tax (UBIT) from the business income generated by CST.  On June 22, 2005, Mr. Ellis received a distribution of $254,206.44 from his former employer’s 401(k) plan, which was deposited into his IRA account.  Mr. Ellis then instructed his custodian to purchase 779,141 membership units of CST on June 23, 2005 in exchange for a cash payment of $254,000 from his IRA to CST.  On August 19, 2005, Mr. Ellis received a second distribution from his former employer’s 401(k) plan of $67,138.81 which he also rolled into his IRA.  Mr. Ellis then directed his custodian to purchase an additional 200,859 membership units in CST on August 23, 2005 in exchange for a cash payment of $65,500 from his IRA to CST.  Following the completion of the $319,500 capital contribution, on June 23, 2005 a single membership certificate was issued for 980,000 units to the custodian of Mr. Ellis’ IRA.

             During tax year 2005 CST paid Mr. Ellis compensation in the amount of $9,754 for his role as general manager of CST, which was duly reported on Form W-2 and deducted by CST.  Mr. Ellis was the only person paid in tax year 2005.  Additionally, CST deducted legal fees of $8,910, which was compensation to Mr. Ellis’ legal counsel for setting up CST.  Mr. Ellis was paid $29,263 in compensation during tax year 2006.

             Mr. Ellis’ legal counsel also formed CDJ, LLC (“CDJ”) in 2005, which was taxed as a partnership and was owned 50% by Mr. Ellis and 12.5% each by Mrs. Sheila K. Ellis and their 3 children.  The purpose of CDJ was to acquire investment property for commercial rental.  CDJ acquired a parcel of real property in December, 2005, and began leasing the property on January 1, 2006 to CST.

             In 2011 the IRS sent Mr. and Mrs. Ellis a notice of deficiency for tax year 2005 or alternatively for tax year 2006.  The IRS’ determinations were based on the premise that at one of a few alternative points during tax years 2005 and 2006 Mr. Ellis engaged in a prohibited transaction under Internal Revenue Code (IRC) Section 4975 with his IRA.  On January 1 of the tax year during which the prohibited transaction occurred, the IRA ceased to be an “eligible retirement plan” and the fair market value of the IRA was deemed to be distributed to Mr. Ellis.  The IRS alleged that Mr. Ellis engaged in a prohibited transaction with his IRA at one or more of the following points: (1) when Mr. Ellis caused his IRA to engage in the sale and exchange of membership interests in CST in tax year 2005; (2) when Mr. Ellis caused CST, an entity owned by his IRA, to pay him compensation in tax year 2005; (3) when Mr. Ellis caused CST, an entity owned by his IRA, to pay him compensation in tax year 2006; or (4) when Mr. Ellis caused CST, an entity owned by his IRA, to enter into a lease agreement with CDJ, an entity owned by the Ellis family, in tax year 2006.  Although the Tax Court only found it necessary to address the first two points, there is no question that the remaining two points were prohibited transactions also.

             The Tax Court first addressed the initial purchase of the membership interests in CST by Mr. Ellis’ IRA. Mr. Ellis argued that he did not cause a prohibited transaction by causing his IRA to invest in CST, because CST was not a disqualified person at the time of the investment.  This argument was based on the Tax Court’s holding in Swanson v. Commissioner, 106 T.C. 76, 88 (1996).  Mr. Swanson organized a corporation called Swansons’ Worldwide, Inc. (Worldwide), of which he was the sole director and officer.  He then instructed the custodian of his IRA to subscribe to all of the original issue stock of Worldwide.  The Tax Court in Swanson held that “a corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e)(2)(G).”  Since Worldwide was not a disqualified person at the time of purchase, the purchase of Worldwide’s stock by Mr. Swanson’s IRA was not a prohibited transaction. In one of the few bright spots in this case, the Tax Court agreed with Mr. Ellis, and found that “an LLC that elects to be treated as a corporation and does not yet have members or membership interests is sufficiently analogous to a ‘corporation without shares or shareholders’. Mr. Ellis organized CST without taking any ownership interest in the company.”

             This ruling should give some comfort to those who have set up checkbook control IRA-owned LLCs and have purchased all of the original issue membership interests.  So far the case law supports the proposition that the initial purchase is not a prohibited transaction. It is what happens after the entity is formed and funded that usually causes the prohibited transactions to occur.

             The Tax Court next addressed the compensation paid by CST to Mr. Ellis.  As a fiduciary of his IRA, Mr. Ellis was a disqualified person as to his IRA.  The Tax Court ruled that the payment of compensation to Mr. Ellis was a prohibited transaction because it constituted a direct or indirect “transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan” (IRC Section 4975(c)(1)(D)) and additionally was “an act by a disqualified person who is a fiduciary whereby he directly or indirectly deals with the income or assets of a plan in his own interest or for his own account” (IRC Section 4975(c)(1)(E)).  As a fiduciary of his IRA and as general manager of CST, Mr. Ellis had discretionary authority to determine the amount of his compensation and to cause the payment to be made.

             Mr. Ellis attempted to defend the payment of compensation by arguing that the amounts paid to him were not plan income or assets of his IRA but merely the income or assets of a company in which his IRA had invested.  The Tax Court rejected this argument, stating that “to say that CST was merely a company in which Mr. Ellis’ IRA invested is a complete mischaracterization when in reality CST and Mr. Ellis’ IRA were substantially the same entity.”

             Mr. Ellis next tried to argue that the compensation paid to him by CST was exempt from being a prohibited transaction because of the reasonable compensation exception contained in IRC Section 4975(d)(10), which provides that the prohibited transactions set forth in IRC Section 4975(c)(1) do not apply to receipt by a disqualified person of any reasonable compensation for services rendered, or for the reimbursement of expenses properly and actually incurred, in the performance of his duties with the plan.  However, the Tax Court ruled that “the amounts CST paid as compensation to Mr. Ellis were not for services provided in the administration of a qualified retirement plan in managing its investments, but rather for his role as general manager of CST in connection with its used car business.  Accordingly, section 4975(d)(10) does not apply.”  The Court further wrote that “in essence, Mr. Ellis formulated a plan in which he would use his retirement savings as startup capital for a used car business.  Mr. Ellis would operate this business and use it as his primary source of income by paying himself compensation for his role in its day-to-day operation. … However, this is precisely the kind of self-dealing that section 4975 was enacted to prevent.”

             Because the Tax Court ruled that Mr. Ellis engaged in a prohibited transaction in tax year 2005, the entire amount of $321,366.25 which Mr. Ellis converted from his former employer’s 401(k) plan was deemed to be distributed to him as of January 1, 2005 and was added to his taxable income for that year.  Additionally, Mr. Ellis was liable for the 10% premature distribution penalty since he had not reached age 59 ½ by January 1, 2005.  The addition of that much money to his taxable income also meant that Mr. Ellis was liable for the 20% accuracy-related penalty under IRC Section 6662(a) for an underpayment attributable to any substantial understatement of income tax or to negligence or disregard of rules or regulations.  An exception to this penalty exists if the taxpayer establishes that he acted in reasonable cause and in good faith, including the reliance on the advice of a tax professional or an honest misunderstanding of the law that is reasonable in light of all the facts and circumstances.  However, Mr. Ellis did not provide sufficient evidence and did not otherwise prove reasonable cause for relief from the penalty determined under section 6662(a).  In the end Mr. Ellis owed the IRS an additional $140,922 in taxes plus and additional $27,187 for the 20% accuracy-related penalty for tax year 2005.

             Another issue discussed by the Tax Court in this case is of some interest.  In discussing the compensation paid to Mr. Ellis by CST, the wrote that “because Mr. Ellis, a fiduciary of his IRA, was the beneficial shareholder of more than 50% of the outstanding ownership interest in CST, CST met the definition of a disqualified person under section 4975(e)(2)(G).  See Swanson v. Commissioner, 106 T.C. at 88 n. 15.”  However, at another place in the case the Tax Court stated that “in reality CST and Mr. Ellis’ IRA were substantially the same entity,” which appears to be logically inconsistent with the earlier statement that CST met the definition of a disqualified person.  If it is true that an entity owned 50% or more by an IRA becomes a disqualified person to that IRA, then additional funding to that entity arguably would be a prohibited transaction as a “transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan” (IRC Section 4975(c)(1)(D)).  There are a couple of Advisory Opinion Letters from the Department of Labor which would seem to disagree with the statement that an entity owned by a plan becomes a disqualified person to that plan (see Advisory Opinion 97-23A and Advisory Opinion 2003-15A).  However, Tax Court cases have value as legal precedent, while Advisory Opinion Letters do not since they only apply to the persons who request the ruling.  The Department of Labor is the government agency responsible for interpreting the prohibited transaction rules of IRC Section 4975, so their interpretations are influential, but should not generally be relied on in the face of conflicting Tax Court opinions.  Therefore the best practice is to fully fund initially any entity to be owned 50% or more by an IRA or a group of related IRAs, and not to make subsequent contributions to that entity.  This may lead to some difficulty when subsequent capital contributions are required or desired, so be extremely careful when deciding how to structure entity investments in an IRA or other plan.

             A self-directed IRA is an extremely powerful tool to build wealth for your retirement.  It allows you to take control of your retirement dollars and invest in what you know best.  However, it does NOT allow you to use those retirement dollars to benefit yourself or any other disqualified person currently, except for building up your retirement account balance.  You cannot buy yourself a job, like Mr. Ellis attempted to do.  Every investment you make in your self-directed IRA must be for the exclusive benefit of your IRA.  In every case coming out of Tax Court, taxpayers are attempting to use their IRAs to do something they just were not intended for.  The best thing about a self-directed IRA is that it is self-directed, which means that you have the broadest possible spectrum of investment choices available to you, without the restrictions of more traditional brokerage-style IRAs.  On the other hand, the worst thing about a self-directed IRA is that it is self-directed, which means you are completely responsible for your investment decisions, and if you lose all of your money because of bad investments or bad decisions you have no one to blame but yourself.

             If anyone tells you that you can use your IRA to benefit yourself or other disqualified persons now, run the other way, because they do not know what they are talking about and are likely just trying to sell you something. If you take the time to learn the rules yourself and invest in what you know and understand best, you will have a great retirement.

             Take advantage of the many FREE educational materials provided by Quest IRA, Inc. on our website at www.QuestIRA.com, and plan on attending as many of the live events as possible to network with other self-directed IRA clients.  Our events schedule may be found at www.questira.com/events/. You can also call our offices toll-free at 800-320-5950 or 855-FUN-IRAS (855-386-4727) and ask to speak to one of our highly trained IRA Specialists.