All posts by Quincy Long
Could I just make a personal loan to my partner in the LLC and he could the pay down the hard money loan?
Question:
I currently have a self-directed IRA and have some cash in it from a recent deal. I am a 50% owner of an LLC with a hard money loan on a home we are currently trying to sell. Basically, I need to determine a safe way to invest(not take a distribution) my Ira money so that the money can ultimately pay off part of that hard money loan.
1. Could I just make a personal loan to my partner in the LLC and he could the pay down the hard money loan? He is not related to me. Or is this just too direct a transaction?
2. I know another real estate investor who has nothing to do with the LLC who is willing to help in any reasonably safe way. Do I have my IRA do a promissory note to this investor who then loans the money to the LLC? Do we have the loans for differing amounts of money? Do we do any of this using some instrument other than or in conjunction with a promissory note, i.e. a second mortgage on the investor’s home and a second on the home that the LLC is trying to sell?
Please advise on the safest way to invest the IRA and get the loan paid down.
Answer:
Unfortunately, there is probably no safe way to accomplish what you want to do. You should understand that your partner in the LLC is, in fact, a disqualified person to your IRA. The reason for this is that any entity owned 50% or more by an IRA owner is a disqualified person to the IRA, which means that your LLC is a disqualified person to your IRA. Furthermore, because your partner owns 10% or more of your LLC, he or she is also a disqualified person to your IRA. So loaning money to your LLC or your partner is out of the question as a direct violation of the prohibited transaction rules.
In your second scenario, what you describe is a step transaction. Unfortunately, you are not permitted to do indirectly what you cannot do directly under the prohibited transaction rules. Since your IRA money cannot be used to pay down the hard money loan directly, trying to take two steps to accomplish the same goal does not work either. Even if you make it harder to detect what is going on through the use of different loan amounts or different timing of the loans, unfortunately it will not change the basic fact that as a direct result of your IRA’s investment in a loan to your non-disqualified investor friend you, your partner and your LLC will all benefit from having the hard money loan paid down. This would also be a prohibited transaction.
If you have not taken a distribution from your IRA in at least twelve months, you could take a distribution and as long as you returned the money to your IRA or another IRA within 60 days it would not be taxable. Of course the danger of this strategy is that if you were unable to return the money to the IRA it would be taxable and you would possibly face penalties if you are under age 59 1/2, assuming the IRA you refer to is a traditional IRA. If you were able to return part of the money to the IRA, then only the part that you were not able to return would be taxable. This may not be the best strategy for you to deal with your issues, given the level of risk involved, but at least it would avoid the danger of a prohibited transaction.
I’m sorry I was not able to offer you a solution to your problem. We are not permitted to give tax, legal or investment advice, but I hope I have given you and your legal or tax counsel some things to think about. If Quest IRA can ever be of service to your or your acquaintances, please do not hesitate to contact us. Have a great day!
Transferring properties between IRAs
Question:
Hi Quincy,
We spoke when I was deciding about IRAs, and I recall that you said you are an attorney, so can you please answer the question below about title policy? I am trying to transfer a property from my other IRA into Quest, and there is an issue about the warranty deed and moving it to Quest. It was written in the name of the current IRA, so do we need to get it transferred and, if so, how do we go about that?
Answer:
I can see arguments both ways, although I think most people would not get a new title policy. Certainly it is true that a new lender would require a title policy for them, but the property is going from one custodian for the benefit of your IRA to another custodian for the benefit of that same IRA. This is analogous to changing trustees on a trust. Even after conveyance, the title policy would have to continue to protect the insured for defects prior to that time. For example, in the Conditions and Stipulations section of the standard title policy, Section 2(b) reads, in part:
“After Conveyance of Title. The coverage of this policy shall continue in force as of the Date of Policy in favor of an insured only so long as … the insured shall have liability by reason of covenants of warranty made by the insured in any transfer or conveyance of the estate or interest.”
So the title protection would not extend to anything that happened to the title after the property was acquired, nor would it directly protect any future owners of the property. But as long as there were covenants of warranty (as in a general warranty deed) the title policy would cover the owner who was insured (in this case, SDIRA Services FBO Your Name), which would likely be included in any lawsuit alleging a defect of title.
Would it be covered for sure? I honestly cannot say. It may have to do with the nature of the defect in title, and of course the timing of when the defect occurred would be critical. It is always possible that you could argue it was, in fact, the same insured, but just with a different “trustee.” I have found that title companies do not necessarily shy away from coverage when it is clear they missed something. I have been protected by title insurance before, as has my mother. But it is not possible for me to render a legal opinion or give legal advice on something that may or may not happen.
As far as what my staff said, it is true that we do not require you to obtain a title policy. That is strictly up to you. I hope this helps you a little. Thank you for the opportunity to serve your self-directed IRA needs. Have a great day!
DOMA Ruled Unconstitutional – Now What? *Updated*
Updated August 29, 2013
On June 26, 2013, the Supreme Court ruled that a key section of the Defense of Marriage Act (DOMA) was unconstitutional. This will allow at least some same sex couples to have the same tax benefits – and burdens – that opposite sex married couples enjoy. So what does that mean for IRAs?
Section 3 of DOMA defines marriage for purposes of administering federal law as the “legal union between one man and one woman as husband and wife.” A spouse is defined as “a person of the opposite sex who is a husband or wife.”
Edie Windsor challenged the law. Ms. Windsor was involved in a long term same sex relationship with Thea Spyer. Ms. Windsor and Ms. Spyer lived together in New York, and in 2007 they got married in Canada. Ms. Spyer died in 2009 and left her entire estate to Ms. Windsor. At the time of Ms. Spyer’s death, their marriage was recognized under New York law, but Section 3 of DOMA prevented recognition of their marriage under federal law. As a result of not being able to take advantage of the unlimited marital deduction allowed for spouses, Ms. Spyer’s estate owed a federal estate tax of over $363,000. Ms. Windsor paid the tax in her capacity as executor and then sued for a refund, alleging that Section 3 of DOMA was unconstitutional.
In a 5-4 decision authored by Justice Kennedy, who was joined by Justices Ginsberg, Breyer, Sotomayor, and Kagan, the Supreme Court held that Section 3 of DOMA was an unconstitutional deprivation of equal protection. The Supreme Court acknowledged that the regulation of marriage was by longstanding tradition considered to be within the authority of the separate states, and that federal law has generally deferred to state law policy decisions in the area of domestic relations. The Court found that DOMA treated married couples within the same state differently, and made unequal a subset of state sanctioned marriages in a wide range of areas including Social Security. The majority decision struck down Section 3 of DOMA as invalid, but its opinion and holding are limited to “lawful marriages.”
The tax and other effects of this decision are far reaching, but many questions remain unanswered. Section 2 of DOMA, which allows states to refuse recognition of same sex marriages performed under the laws of other jurisdictions, was not at issue in the Windsor case. New York law recognized the marriage of Ms. Windsor and Ms. Spyer, even though they were married in Canada. This means that at least for now states which have banned recognition of same sex marriage may continue to do so for state law purposes, regardless of whether or not a marriage is recognized under federal law. There is little doubt that this will lead to substantial confusion in many areas of law, which will take some time to sort out.
Update: On August 29, 2013, the IRS issued Revenue Ruling 2013-17, which addressed some of the issues that were still outstanding after the Windsor decision. The IRS clarified that:
For federal income tax purposes, the IRS has a general rule recognizing a marriage of same-sex spouses that was validly entered into in a domestic or foreign jurisdiction whose laws authorize the marriage of two individuals of the same sex even if the married couple resides in a domestic or foreign jurisdiction that does not recognize the validity of same-sex marriages.
For tax year 2013 and going forward, same-sex spouses generally must file using a married filing separately or jointly filing status. For tax year 2012 and all prior years, same-sex spouses who file an original tax return on or after Sept. 16, 2013 (the effective date of Rev. Rul. 2013-17), generally must file using a married filing separately or jointly filing status. For tax year 2012, same-sex spouses who filed their tax return before Sept. 16, 2013, may choose (but are not required) to amend their federal tax returns to file using married filing separately or jointly filing status. For tax years 2011 and earlier, same-sex spouses who filed their tax returns timely may choose (but are not required) to amend their federal tax returns to file using married filing separately or jointly filing status provided the period of limitations for amending the return has not expired. A taxpayer generally may file a claim for refund for three years from the date the return was filed or two years from the date the tax was paid, whichever is later.
Qualified retirement plans must comply with these rules as of Sept. 16, 2013. Although Rev. Rul. 2013-17 allows taxpayers to file amended returns that relate to prior periods in reliance on the rules in Rev. Rul. 2013-17 with respect to many matters, this rule does not extend to matters relating to qualified retirement plans. The IRS has not yet provided guidance regarding the application of Windsor and these rules to qualified retirement plans with respect to periods before Sept. 16, 2013. The IRS intends to issue further guidance on how qualified retirement plans and other tax-favored retirement arrangements must comply with Windsor and Rev. Rul. 2013-17.
A list of Frequently Asked Questions on Revenue Ruling 2013-17, including the above information and more, may be found at http://www.irs.gov/uac/Answers-to-Frequently-Asked-Questions-for-Same-Sex-Married-Couples.
For legally married same-sex couples, there are some implications for their IRAs, presumably including:
1) A spouse who does not work outside the home may now qualify to make a contribution based on their spouse’s income (a spousal IRA).
2) For a married couple filing jointly, their combined Modified Adjusted Gross Income (MAGI) may prevent each spouse from directly making a Roth IRA contribution or from deducting a traditional IRA contribution if at least one spouse is covered by a retirement plan at work and their MAGI is above certain income limits.
3) Upon death of an IRA owner, the surviving spouse may rollover or transfer the deceased spouse’s IRA to their own IRA.
4) If the IRA owner died before the year in which he or she reached age 70 ½, a spouse who is the sole beneficiary of the IRA can defer taking RMDs from the beneficiary IRA until the year in which the deceased spouse would have reached age 70 ½.
5) If the sole beneficiary of the IRA is a spouse who is 10 years or more younger than the IRA owner then the IRA owner may use the Joint Life and Last Survivor Expectancy Table (Table II) in IRS Publication 590 to calculate a lower Required Minimum Distribution (RMD) for those who are at least age 70 ½.
6) Retirement assets can be split tax free in a divorce.
7) In the case of an HSA, the account becomes the account of the surviving spouse and continues as an HSA as opposed to being distributed and taxed upon the death of the HSA account owner.
This blog post will be updated as the IRS issues further guidance on how the Windsor decision and Revenue Ruling 2013-17 impacts qualified retirement plans, IRAs, and other tax-favored arrangements.
Inherited Roth IRAs – The Gift That Keeps On Giving
The benefits of a Roth IRA are legendary, but the benefits of an inherited Roth IRA are even better. One of the best legacies you can leave to your children or grandchildren is an inherited Roth IRA. By leaving a Roth IRA to your beneficiaries, you leave them with the ability to create a stream of tax and penalty free income for their lifetime, regardless of their age when they inherit the account. This is particularly powerful if the beneficiary of the Roth IRA is a young child.
Recently a client of Quest IRA, Inc. opened a couple of Roth IRAs with a relatively small deposit into each. The beneficiary of each Roth IRA was one of his young grandchildren. The client has been a successful real estate investor his whole life, and he has friends who are also real estate investors. The fact that there is not a lot of money in each account does not mean that they cannot be invested successfully. The accounts may combine with other IRA accounts to enter into transactions, or they may be invested separately using real estate investing techniques which do not require a lot of money. While the client is still alive, he will likely invest the Roth IRAs primarily into real estate based assets, since that is what he is most familiar with as an investor. Because the beneficiaries are so young at this time, the client has made arrangements with his real estate investor friends to ensure that the accounts continue to be invested for maximum cash flow and growth for the benefit of his grandchildren after he dies. If the client dies prior to his grandchildren reaching the age of majority, his children will have to set up the inherited Roth IRAs for the benefit of his grandchildren, so their cooperation and understanding is essential to the success of his plans.
What You Need To Know To Set Up A Roth IRA. In order to set up a Roth IRA you (or your spouse if you are married and filing taxes jointly) must have compensation at least in the amount of the contribution, and no more than the maximum Modified Adjusted Gross Income (MAGI). Compensation is generally described as wages, salaries, commissions, tips, self-employment income, taxable alimony or separate maintenance, and non-taxable combat pay. In order to qualify for a direct contribution to a Roth IRA in 2013, the MAGI of single individuals cannot exceed $127,000, and for married couples filing jointly the MAGI limit is $188,000. These limits are adjusted each year. If you have MAGI over the limit and are under age 70½ with compensation, you may still indirectly qualify for a Roth IRA. Under these circumstances you can contribute to a traditional IRA and then convert that IRA to a Roth IRA. There are no longer income limits for converting from a traditional IRA to a Roth IRA. The maximum contribution for 2013 is $5,500 for a person under age 50 and $6,500 for a person who will be age 50 or older by the end of the year.
Unlike a traditional IRA, there is no age discrimination for contributing to a Roth IRA. Anyone with compensation may contribute to a Roth IRA, including those over age 70 ½. If you do not have any compensation, you may have to create some in order to qualify for a contribution. Often the potential beneficiaries of the Roth IRA or their parents are willing to help you create compensation. Depending on your abilities, this may include anything from consulting services to stuffing envelopes to answering phone calls or otherwise helping in their business. Be sure that your hours worked and the services performed are carefully documented and that your pay is a reasonable wage. Keep in mind that any compensation may cause you to owe additional taxes, depending on your income level. Any self-employment income of $400 or more will be subject to Social Security and Medicare taxes even if you do not owe any income taxes, and you will be required to file a tax return to pay those taxes.
What Happens After The Roth IRA Is Inherited. Although there is no requirement that you as the original Roth IRA owner take Required Minimum Distributions (RMDs) from the account during your lifetime, your beneficiaries will be required to take RMDs beginning in the year after they inherit the account. The good news is that distributions from an inherited Roth IRA never incur the 10% premature distribution penalty, regardless of the age of the person taking the distribution. Even better, if a five year test for qualified distributions is met, the distribution is tax free as well. Creating tax and penalty free income for your beneficiaries is the ultimate goal when setting up a Roth IRA to be inherited.
The five year test for a qualified (tax and penalty free) distribution will be satisfied if, at the time of the distribution, you had a Roth IRA established for your benefit for at least five tax years. For example, if the first Roth IRA you ever had was opened before April 15, 2013 for the tax year of 2012, qualified distributions could begin as early as January 1, 2017. Since you only have one five year test for all of your Roth IRAs, the five year clock begins to run on January 1 of the first tax year for which any Roth IRA is opened for your benefit. The account which is being inherited does not have to separately meet the five year test for qualified distributions.
If you did not have a Roth IRA set up for your benefit for at least five tax years when your beneficiaries take their RMDs, the number of years the inherited Roth IRA has been established is added to the years that you had any Roth IRA set up for your benefit to determine if a distribution is a qualified distribution. For example, if you die after having had a Roth IRA open for only three tax years, the RMDs would not be qualified distributions until your beneficiary had the inherited Roth IRA open for an additional two tax years. Your beneficiary must still take RMDs from the account regardless of whether or not the distributions are qualified distributions. If the account grows in value substantially before the five year test has been met and the RMDs exceed your contributions, a portion of the distribution may be taxable to your beneficiary. This may affect the investment strategy for an inherited Roth IRA, at least until the 5 year test has been met. Your beneficiary should also be aware that no additional money may be contributed to an inherited Roth IRA, so some conservatism in investing the account is justified.
To figure out how much the RMD is each year for an inherited Roth IRA, the first task is to determine the relevant life expectancy factor based on the inherited Roth IRA owner’s age in year following the date of death of the original Roth IRA owner. This factor may be found on the IRS Single Life Expectancy Table, which is Table 1 in Appendix C of IRS Publication 590. You can download all IRS publications from www.irs.gov. Take the value of the account as of December 31 of the prior year and divide it by the life expectancy factor to get the RMD amount. For example, a beneficiary who must begin taking distributions from an inherited Roth IRA at age 10 has a life expectancy factor from the IRS table of 72.8. If the original Roth IRA owner dies in 2013 and balance in the inherited Roth IRA is $1,000 as of December 31, 2013, the first year RMD to be taken in 2014 is calculated as follows:
Prior Year End Balance ($1,000)
Life Expectancy Factor (72.8) = Required Minimum Distribution ($13.74)
In subsequent years the factor is reduced by 1, and in each subsequent year the balance on December 31 of the prior year is divided by the new factor. For example, the life expectancy factor in this scenario is 71.8 in year 2, 70.8 in year 3, and so on. Since the original life expectancy factor in this example was 72.8, after a total of 73 years the inherited Roth IRA must be completely distributed, either to the original beneficiary or to his or her heirs. If the inherited Roth IRA owner prefers, he may choose to take the entire account balance by the end of the fifth year following the death of the original Roth IRA owner. With this choice no RMDs are required at all during the five years, but it does somewhat defeat the purpose of setting up the inherited Roth IRA. A spouse who inherits a Roth IRA has some additional choices which are not discussed in this article.
Leaving a Roth IRA to a young beneficiary means that beneficiary has to take very little money from the account in RMDs in the early years, and the distribution period is much longer. The initial distribution in the above example was only 1.374% of the prior year end account balance. For comparison, if the first distribution was at age 50 the relevant life expectancy factor from the table would be 34.2 and the distribution would be approximately 2.92% of the prior year account balance. To the extent investment earnings in the account exceed the percentage of the account balance that must be taken as an RMD, the account will continue to grow in value, as will the dollar amount of the RMD each year. If your beneficiary needs more than the RMD in any given year they can take a higher amount, but it will not be credited towards RMDs in future years.
The Power Of Self-Direction. The power of an inherited Roth IRA is magnified greatly if the account is self-directed. With a self-directed IRA you can invest in what you know best, which substantially lowers your investment risk and can greatly increase your yield, especially if you are a good investor. There are very few investment restrictions imposed on IRAs by the Internal Revenue Code, but you do have to have a custodian or third party administrator like Quest IRA, Inc. to hold non-traditional assets in your IRA. Popular investments in self-directed IRAs include real estate, promissory notes, options, tax liens, trusts, LLCs, partnership interests, and private stock, among many other choices. Contrary to what you may have heard, your IRA is not locked into only investing in the stock market. This opens up almost endless possibilities for growing your IRA. To learn more about self-directed IRAs, visit www.QuestIRA.com, where you will find a lot of great FREE education.
Setting up a Roth IRA for the benefit of your child or grandchild is a wonderful legacy which can benefit them for a lifetime. You are leaving your beneficiaries with endless possibilities to create tax and penalty free income which is accessible to them at any age in any amount for any reason to meet their needs. You will never make a better investment of your time and money than setting up and funding a Roth IRA for the benefit of your children or grandchildren, then sharing with them your knowledge and skills as an investor. An inherited Roth IRA is truly the gift that keeps on giving. Get started today!
H. Quincy Long is a Certified IRA Services Professional (CISP) and an attorney. He is also President of Quest IRA, Inc. (www.QuestIRA.com), a self-directed IRA third party administrator with offices in Houston, Dallas, and Austin, Texas, and in Mason, Michigan. He may be reached by email at Quincy@QuestIRA.com. Nothing in this article is intended as tax, legal or investment advice.
© Copyright 2013 H. Quincy Long. All rights reserved.
Can my IRA lend to a non disqualified person to purchase a home for my daughter?
Question:
I understand my self directed Ira cannot lend to my daughter. But what if my Realtor borrows money from my IRA to buy a house and then sells that house to my daughter on a wrap,and some time later decided that he wants to sell out his equity in the wrap, could my IRA buy that note?
Answer:
Thank you for your question. The answer is no, your IRA cannot buy the note. There can be no direct or indirect benefit to a disqualified person (which your daughter is). Loaning money to your Realtor with the intention that the Realtor sell the house to your daughter on a wrap is only attempting to do indirectly what you cannot do directly, which is to benefit your daughter by facilitating her purchase of a house through the lending of money from your IRA. This is likely to violate more than one of the prohibited transaction rules.
For your reference, see Internal Revenue Code Section 4975(c)(1)(B), which prohibits the direct or indirect lending of money or other extension of credit between a plan (including an IRA) and a disqualified person. Also, you may be interested in Advisory Opinion Letter 2011-04A (Warfield), where the applicants asked if they could purchase a loan with their IRA that they owed to a third party bank who had loaned them money several years earlier. The Department of Labor ruled that the entire loan transaction needed to be reviewed from beginning to the end for prohibited transactions. Even though the loan was obviously not a prohibited transaction when originated, the purchase of the loan from the bank and the subsequent payments to the IRA would be prohibited transactions. Finally, to quote the Tax Court in the recent case of Fleck and Peek v. Commissioner, “Section 4975(c)(1)(B) prohibits “any direct or indirect * * * extension of credit between a plan and a disqualified person”. (Emphasis added.) 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. Commissioner v. Keystone Consol. Indus., Inc., 508 U.S. 152, 159-160 (1993).”
I know that’s not what you wanted to hear, but it’s better to ask questions now than to destroy your IRA and possibly owe taxes and penalties. Have a great day!
How far does an ‘indirect benefit’ reach? (Prohibited Transactions)
Question:
Quincy,
I don’t know how “indirect” is defined, exactly and to what extent it stretches.
Here’s the scenario.
Kyle has a co-worker, Jim, who is considering investing with us via a note and self-directed IRA.
We are also considering working with Jim and kids in some real estate transaction where the kids manage a property we acquire in the future.
If Jim’s IRA has an option on a property or a holds a lien/note on a property but does not have ownership (3rd party/we own), can his children live in the property or manage it? I’m guessing this is a no because it could be considered an indirect benefit.
Is there any scenario where something like this could work? What if we give his IRA a lien on a property we own, Property A?
Then, at some point in the future, we buy a new property, Property B, maybe using some of the cash we received from Jim’s IRA, some from our w-2 income (all coming out of our bank account) but his IRA has no relation to new property B. Could Jim’s kids be involved in living or managing the new property? These wouldn’t be concurrent transactions, nor contingent on one another, nor identical in value. So, it seems to me like there wouldn’t be a problem. Once the cash is infused into our bank account it becomes our money, right? How could you say that part of our bank account belongs to Jim? We could use it to buy another property at some point as it’s now our money. If Jim’s kids are involved in a future transaction with us, then that shouldn’t be a problem at that point, right?
Answer:
I would definitely say that if Jim’s IRA had a lien or even an option on a particular property that it is not a good idea for them to live in or manage that property. Some people would probably argue with me about that, but I try to take a conservative approach on these issues. You make a very good point when you say that you don’t know how “indirect” is defined, exactly, and to what extent it stretches. The best sense I can give you is that if as a result of an IRA investment a benefit accrues to a disqualified person, then that may be considered to be a prohibited transaction. Unfortunately there isn’t much guidance on the issue, except for the few cases and Advisory Opinion Letters from the Department of Labor. In case you are a nerd like me and want to go to the source, I have attached my 2012 IRA Entity Investments paper which describes the rules and has what I consider to be major cases attached to it. This whole discussion reminds me of that famous quote from Supreme Court Justice Potter Stewart in 1964 when discussing how to define obscenity. In the opinion, he wrote:
I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description [“hard-core pornography”]; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that. [Emphasis added.]
—Justice Potter Stewart, concurring opinion in Jacobellis v. Ohio 378 U.S. 184 (1964), regarding possible obscenity in The Lovers.
As applied here, it may be very difficult, if not impossible, to intelligibly define what an “indirect” benefit is, but the IRS will know it when they see it!
I get the sense of what you’re saying below. Obviously the more disconnect there is between Jim’s IRA money and his kids the better. I am not saying that just because Jim loans you money you can never enter into any transaction with Jim’s kids. I’m simply saying that there can be no direct or indirect connection between the two events. In the end I am not the arbiter of what is or is not prohibited.
I appreciate so much that you are asking questions and trying to get a sense of what the rules are. I realize that I may be frustrating you by not telling you “the answer” but all I can do is provide some education to you (and indirectly to Jim). In the end Jim will have to make his own decision.
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Quest IRA President H. Quincy Long on the Lifetime Network
Another Blow to Checkbook Control IRA Owned Entities
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.