You've been warned: A recent ruling by the U.S. Tax Court holds a costly reminder about the consequences of making inappropriate transactions within a client's IRA.
In a case that centered on two investors' relationship to a company held by their retirement accounts, the court ruled that two business partners' IRAs were disqualified under the prohibited transaction rules when they guaranteed loans to a company owned by their IRAs. As a result, when the stock of the company was later sold inside their disqualified Roth IRAs, they owed taxes on the capital gain.
The court also upheld accuracy-related penalties that the IRS assessed. In doing so it found that, as a result of the disqualification, the taxpayers were negligent for failing to report the sale of stock they owned personally.
The case serves as another reminder for advisors to talk to clients about the potential tax nightmares that can await them should they venture too far off the beaten path with their IRA investments. It is all too easy to run afoul of the prohibited transaction rules.
In 2001, Darrell Fleck was looking to buy Abbott Fire Safety, a company specializing in providing alarms and fire protection systems for businesses. Lawrence Peek, a lawyer who had previously provided Fleck with legal services, was interested in participating, as well.
Fleck was introduced to Christian Blees, a CPA, by the brokerage firm that was offering the fire safety company for sale. Fleck and Peek hired Blees and his firm to structure the purchase of Abbott's assets and to perform due diligence on the transaction.
The CPA presented Peek and Fleck with a strategy for using their IRAs to acquire the fire safety company's assets. The strategy called for them to establish new self-directed IRAs and transfer existing IRA and retirement plan money into those accounts. They would then set up a new corporation, have their self-directed IRAs purchase the shares of that corporation and ultimately use the money from the sale to buy Abbott.
To implement the strategy, Fleck and Peek each set up self-directed IRAs funded by rollovers from existing retirement funds. Fleck and Peek set up a new firm called FP Co., over which they exercised full control as officers and directors.
In September 2001, each IRA bought 5,000 shares of the newly issued FP stock for $309,000. This gave each IRA a 50% share of ownership. It also gave the company more than $600,000 in cash, which Peek and Fleck intended to use to buy Abbott. A few weeks later, FP bought most of Abbott's assets for $1.1 million.
Since the purchase price exceeded the cash that FP had on hand, other sources were needed. Ultimately, the purchase price was satisfied in part with an additional bank loan, a promissory note from a broker and, most important, a $200,000 promissory note from FP that was personally guaranteed by Fleck and Peek. These personal guarantees remained in effect until FP was sold in 2006.
In 2003, both Fleck and Peek converted half of their IRAs to Roth IRAs; they converted the remaining IRA amounts in 2004. These conversions were accomplished by transferring shares of FP stock to the Roth IRA from the IRA. Fleck and Peek properly reported the fair market value of the shares that they converted to their respective Roth IRAs as taxable income for 2003 and for 2004.
Two years later, each of the Roth IRAs sold its FP stake for almost $1.7 million, paid over two years. The holders filed their 2006 and 2007 federal income tax returns, but did not pay taxes on the sale of the FP stock because it was held inside their Roth IRAs - and investments sold inside a Roth IRA are typically not taxable.
Typically is the key word. The IRS examined the pair's respective tax returns for 2006 and 2007 and determined that the personal guarantees of the loans were prohibited transactions. As a result, the IRS increased their personal income to include capital gains from the sale of FP stock; because of the increased income, the IRS also adjusted itemized deductions, exemption amounts and other items.
These adjustments added nearly $250,000 each to the two investors' 2006 tax bills. In addition, the IRS imposed almost $50,000 in accuracy-related penalties to each. Smaller tax liabilities and penalties were added to the men's 2007 tax returns.
The IRS contended that because of Fleck's and Peek's loan guarantees, there were prohibited transactions in 2001 through 2006. As a result of those transactions, the IRA accounts were deemed distributed in 2001 - thus invalidating the Roth IRAs financed with money from those accounts. That in turn made the gain on the sale of FP stock taxable as capital gains in 2006 and 2007.
Not surprisingly, Fleck and Peek disagreed with the IRS, and the issue went to Tax Court.
The crux of the matter was whether their guarantees on the $200,000 promissory note - which FP used to help purchase Abbott in 2001 - were prohibited transactions. The IRS argued that it was an indirect lending of money or other extension of credit between a retirement plan and a disqualified person, and therefore one of the many prohibited transactions.
Fleck and Peek countered that the loan guarantees were not between a retirement plan and disqualified persons. Their position was that although FP was wholly owned by their IRAs, the loan they guaranteed was in the name of FP and not directly connected to their IRAs - and therefore not prohibited.
The Tax Court disagreed. In ruling in favor of the IRS, the court said that, "given [the tax code's] obvious and intended meaning, [it] prohibited Mr. Fleck and Mr. Peek from making loans or loan guaranties either directly to their IRAs or indirectly to their IRAs by way of the entity owned by the IRAs."
The court also shot down the investors' argument that the IRS notices of deficiency for 2006 and 2007 were beyond the statute of limitations. It reasoned that the loan guarantees were not a one-and-done transaction in 2001, but continued to be ongoing prohibited transactions through 2006, when the loan was paid off.
The pair also tried to get out of the 20% accuracy-related penalty the tax code imposes for, among other factors, underpayment of federal income tax due to negligence or disregard of the rules. Fleck and Peek claimed they had acted with reasonable cause and in good faith, relying on advice from Blees, the CPA - but the court found Blees was not acting as an independent tax professional but as an "active promoter" of a business strategy. The information the two received from Blees, the court concluded, "was not advice so much as a sales pitch."
Advisors should warn clients that directing their IRA to buy shares of their own company or a newly formed corporation is risky, and a prohibited transaction could disqualify the IRA. In addition, clients need to get an independent review by a tax professional who does not have a conflict of interest.
Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning contributing writer, an IRA distribution expert, professional speaker and author of numerous books on IRAs.
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