Guaranteeing Loans to a Company Owned by One’s IRA is a Prohibited Transaction
Sec. 408(e) of the Internal Revenue Code states that if an IRA engages in a prohibited transaction, as defined in Sec. 4975, it ceases to be an IRA as of the first day of the year in which the prohibited transaction occurs. The Tax Court held that loans guaranteed by the IRA owners to a corporation owned by their IRAs were an indirect extension of credit to the IRAs, and were thus prohibited transactions.
The result was that the IRAs were disregarded, and the gain on the subsequent sale of the corporation was attributed to the individuals.
Accuracy related penalties were added, just for good measure.
Here’s the story.
Darrell Fleck (Fleck) wanted to buy Abbot Fire and Safety, Inc. (AFS). Lawrence Peek (Peek) approached Fleck about joining him in this venture. They hired Christian Blees, CPA (Blees) to assist them in structuring the deal to purchase the assets of AFS.
Blees came up a strategy known as “IACC”. Under this strategy, Fleck and Peek would establish self-directed IRAs by rolling over other IRA or 401(k) money into these new IRAs. A new corporation was formed, FP Company (FP), and Fleck and Peek’s IRAs each contributed $309,000 and thus each one’s IRA owned 50% of FP.
In 2001, FP acquired most of the assets of AFS for $1,100,000. $200,000 of the purchase price was in the form of a promissory note from FP to the sellers, secured by personal guaranties from Fleck and Peek. As part of Fleck’s and Peek’s personal guaranties, a deed of trust on their personal residences was recorded in favor of the sellers.
In 2003 and 2004, Fleck and Peek converted their IRAs into Roth IRAs.
In 2006, FP was sold. Each Roth IRA received $1,573,721 in 2006, and another $94,471 in 2007.
Upon audit, the IRS determined that the 2001 loan guarantees constituted a prohibited transaction. They therefore deemed the IRA to be non-existent and attributed the gain on the sale to Fleck and Peek personally.
The IRS based their argument on Sec. 4975(c)(1)(B) which prohibits any “direct or indirect * * * lending of money or other extension of credit between a [retirement] plan and a disqualified person”.
Fleck and Peek argued that this section did not apply because the personal guaranties did not involve the IRA; the language in the section specifies “between a plan and a disqualified person”. Here, argued Fleck and Peek, the loan guarantees were between them and FP.
The Tax Court stated that the language of Sec. 4975(c)(1)(B) should be read broadly. The Court stated that if Congress had meant to exclude a transaction such as the one here, taxpayers could get around the “indirect” extension of credit by merely creating a shell subsidiary and making loans through that entity. Clearly, said the Court, this would circumvent the intent of Congress in creating this section. Said the Court, “The language of section 4975(c)(1)(B), when given its obvious and intended meaning, 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.”.
Given these facts, the Tax Court determined that the accounts that held the FP stock at the time of the sale were not IRA accounts, that the accounts ceased to be IRA accounts in 2001, and Fleck and Peek were personally liable for the tax on the capital gains realized in 2006 and 2007 on the sale of FP.
As to the accuracy related penalty, the mere size of the tax deficiency was enough to trigger the penalty, subject to a taxpayer being able to come forward with evidence that they were not negligent.
Here, Peek and Fleck stated that they relied on advice from Blees.
First, the Court said, they could not rely on advice from Blees because Blees was a promoter (he sold the IACC plan), and therefore not a disinterested professional.
In addition, stated the Court, there was no indication the Blees knew that Fleck and Peek were going to personally guarantee FP loans and advised them that the guaranties would not be prohibited transactions. In fact, Blees’ documentation in setting up the IACC specifically stated that Fleck and Peek should make sure that they do not engage in any prohibited transactions, and that engaging in prohibited transactions would have negative tax consequences.
The Court therefore sustained the imposition of the accuracy related penalties.
One needs to look before they leap.
Before taxpayers set up similar type transactions with the understanding that they will not engage in a prohibited transaction including direct or indirect extension of credit, note that there were other issues that the Court did not feel the need to address.
The IRS also claimed that there were prohibited transactions when FP paid wages to Fleck and Peek, and when FP paid rent to entities owned by Mrs. Fleck and Mrs. Peek. The Court basically said that having already destroyed the Fleck and Peek IRAs based upon the loan guaranties, no need to delve into these other issues. So they’re still out there for anyone else who so acts.
Any situation involving an IRA and a corporation, where absent the corporate entity the transactions would be a prohibited one, is a minefield and should be avoided.
