Loan Guarantees to IRA-Owned Businesses Results in Loss of IRA Status
(Parker's Federal Tax Bulletin: May 23, 2013)

A Tax Court decision earlier this month serves as a cautionary tale on how using a self-directed IRA to invest in a business can backfire when the owner fails to fully account for the breadth of the prohibited transaction rules. In Peek v. Comm'r, 140 T.C. No. 12 (5/9/13), the Tax Court held that loan guarantees made by two taxpayers were prohibited transactions which caused their self-directed IRAs to lose their status as IRAs, resulting in immediate taxation.

Facts

In 2001, Darrell Fleck identified Abbott Fire & Safety, Inc. (AFS), as an attractive business opportunity. Darrell contacted A.J. Hoyal & Co., the brokerage firm through which AFS was offered for sale. Lawrence Peek, an attorney who had provided legal services to Darrell in the past, approached Darrell about joining the venture. A.J. Hoyal introduced Darrell to Christian Blees, a CPA, and Darrell later introduced Christian to Lawrence. Neither Darrell nor Lawrence knew Christian previously. Darrell and Lawrence engaged Christian and his firm to assist in structuring the purchase of AFS's assets and to perform due diligence on the transaction.

Christian presented to Darrell and Lawrence information on a strategy he identified as the IACC. This strategy called for the participant to establish a self-directed individual retirement account (IRA), transfer funds into that IRA from an existing IRA or 401(k) plan account, set up a new corporation, sell shares in the new corporation to the self-directed IRA, and use the funds from the sale of shares to buy a business interest. The IACC documents included an extensive discussion and an opinion letter from Christian about prohibited transactions, which stated that such transactions would be detrimental to the IACC plan's tax objectives. The documents warned that the taxpayer could not engage in transactions with the IRA that the IRS would determine to be prohibited transactions. Lawrence completed and submitted an IACC Application and, in response, received the IACC Plan for FP Company, a document that outlined a plan for the purchase of AFS's assets. Darrell and Lawrence subsequently implemented this plan and compensated Christian and his firm for structuring the purchase and performing due diligence. Both Darrell and Lawrence were aware of the compensation.

Darrell and Lawrence each established accounts intended to be self-directed IRAs, over which they each retained all discretionary authority and control concerning investments. Darrell rolled over funds on August 17, 2001, into his IRA, from an existing 401(k) account maintained for his benefit. Lawrence rolled over funds on August 30, 2001, into his IRA from an existing account maintained for his benefit at Charles Schwab. Neither Darrell nor Lawrence contributed to the other's IRA. On August 27, 2001, the articles of incorporation for FP Company, Inc. were filed. At formation, Darrell and Lawrence intended that FP Company would purchase the assets of AFS and engage in the retail sale of AFS's products.

On September 11, 2001, at its owner's direction, each IRA purchased 5,000 shares of newly issued stock in FP Company for $309,000 and thereby acquired a 50 percent interest in FP Company. In so doing, Lawrence and Darrell both intended that FP Company would purchase the assets of AFS. At the time of purchase, both Lawrence and Darrell also intended to serve as corporate officers and directors of FP Company.

In a transaction closed in mid-September 2001 (but with an agreed effective date of August 28, 2001), FP Company acquired most of AFS's assets for a price of $1,100,000, consisting of: (1) $850,000 in cash (derived from a $450,000 bank loan to FP Company from a credit union and $400,000 of the proceeds of the sale of FP Company's stock to the IRAs); (2) a $50,000 promissory note from FP Company to A.J. Hoyal (the broker); and (3) a $200,000 promissory note from FP Company to the sellers, secured by personal guaranties from Darrell and Lawrence. As part of Darrell's and Lawrence's personal guaranties, a deed of trust on their personal residences was recorded in El Paso County, Colorado, on September 17, 2001. Darrell and Lawrence were grantors, and Leslie and Carol Heinrich, the shareholders of the corporation selling AFS's assets, were the grantees of the deed of trust. The guaranties remained in effect until the sale and merger of FP Company in 2006.

On September 25, 2001, FP Company filed a statement that named Lawrence as the new registered agent of FP Company. Also on September 25, FP Company filed two certificates indicating that it would do business as Abbott Fire & Safety, Inc. and Abbott Fire Extinguisher Company, Inc. From 2001 until the 2006 sale, Darrell and Lawrence were the only corporate officers and directors of FP Company.

In 2003, Darrell and Lawrence converted half of their respective IRAs to Roth IRAs. In 2004 they transferred the remaining half of their respective IRAs into their Roth IRAs, so that thereafter each Roth IRA owned 50 percent of the stock of FP Company. Darrell and Lawrence each reported the fair market values of the converted portions of their accounts as taxable income for 2003 and 2004. In 2006 the Roth IRAs sold FP Company to Xpect First Aid Co. Following the sale, neither Roth IRA owned any interest in FP Company, and neither Darrell nor Lawrence had any involvement with FP Company or Xpect First Aid Co.

Both the Flecks and Peeks timely filed federal income tax returns for 2006 and 2007. The IRS audited those returns, adjusted the Flecks' and the Peeks' income to include capital gain from the sale of FP Company stock. The IRS issued deficiency notices and the Flecks and Peeks timely filed Tax Court petitions.

Self-Directed IRAs and Prohibited Transactions

A self-directed IRA is an individual retirement account under which will be held in the IRA. Thus, the owner of a self-directed IRA may choose from the complete range of investments permitted for IRAs including real estate, limited partnerships, mortgages, notes, franchise businesses, etc. rather than being limited to the typical investments offered by IRA custodians and trustees (e.g., stocks, bonds, mutual funds, etc.). This higher degree of flexibility in choosing IRA investments allows for the IRA owner to invest in assets with greater wealth-building potential.

OBSERVATION: Along with the additional flexibility associated with self-directed IRAs comes the increased potential for mistakes. For example, taxpayers with self-directed IRAs run a greater risk of running afoul of the prohibited transaction rules. These rules impose an excise tax on certain transactions between a plan and a disqualified person. Further, certain prohibited transactions can cause an IRA to lose its status as an IRA, resulting in immediate taxation. One such rule, found in Code Sec. 4975(c)(1)(B), prohibits any direct or indirect lending of money or other extension of credit between a retirement plan and a disqualified person.

The prohibited transaction rules define the term "plan" to include an IRA and those rules define the term "fiduciary" to include any person who exercises any discretionary authority or discretionary control respecting management of the plan or exercises any authority or control respecting management or disposition of its assets. Because the IRA owner retains investment discretion over the IRA, the IRA owner is a fiduciary - and the prohibited transaction rules define a "disqualified person" to include a fiduciary and certain members of the family of a fiduciary.

IRS's Argument

The IRS argued that Darrell's and Lawrence's IRAs ceased to qualify as IRAs as of the first day of 2001 through 2006 because Darrell's and Lawrence's personal guaranties of the $200,000 promissory note from FP Company to the sellers of AFS in 2001 as part of FP Company's purchase of AFS's assets were prohibited transactions under Code Sec. 4975(c)(1)(B). The IRS therefore concluded that the IRAs' assets were, under Code Sec. 408(e)(2)(B), deemed to have been distributed to Darrell and Lawrence, who both therefore owed income tax on the gain on sale in 2006 and 2007.

Taxpayers' Argument

Darrell and Lawrence disputed the IRS's contention that any prohibited transactions occurred, and instead claimed that the IRAs remained qualified as such and therefore remained exempt from tax under Code Sec. 408(e)(1). Darrell and Lawrence argued that their personal guaranties were not prohibited transactions because the extension of credit that is prohibited under Code Sec. 4975(c)(1)(B) is between a plan and a disqualified person, and the personal guaranties made by Darrell and Lawrence did not involve the plan (i.e., the IRAs). Rather, the loan guaranties at issue were between disqualified persons (Darrell and Lawrence) and an entity other than the plans--i.e., FP Company, an entity owned by the IRAs, rather than the IRAs themselves.

Loan Guaranties Were Prohibited Transactions

The Tax Court held that the loan guarantees made by Darrell and Lawrence were prohibited transactions. According to the court, Darrell's and Lawrence's reading of the statute would rob it of its intended breadth. Code Sec. 4975(c)(1)(B) prohibits any direct or indirect * * * extension of credit between a plan and a disqualified person. The court cited Comm'r v. Keystone Consol. Indus., Inc., 508 U.S. 152 (1993), in which the Supreme Court observed that when Congress used the phrase any direct or indirect in Code Sec. 4975(c)(1), it thereby employed broad language and showed an obvious intention to prohibit something more than would be reached without it. 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. That, however, is an obvious evasion that Congress intended to prevent by using the word indirect. The Tax Court concluded that the language of Code Sec. 4975(c)(1)(B), when given its obvious and intended meaning, prohibited Darrell and Lawrence 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.

Tax Consequences of the Guaranties on the Sale of Stock

The IRS's deficiency notices asserted that the prohibited transaction triggered a liquidation of the IRAs in 2001. The Tax Court held that, following that liquidation, the stock of FP Company Inc. was treated as owned by Darrell and Lawrence personally. Consequently, Darrell and Lawrence were taxed personally on any gain on the sale of such stock.

The Tax Court noted that Darrell and Lawrence seemed to be arguing that (1) the deficiency notices issued for 2006 and 2007 were too late (because the loan guaranties were made in 2001), and that, in the absence of an earlier notice of deficiency, the IRAs remained exempt; (2) if the IRAs did not lose their exemption until 2006, then Darrell and Lawrence would have realized ordinary income in that year, rather than the capital gain determined in the notices; and (3) since the notices did not make that particular adjustment, the notices were inadequate to support an assessment of tax based on capital gains. The Tax Court found that this argument either misconstrued the tax consequences to an individual who engages in prohibited transactions with respect to an IRA or exaggerated the importance of the wording of the notices.

According to the court, the notices determined deficiencies for 2006 and 2007 on the basis of a prohibited transaction that took place in 2001. The Tax Court was now redetermining those 2006 and 2007 deficiencies and deciding (1) whether the accounts that held the FP Company stock were IRAs in 2006 when the stock was sold (the court held they were not); (2) when they ceased to be IRAs and therefore exempt from income tax (the court held that occurred in 2001), and (3) the tax consequences of their non-exemption (the court held that Darrell and Lawrence were liable for tax on the capital gains realized in 2006 and 2007 from the sale of the FP Company stock). The loan guaranties were not a once-and-done transaction with effects only in 2001 but instead remained in place and constituted a continuing prohibited transaction, thus preventing Darrell's and Lawrence's accounts that held the FP Company stock from being IRAs in subsequent years. On January 1, 2006, it remained true that Darrell and Lawrence guaranteed the loan to FP Company, so that if FP Company defaulted, they would pay. By its nature, the loan guaranty that each man made put him and his account in an indirect lending relationship that would persist until the loan was paid off.

Consequently, the Tax Court held that, under Code Sec. 408(e)(2)(A), each original account holding the FP Company stock ceased to qualify as an IRA in 2001. In 2003 and 2004 when Darrell and Lawrence established Roth IRAs, those accounts ceased to be Roth IRAs when they funded the accounts with FP Company stock, because the prohibited transactions continued as to those accounts. For the same reasons, the accounts holding the FP Company stock when the stock was sold in 2006 were not Roth IRAs, and the gains from the sale realized in 2006 and 2007 were not exempt from tax. The tax liability from the gain was properly attributable to Darrell and Lawrence as the creators and beneficiaries of the accounts that sold the FP Company stock. Darrell and Lawrence were therefore liable for tax on the gains realized in the sale transaction as determined in the notices of deficiency.

Accuracy-Related Penalties

The Tax Court also upheld accuracy-related penalties imposed by the IRS. The court concluded that, given that Darrell and Lawrence were made aware of the hazards of prohibited transactions and their personal involvement with the FP Company transactions (in particular, their personal guaranties), they were negligent when they failed to report income from the sales of FP Company stock after they had engaged in a prohibited transaction. Further, the court rejected Darrell and Lawrence's claim that they had acted with reasonable cause and in good faith when they failed to report the capital gains at issue because they relied on advice provided by Christian, the CPA.

According to the Tax Court, because of Christian's role as promoter, Darrell and Lawrence could not reasonably and in good faith rely on that advice. Moreover, there was no indication that Darrell and Lawrence informed their accountant of their intention to personally guarantee FP Company loans, or that Christian gave them any advice that their personal guaranties would not be a prohibited transaction. Rather, they were warned not to engage in any transactions that the IRS would determine to be a prohibited transaction. Since Christian's advice did not address the issue of personal guaranties, the Tax Court concluded that Darrell and Lawrence did not rely on their accountant's advice with regard to the prohibited transactions in these cases, and did not have reasonable cause or act in good faith in failing to report the capital gains in these cases.

Staff Editor Parker Tax Publishing

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