Taxpayer Takes a Hit for Collecting Salary from Business Started with Self-Directed IRA.

(Parker Tax Publishing June 22, 2015)

A taxpayer engaged in a prohibited transaction when he used a self-directed IRA to invest in a used car business and then collected a salary from the business. Ellis v. Comm'r, 2015 PTC 180 (8th Cir. 2015).

Self-directed individual retirement accounts (IRAs) have gained attention lately as a tool that taxpayers can use to invest in new business ventures. Rather than withdraw money from an IRA and pay tax on the withdrawal, as well as the 10 percent penalty tax if the IRA owner is under 59 and 1/2, an individual can direct his or her IRA to make the investment. However, as the taxpayers in Ellis v. Comm'r, 2015 PTC 180 (8th Cir. 2015) discovered, failing to successfully navigate the tax landmines associated with using a self-directed IRA in a business venture can leave a taxpayer far worse off than if he or she had withdrawn the money from the IRA in the first place.

In Ellis, the taxpayer used his IRA to invest in a used car business and the business compensated him for his services in managing the business. The Tax Court held that this was a prohibited transaction. As a result, the IRA lost its tax-favored status and the entire fair market value of the IRA was treated as taxable income. The taxpayer was also hit with a penalty tax of over $32,000, as well as accuracy-related and late-filing penalties. On appeal, the Eighth Circuit upheld the Tax Court's holding. The situation in the instant case is a cautionary tale for anyone who wants to use their IRA to invest in a business. While it can be done, it's important to find a reputable IRA sponsor experienced in dealing with self-directed IRA investments to help negotiate the pitfalls inherent in such investments.

Facts

By 2005, Terry Ellis had accumulated a sizable amount in his 401(k) retirement plan from his many years of service as a pharmaceutical company employee. In 2005, Ellis hired a law firm to advise him on restructuring his investment holdings. The following month, the firm helped Ellis and his wife organize CST, a Missouri limited liability company formed to engage in the business of selling used vehicles. Ellis received distributions from his 401(k) plan and rolled them over into an IRA.

CST's operating agreement listed the original members of CST as Ellis' self-directed IRA, owning 980,000 membership units or 98% in exchange for an initial capital contribution of $319,500, and an unrelated party owning the remaining 20,000 membership units or 2%. Ellis was designated as the general manager for CST and given full authority to act on behalf of the company.

To compensate him for his services as general manager, CST paid Ellis a salary of almost $10,000 in 2005 and approximately $29,000 in 2006. The wages were drawn from CST's corporate checking account and were reported as income on the Ellises' joint tax returns for both years. The Ellises also reported pension distributions of approximately $321,000 on their 2005 tax return but did not report any portion of these distributions as taxable. Nor did they report that Ellis' IRA purchased a total of 980,000 membership units of CST in 2005. The Ellises likewise did not disclose that CST, an entity that had paid compensation to Mr. Ellis in 2005, was owned primarily by his IRA.

In 2011, the IRS sent the Ellises a notice of income tax deficiency, assessing an accuracy-related penalty and a late-filing penalty. The IRS determined that Ellis engaged in prohibited transactions under Code Sec. 4975(c) by (1) directing his IRA to acquire a membership interest in CST with the expectation that the company would hire him, and (2) receiving wages from CST. As a result of these transactions, the IRS said, the IRA lost its status as an IRA and its entire fair market value was treated as taxable income under Code Sec. 408(e)(2). Ellis and his wife disagreed with the assessment and filed suit in Tax Court.

The Tax Court upheld the IRS's assessment and determined that Ellis had formulated a plan in which he would use his retirement savings as startup capital for a used car business and use the business as his primary source of income. Because Ellis could direct his compensation from CST, the Tax Court concluded that he engaged in the transfer of plan income or assets for his own benefit in violation of Code Sec. 4975(c)(1)(D) and dealt with the income or assets of his IRA for his own interest or account in violation of Code Sec. 4975(c)(1)(E). The Ellises appealed to the Eighth Circuit.

Limitations on the Use of Nontaxable IRA Distributions

Code Sec. 4975 limits the allowable transactions for certain retirement plans, including IRAs under Code Sec. 408(a). It does so by imposing an excise tax on a list of prohibited transactions between a plan and a disqualified person. Under Code Sec. 4975(c)(1)(D) and (E), prohibited transactions include (1) any direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; or (2) any act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account. Such transactions are prohibited even if they are made in good faith or are beneficial to the plan.

If a disqualified person engages in a prohibited transaction with an IRA, the plan loses its status as an IRA and, under Code Sec. 408(e)(2), its fair market value as of the first day of the tax year is deemed distributed and included in the disqualified person's gross income.

Taxpayer's Arguments

On appeal to the Eighth Circuit, Ellis relied on a Department of Labor regulation, 29 C.F.R. Sec. 2510.3-101, also known as the Plan Asset Regulation, in arguing that a prohibited transaction did not occur because his salary was drawn from CST's corporate account and not from the income or assets of the IRA.

Ellis also argued that the payment of wages in this circumstance was exempt under Code Sec. 4975(d)(10). That provision excludes from the list of prohibited transactions the 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 the person's duties with the plan.

Eighth Circuit's Analysis

The Eighth Circuit affirmed the Tax Court. In doing so, the Eighth Circuit rejected Ellis' reliance on the Plan Asset Regulation because, the court said, the plain language of Code Sec. 4975(c) prohibits both direct and indirect self-dealing of the income or assets of a plan. The Plan Asset Regulation, the court stated, cannot be read to nullify the general rule against indirect self-dealing. The court also cited a Department of Labor Opinion which explains that certain transactions between a disqualified person and a corporation in which a plan invests are prohibited regardless of whether they meet the Plan Asset Regulation.

With respect to the alternative argument that the wages were exempt under Code Sec. 4975(d)(10), the Eighth Circuit cited Lowen v. Tower Asset Management, Inc. 829 F.2d 1209 (2d Cir. 1987) for the proposition that such exemption applies only to compensation for services rendered in the performance of plan duties. CST compensated Ellis for his services as general manager of the company, the court observed, not for any services related to his IRA. Thus, Code Sec. 4975(d)(10) did not apply in this case.

For a discussion on self-directed IRAs, see Parker Tax ¶134,505. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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