One of the more common questions asked about using a self-directed IRA to make investments is what type of services can the IRA holder make, as a disqualified person, without triggering the IRS prohibited transaction rules. Well – finally – we have an answer.
IN RE: CHERWENKA, Cite as 113 AFTR 2d 2014-2333 (508 B.R. 228), Code Sec(s) 408; 4975, (Bktcy Ct GA), 03/06/2014
The Cherwenka cases involved a Georgia statutory bankruptcy estate exemption for individual retirement account within meaning of IRC Section 408, which covered self-directed IRAs held by Michael Cherwenka who was in business of “flipping houses. Contrary to creditor claim that IRA lost it IRC Section 408 qualification when taxpayer engaged in prohibited transactions under IRC Section 4975 , by co-owning property with IRA, the Court held there was no evidence of any such prohibited ownership structure for stated property or that taxpayer impermissibly benefitted from apportioned purchase and resale of same.
Michael Cherwenka established a self-directed IRA with Pensco to buy real estate. After a property is purchased, the property is resold. Any and all profits from the sale of any Pensco IRA asset are realized exclusively by the Pensco IRA. Sometimes the properties would be renovated or improved before sale. Sometimes the properties would simply be held and sold at a later date, hopefully capitalizing on advantageous market conditions or market swings. It is unclear whether the decision to improve a property and to what extent the properties were improved was made by Cherwenka or a contractor he regularly engaged. Cherwenka was not compensated for any real property research he performed, nor was he compensated for any recommendations, management or consulting services he provided relating to how the Pensco IRA properties were improved before resale. Cherwenka explained his role in buying and selling of these properties as being limited to identifying the asset for purchase and later selling the asset. Cherwenka then engages his contractors to decide or oversee the scope of work with improved properties. Cherwenka testified that he “read and approved” the expense forms prior to Pensco paying funds to reimburse the submitted expenses. Contractors were paid by the job, which accounted for labor costs, but no management fee or additional cost was included in the expenses submitted to Pensco. Cherwenka stated he would inspect or confirm that work was completed through site visits or communication with his “team” before he would approve expenses to be paid by Pensco.
Of interest, Cherwenka stated that he has never jointly owned a property with Pensco. Yet, he also testified that the property was owned in part by Pensco and in part by him personally. Debtor recollected that he owned 55% of the property with the remaining 45% owned by the Pensco IRA.
In Cherwenka, the court considered whether a debtor could exempt a self-directed IRA utilized to invest in distressed real properties and have the IRA realize profit from the later sale of these properties. The court agreed that the debtor was a disqualified person under IRC Section 4975. It was argued that Cherwenka performed work on the properties by researching and identifying the subject properties, appointing and approving work on the properties, and overseeing payment from Pensco for such work and those acts constitute prohibited transactions under IRC Section 4975(c)(1)(C) as direct and indirect services by the IRA holder, a disqualified person. The court disagreed and held that the State’s position requires the Court to read out of the statute the word “transaction.” There is no evidence that Cherwekna engaged in any transaction. A transaction includes an exchange of goods or services and the evidentiary record does not include that Cherwenka received anything in exchange for his alleged services. In fact, Cherwenka testimony included that he received no money, discount, or other benefit for the identified activities he undertook with the Pensco IRA.
Although Cherwenka was a disqualified person based on his ownership of the IRA, the court found that the debtor’s involvement in selecting property and participating in other actions taken by the IRA did not constitute a prohibited transaction because the evidence failed to demonstrate that the IRA-owned properties resulted in any benefit to Cherwenka outside of the plan.
The court stated the following:
Self-directed IRAs are authorized by federal law and are held by a trustee or custodian that permits investment in a broader set of assets than is permitted by traditional IRA custodians.” Levine v. Entrust Grp., Inc. , 2012 WL 6087399 (N.D. Cal. Dec. 6, 2012). By its very nature, Debtor, as IRA owner, is required to make decisions regarding the Pensco IRA’s assets and investments. Essentially, Debtor’s decision-making regarding asset acquisition and sale is characterized by RESGA as a prohibited transaction under IRC 4975(c)(1)(C)—as a service between a plan (Pensco IRA) and a disqualified person (Cherwenka). However, the recognition of self-directed IRAs as qualified IRAs, necessarily implies that a disqualified person (the owner as fiduciary) will make investment decisions regarding the plan. RES-GA has failed to establish sufficient evidence that Debtor received any personal benefit besides asset appreciation of those properties held by the Pensco IRA. There is no evidence to support a determination that Debtor’s selection of real estate and any other decisions or recommendations regarding the IRA-owned properties resulted in any benefit to Debtor outside of the plan. There is no basis to hold that Debtor’s actions constituted a prohibited transaction, so there is no basis to disqualify the Pensco IRA.
The State’s next main argument was that the Pensco IRA is disqualified and not eligible for exemption because of a purported co-ownership of a prepetition property by Cherwenka (or a wholly-owned LLC) and the Pensco IRA. The State claims this co-ownership is also a prohibited transaction under IRC section 4975(c)(1)(D) and (E) because Cherwenka allegedly used IRA assets for his personal interest or benefit. The only evidence presented at the hearing regarding this alleged prohibited transaction is Cherwenka’s testimony that he held a 55% interest in the respective property and the IRA held the remaining 45%. No documentary evidence of the transaction or ownership structure was presented. The State asserted that this arrangement is a prohibited transaction because Cherwenka personally used or benefitted from the plan’s interest in property. The Cout felt that this position was unsupportive by the evidence, and the State failed to meet its evidentiary burden of establishing that Cherwenka was not entitled to exempt the Pensco IRA under Georgia Code section 44-13-100(a)(2.1)(D).
What Can We Lean From The Case?
The Cherwenka case is an important case in the self-directed IRA real estate context because it appears to hold that engaging in passive activities related to the purchase and sale of real estate assets would not rise to the level of a transaction involving goods and services pursuant to IRC 4975 and, thus, trigger the prohibited transaction rules. In this case, Cherwenka would locate the real estate to serve as the investment for the self-directed Pensco IRA. A real estate agent would then work with him to submit a proposed offer to Pensco. Cherwenka would then review the closing statements and communicates with Pensco in instances where there are discrepancies in fees or other figures on the HUD-1 or related documents. Cherwekna was not compensated for any real property research he performed, nor was he compensated for any recommendations, management or consulting services he provided relating to how the Pensco IRA properties were improved before resale. Cherwekna explained his role in buying and selling of these properties as being limited to identifying the asset for purchase and later selling the asset. Cherwenka engaged contractors to decide or oversee the scope of work with improved properties. Cherwenka testified that he “read and approved” the expense forms prior to Pensco paying funds to reimburse the submitted expenses. Contractors were paid by the job, which accounted for labor costs, but no management fee or additional cost was included in the expenses submitted to Pensco. Cherwenka stated he would inspect or confirm that work was completed through site visits or communication with his “team” before he would approve expenses to be paid by Pensco. In essence, the case gives real estate investors a good road map or guide as to the type of activities that would likely not be considered transactions or services under the prohibited transaction rules pursuant to IRC Section 4975. Because most real estate investors tend to perform the same sort of tasks that Cherwenka performed, the case offers a legal foundation for the position that passive real estate activities performed by the IRA holder in context of a self-directed IRA real estate transaction, would not be considered a prohibited transaction. Moreover, the fact that Cherwenka used his IRA and personal funds in the same transaction could have changed the Court’s ruling in the case that Cherwenka engaged in a prohibited transaction, however, the State, for some reason, was not able to prove the co-ownership. Like the Kellerman case showed ( KELLERMAN, Cite as 115 AFTR 2d 2015-1944 (531 B.R. 219), Code Sec(s) 408; 4975, (Bktcy Ct AR), 05/26/2015), using retirement and personal funds in the same transaction is not advisable and could trigger a prohibited transaction under IRC 4975.