The Internal Revenue Code does not describe what a Self Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of IRAs for accumulation of retirement savings and to prohibit those in control of IRAs from taking advantage of the tax benefits for their personal account.
The foundation of the prohibited transaction rules are based on the premise that investments involving IRA and related parties are handled in a way that benefits the retirement account and not the IRA owner. The rules prohibit transactions between the IRA and certain individuals known as “disqualified persons”. The outline for these rules can be found in Internal Revenue Code Section 4975.
ELLIS v. COMM., Cite as 115 AFTR 2d 2015-2072 (787 F.3d 1213), Code Sec(s) 4975; 408; 72; 61; 72; 7491, (CA8), 06/05/2015
The Tax Court held that that Mr. Ellis/general manager of a used car business/LLC, which was held 98% by IRA engaged in prohibited transaction under IRC Section 4975 when he caused the corporation. to pay him compensation. The Court held that Mr. Ellis, as IRA’s fiduciary and beneficial shareholder, engaged in indirect transfer of IRA’s income and assets for his own benefit in violation of IRC Section 4975(c)(1)(D) and indirectly dealt with such income and assets for his own interest or his own account in violation of IRC Section 4975(c)(1)(E).
On May 25, 2005, an attorney for Mr. Ellis formed CST Investments, LLC (CST), to engage in the business of used automobile sales in Harrisonville, Missouri. The operating agreement for CST listed two members: (1) a self-directed IRA belonging to Mr. Ellis, and (2) Richard Brown, an unrelated person who worked full-time for CST. By the end of 2005, the IRA had a fair market value of $321,253, consisting of its membership interest in CST and $1,773 in cash. To compensate him for his services as general manager, CST paid Mr. Ellis a salary of $9,754 in 2005 and $29,263 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 argued that the tax court erred in upholding the Commissioner’s determination that Mr. Ellis engaged in a prohibited transaction by causing CST to pay him wages in 2005. The Court agreed with the Tax Court which held that Mr. Ellis engaged in a prohibited transaction by directing CST to pay him a salary in 2005. The record establishes that Mr. Ellis caused his IRA to invest a substantial majority of its value in CST with the understanding that he would receive compensation for his services as general manager. By directing CST to pay him wages from funds that the company received almost exclusively from his IRA, Mr. Ellis engaged in the indirect transfer of the income and assets of the IRA for his own benefit and indirectly dealt with such income and assets for his own interest or his own account (IRC Section 4975(c)(1)(D) & (E).
What Can We Lean From The Case?
The Ellis case is important for two main reasons. Firstly, it is the first case that directly reinforces the legality of using a newly established LLC to make IRA investments without triggering a IRS prohibited transaction. Secondly, it demonstrates the importance of working with tax professionals who have specific expertise working with the very complex IRS rules concerning using retirement funds to make investments. Accordingly, if Mr. Ellis used a 401(k) plan instead of an IRA to buy C Corporation stock, he could have availed himself of an exception to the prohibited transaction rules under IRC 4975(d)(13) for the purchase of qualifying employer securities, also known as a Rollover Business Start-Up (“ROBS) solution.