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.
Lawrence F. Peek, et ux., et al. v. Commissioner, 140 TC 216 (5/9/2013)
The Court held that Mr. Peek, his attorney, and business colleague’s personal guaranties of a loan/note from their newly-formed corporation stock of which was owned by taxpayers’ self-directed IRAs, to third party incident to asset purchase transaction was an IRC Section 4975 prohibited transaction. The Court held that the fact that loan guaranties didn’t involve IRAs directly was irrelevant since IRC Section 4975 was broadly worded to include both direct and indirect loans or guaranties to IRAs, by way of entity that IRAs owned.
In 2001, two taxpayers, Mr. Lawrence Peek and Darrel Fleck sought to use self-directed IRAs to acquire a business. The taxpayers established self-directed IRAs using 401(k) rollovers, created a new company (FP Company), and then directed the IRAs to purchase the common stock of FP Company with the cash in the IRAs. FP Company then sought to purchase the business. To consummate the purchase, in addition to the cash and other credit lines, FP Company provided a promissory note to the sellers. This promissory note was backed by the personal guarantee of the taxpayers, and the guarantees were then backed by the deeds to the taxpayers’ homes. In 2003 and 2004, the taxpayers converted their traditional IRAs to Roth IRAs. In 2006 and 2007, the IRAs sold FP Company for a gain. Because a Roth IRA recognized the gain, there would be no tax on the gain from the sale of stock.
The IRS audited the income tax return for both Mr. Peek and Mr. Fleck for the tax years of 206 and 2007. After reviewing the individuals’ tax returns, the IRS adjusted their tax returns to include the capital gains income from the sale of the stock as well as imposed excise tax for excess IRA contributions. Both Mr. Peek and Fleck contested the IRS’s adjustment and filed a petition with the Tax Court.
The IRS argued that Mr. Fleck’s and Mr. Peek’s personal guarantee of a $200,000 promissory note from FP Company to the sellers of the business in 2001 as part of FP Company’s purchase of the business assets were prohibited transactions. Tax Court agreed with the IRS and found that the taxpayers had committed prohibited transactions, that the IRAs had ceased to be IRAs as of the beginning of 2001, and that the capital gain from the sale of FP Company by the IRAs was immediately taxed to the taxpayers. The Tax Court agreed with the IRS and held that since Internal Revenue Code Section 4975 prohibits both “direct and indirect . . . lending of money or extensions of credit” between an IRA and its owner, it did not matter that the loan guarantee by the taxpayers was to FP Company and not the IRAs directly. Internal Revenue Code Section 4975 clears prohibits the lending of money or extension of credit between a retirement plan and a disqualified person.
Mr. Peek and Mr. Fleck argued that the IRS’s notice issued in 2006 and 2007 were too late because the loan was made in 2001. The IRS contended and the Tax Court agreed that since the non-recourse loan was ongoing the prohibited transaction continued and on January 1, 2006 it remained true that both Mr. Peek and Mr. Fleck personally guaranteed the company loan.
The Tax Court held that the Peeks and the Flecks were liable for a 20% accuracy-related penalty because their underpayments of tax were “substantial understatement of income tax” under Internal Revenue Code Section 6662.
While the penalty for an IRC 4975 violation is normally an excise tax, a prohibited transaction between an IRA and its owner results in the tax disqualification of the IRA under IRC Section 408(e)(2), in which case the IRA assets are treated for tax purposes as distributed to the IRA owner.
What Can We Lean From The Case?
The Peek case reinforced the legality that an IRA holder can use retirement funds to invest in a wholly owned entity which is controlled by him or her without triggering the IRA prohibited transaction rules. Peek also adds to the limited guidance on the situations in which “indirect” transactions fall within Internal Revenue Code Section 4975. In addition, the case highlighted the importance of working with independent tax attorneys who can properly advise on a proposed investment. Mr. Peek and Mr. Fleck relied on the advice of Mr. Blees, a CPA, who was also the promoter of the transaction. As a result, Mr. Blees did not warn Mr. Peek and Mr. Fleck about personally guaranteeing the business loan for their IRA investment