IRA as a rollover disallowed by Tax Court and 8th Circuit
June 10, 2015
Many clients have approach me regarding the merits of self-directed IRAs. These accounts allow normal folks to pick and choose the investments of a retirement account. Most commonly, a self-directed IRA will take a position in real estate, like owning an apartment building. Some folks have gone out to invest in new business ventures. Say, you've worked and mustered up $200,000 in your old company's 401(k) plan. You take a package and decide to take the $200,000 and invest in your own business. This is where it gets tricky as Terry Ellis found out.
As indicated below, Mr Ellis took his 401(k) money, rolled into an IRA to acquire a auto dealership. On paying himself wages, $9,754, the IRS deemed this to being a self-dealing transaction and then proceeded to deam the entire $319,000 as a distribution, subject to income tax and penalties.
In short, while there are perfect legal ways to set up your self-directed IRA - tread carefully. Paying himself $9,754 in wages will now cost him over $200,000 in tax, interest and penalties.
You can read more about the decision below.
CA 8: payment of wages to taxpayer by his IRA-owned LLC was prohibited transaction
Ellis, et ux. v. Comm., (CA 6/5/2015) 115 AFTR 2d ¶ 2015-805
The Court of Appeals for the Eighth Circuit, affirming the Tax Court, has concluded that where an individual taxpayer had his IRA own the shares of his business, a limited liability company (LLC), the LLC's payment of compensation to the taxpayer for his services to the LLC was a prohibited transaction resulting in disqualification of the IRA and a deemed distribution of its assets.
Facts. In May, 2005, Terry Ellis organized CST, an LLC. The operating agreement of CST was signed by Mr. Ellis on behalf of the Terry Ellis IRA, an entity that did not yet exist. The agreement listed the original members of CST as the Terry Ellis IRA, owning 980,000 membership units (or 98%) in exchange for an initial capital contribution of $319,000, and a member not a party to the case owning the remaining 20,000 membership units (or 2%).
CST was formed to engage in the business of used car sales. Mr. Ellis was the general manager of CST. In June, 2005, he created the Terry Ellis IRA. Shortly thereafter, he transferred $319,000 from his 401(k) account with a former employer to the IRA and caused CST to issue the IRA the 980,000 units of CST. CST elected to be treated as an association taxable as a corporation.
During tax year 2005, CST paid Mr. Ellis $9,754 as compensation for his role as general manager of CST. CST made these payments through checks issued from its corporate checking account, and not from the custodial account of Mr. Ellis' IRA. CST deducted that amount on its corporation tax return.
On his 2005 return, Mr. Ellis reported the $9,754 as taxable compensation. He also reported pension distributions from the 401(k) but did not report any portion of these distributions as taxable.
On audit, IRS issued Mr. Ellis a notice of deficiency. IRS's determinations in the notice were based on the premise that at one of the following alternative points, Mr. Ellis engaged in a prohibited transaction under Code Sec. 4975 with his IRA: (1) when he caused his IRA to engage in the sale and exchange of membership interests in CST; or (2) when he caused CST, an entity owned by his IRA, to pay him compensation.
Background. Code Sec. 4975 sets out certain prohibited transactions with respect to qualified retirement plans, including IRAs. Code Sec. 4975(c) defines these prohibited transactions and includes as prohibited transactions any direct or indirect: (1) sale or exchange, or leasing, of any property between a plan and a disqualified person (Code Sec. 4975(c)(1)(A)); (2) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan (Code Sec. 4975(c)(1)(D)); or (3) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account. (Code Sec. 4975(c)(1)(E)) Code Sec. 4975(d)(10) excludes from 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 his duties with the plan.”
For Code Sec. 4975 purposes, a plan fiduciary is any person who: (1) exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets; (2) renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so; or (3) has any discretionary authority or discretionary responsibility in the administration of such plan. (Code Sec. 4975(e)(3)) A fiduciary of a qualified retirement plan is also a disqualified person for the purposes of Code Sec. 4975. (Code Sec. 4975(e)(2)(A))
In addition to a fiduciary, a “disqualified person” under Code Sec. 4975(e)(2) includes a corporation or a partnership of which 50% or more of: (a) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation; or (b) the capital interest or profits interest of a partnership, is owned directly or indirectly or held by a fiduciary as described in Code Sec. 4975(e)(2)(A). (Code Sec. 4975(e)(4)) Code Sec. 4975(e)(2)(G) incorporates the constructive ownership rule of Code Sec. 267(c)(1), which provides that stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust will be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries.
If an individual or his beneficiary, during any tax year of an individual for whose benefit any IRA is established, engages in a prohibited transaction under Code Sec. 4975, the account will cease to be an IRA as of the first day of the tax year. (Code Sec. 408(e)(2)(A)) In such a case, the IRA will no longer be exempt from tax under Code Sec. 408(e)(1). Where such an account ceases to be an IRA by reason of Code Sec. 408(e)(2)(A), the account is deemed to have been distributed on the first day of the tax year. (Code Sec. 408(e)(2)(B); Reg. § 1.408-4(d)(1) )
In general, any amount paid or distributed out of an individual retirement plan is included in the gross income of the payee or distributee as provided in Code Sec. 72. (Code Sec. 408(d)(1)) Code Sec. 72(t) imposes a 10% additional tax on early distributions from qualified retirement plans unless the distribution falls within a statutory exemption.
Tax Court decision. The Tax Court concluded that, while the formation of CST didn't involve a prohibited transaction, the compensation that CST paid to Mr. Ellis was a prohibited transaction. Mr. Ellis exercised discretionary authority over his IRA and control over the disposition of its assets. He also exerted control over his IRA in causing it to engage in the purchase of membership units of CST. Accordingly, Mr. Ellis was a fiduciary of his IRA under Code Sec. 4975 and consequently a disqualified person with respect to that plan. Because the payment of compensation was a prohibited transaction, the full amount that he transferred to the IRA from his old 401(k) account was deemed distributed on Jan. 1, 2005, under Code Sec. 408(e)(2)(A). That amount was includible in his gross income for the 2005 tax year under Code Sec. 72(a) and Code Sec. 4975. As there was no exception to the 10% additional tax under Code Sec. 72(t), the Tax Court also found that he was liable for that additional tax. (Ellis, TC Memo 2013-245, see Weekly Alert ¶ 34 11/07/2013)
By paying the compensation, he engaged in the prohibited transactions described in Code Sec. 4975(c)(1)(D) and Code Sec. 4975(c)(1)(E). Mr. Ellis was the sole individual for whose benefit the IRA was established and therefore the beneficial owner of 98% of the outstanding membership interests of CST. (Code Sec. 4975(e)(4), Code Sec. 267(c)(1)) Because Mr. Ellis (a fiduciary of his IRA) was the beneficial shareholder of more than 50% of the outstanding ownership interest in CST, CST met the definition of a disqualified person under Code Sec. 4975(e)(2)(G). As the fiduciary of his IRA and the general manager of CST, Mr. Ellis ultimately had discretionary authority to determine the amount of his compensation.
The Tax Court rejected Mr. Ellis' argument that there was no prohibited transaction because the compensation CST paid him did not consist of plan income or assets of his IRA, but merely the income or assets of a company in which his IRA had invested. CST was funded almost exclusively by the IRA's assets, and the IRA's assets consisted only of its ownership interest in CST. In causing CST to pay him compensation, Mr. Ellis engaged in the transfer of plan income or assets for his own benefit in violation of Code Sec. 4975(c)(1)(D) . Further, in authorizing and effecting this transfer, Mr. Ellis dealt with the income or assets of his IRA for his own interest or for his own account in violation of Code Sec. 4975(c)(1)(E).
The Tax Court also rejected Mr. Ellis' argument that Code Sec. 4975(d)(10) exempted the CST compensation from being classified as a prohibited transaction. The amounts CST paid as compensation to Mr. Ellis were not for services provided in the administration of a qualified retirement plan in managing its investments, but rather for his role as general manager of CST in connection with its used car business. Accordingly, the Court said, Code Sec. 4975(d)(10) did not apply.
Appellate Court decision. The Eighth Circuit concluded that the Tax Court properly found that Mr. Ellis engaged in a prohibited transaction by directing CST to pay him a salary in 2005. The record establishes that he 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 under Code Sec. 4975(c)(1)(D), Code Sec. 4975(c)(1)(E), and Labor Reg. 2509.75-2(c).
The Court noted that it was undisputed that Mr. Ellis was a disqualified person under Code Sec. 4975(e)(2)(A) because he was his IRA's fiduciary under Code Sec. 4975(e)(3), i.e., one who exercises any discretionary authority or discretionary control respecting management of the plan or management or disposition of its assets. The parties also agreed that CST was a disqualified person because Mr. Ellis was a beneficial owner of the IRA's membership in the company under Code Sec. 4975(e)(2)(G)(i) (which includes as a disqualified person a corporation in which 50% or more of the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of the corporation is owned by a fiduciary) and Code Sec. 4975(e)(4) (which states that ownership includes indirect ownership).
The Eighth Circuit rejected Mr. Ellis' reliance on Labor Reg. 2510.3-101 (which (provides that the underlying assets of an operating company in which a plan invests aren't considered plan assets for determining whether a prohibited transaction occurred). Mr. Ellis argued that a prohibited transaction did not occur because Mr. Ellis' salary was drawn from CST's corporate account and not from the IRA's income or assets. The Court determined that the plain language of Code Sec. 4975(c) prohibits both “direct and indirect” self-dealing of the income or assets of a plan, and the Labor reg couldn't be read to nullify this general rule against indirect self-dealing.
The Eighth Circuit also rejected Mr. Ellis' contention that the payment of wages under the circumstances was exempt under Code Sec. 4975(d)(10). The Eighth Circuit, as had the Tax Court, noted that this exemption applies only to compensation for services rendered in the performance of plan duties, and so Code Sec. 4975(d)(10) was inapplicable. CST compensated Mr. Ellis for his services as general manager of the company, not for any services related to his IRA.