Taxing Lessons From Court Decisions

Decisions — Directly prohibited

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You can’t do that. The Beatles sang the song and the US congress wrote the law: certain transactions are prohibited when you own an individual retirement account. The consequences and penalties for engaging in those transactions can be severe.

For example, what normally happens in the case of a prohibited transaction is that the IRA is terminated as of the first day of the year in which the prohibited transaction occurred. In addition, the IRA owner is deemed to have received a distribution of the fair market value of the assets in the IRA as of the day the IRA is terminated. The deemed distribution is generally included in the IRA owner’s gross income. When the IRA owner is younger than 59-1/2, an additional 10% penalty-tax also applies.

Most of the time.

In T.C. Memo. 2018-49 (Marks), the taxpayer owned a self-directed individual retirement account. In 2005, the account made a $40,000 loan to the taxpayer’s father and received a promissory note in exchange. In 2012, the account made another loan, of $60,000, to one of the taxpayer’s friends and received a promissory note in exchange.

In December 2013, the taxpayer opened a new retirement account and attempted to roll over the assets of the old account. Those assets were the two notes (with a combined face value of $100,000) and $96,508 in cash. The taxpayer did not report the attempted rollover as a taxable distribution on her 2013 federal income tax return.

The IRS said the cash was excludable from income because it was successfully rolled over from one IRA account to another. However, the IRS said the notes were not rolled over and were instead a distribution to the taxpayer that should be included in her income in 2013.

The tax court said both the taxpayer and the IRS were overlooking the fact that the loan to the taxpayer’s father in 2005 was a prohibited transaction. Since one consequence of an IRA engaging in a prohibited transaction is the loss of tax-deferred status for the IRA as of the first day of the taxable year in which the transaction occurs (see internal revenue code section 408(e)(2)(A)), the distributions in this case were no longer made from an IRA.

The court concluded that the taxpayer did not have to include the fair market value of the notes in her income for 2013.

Note that the IRS generally must assess tax within three years after a federal income tax return is filed. The three-year period may be extended to six years when a taxpayer fails to report gross income in excess of 25% of the amount of gross income reported on the return.

In this case, the IRA was disqualified in 2005 and the taxpayer should have reported the deemed distribution in that taxable year (eight years before taxable year 2013, the year at issue in this case).


Do you know what transactions are prohibited in a traditional IRA?

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment, or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment, or tax advice. Always consult your legal, investment, and/or tax advisor regarding your personal situation.


Examples of prohibited transactions with a traditional IRA include

Borrowing money from the IRA.

Selling property to the IRA.

Using the IRA as security for a loan.

Buying property for personal use (present or future) with IRA funds.

Generally, a prohibited transaction in an IRA is any improper use of an IRA account or annuity by the IRA owner, his or her beneficiary, or any disqualified person.

Disqualified persons include the IRA owner’s fiduciary and members of his or her family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).