Decisions — Gas in the SEP

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In general, amounts distributed from your individual retirement accounts are included in your income, unless an exception applies. But what if you’re acting as a conduit or agent? That is, do you still have a claim of right to the distribution (and therefore must include it in your income) if all you do is arrange the transaction and deliver the check?

In T.C. Memo. 2016-29 (Vandenbosch), the taxpayer, an anesthesiologist, owned a self-directed simplified employee pension (SEP) plan. A brokerage firm acted as custodian for the account, and the taxpayer could direct the firm as to what assets he wanted to buy or trade.

The taxpayer’s friend, a former stockbroker, told the taxpayer about a company that needed capital in order to develop a liquefied natural gas plant in Colombia. The friend told the taxpayer that loans would be repaid quickly because the company expected to receive funding from a large Colombian company.

The taxpayer agreed to lend $125,000 to the company. He and his friend executed a contract that specified the payment terms, interest rate, date of payment, late payment penalty, and place of payment. They agreed the borrower would repay the loan to the taxpayer at his personal residence. Both the taxpayer and his friend signed the note in their personal capacities.

In March 2011, the taxpayer signed a form titled “Retirement Distribution or Internal Transfer.” He requested that the brokerage-custodian distribute $125,000 from his SEP into his account at the brokerage. He did not elect to have federal and state income tax withheld. He checked a box indicating “I am under the age of 59-1/2. (IRS premature distribution TAX APPLIES * * * ).”

The brokerage distributed $125,000 from the taxpayer’s SEP into his brokerage account. The taxpayer wired $125,000 from the brokerage account to his personal account at a bank. Then he wired $125,000 from his bank account to his friend’s account at another bank.

As of the court date, the loan had not been repaid. The taxpayer’s friend asked for and received extensions of the due date on the loan because the company had not yet generated revenue. To date, the taxpayer has not sought repayment. He is confident his friend will repay the loan.

In January 2012, the taxpayer received Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., reporting a gross distribution of $125,000 from his SEP. The form contained a code indicating the withdrawal was an early distribution and that the entire $125,000 was taxable.

The taxpayer reported the $125,000 on his tax return as a nontaxable rollover. He believed he did not receive a taxable distribution from his SEP because the various transactions beginning with the note and ending with the funds being transferred to his friend should be viewed as a whole, collapsed, and treated as an investment by the SEP in the Columbian company.

The IRS says the distribution was taxable because it was used to finance a loan to the taxpayer’s friend. The IRS argues that the promissory note was not a bona fide investment because the taxpayer and his friend signed in their personal capacities and because the loan was never repaid.

The taxpayer says the transactions should be treated as if the SEP distributed the funds directly to the taxpayer’s friend for the Columbian company and then the SEP held the note as an asset. He argues the withdrawal was not a distribution because he did not have a claim of right to the withdrawn funds.

Alternatively, he argues the withdrawal was a nontaxable rollover. He says if this is a distribution, it was reinvested in the SEP within the prescribed 60-day period based on the substance of the transaction instead of the form. He distributed $125,000 out of his SEP, immediately placed the funds back into the SEP, and then distributed them to his friend. Because the SEP was funding its obligation under the note, the distribution should be considered paid directly to his friend.

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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.

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Right answer!

For the IRS.

A taxpayer has a claim of right to income if the taxpayer: (1) receives the income; (2) controls the use and disposition of the income; and (3) asserts either a “claim of right” or entitlement to that income.

The record before us demonstrates the taxpayer had a claim of right with respect to the $125,000 withdrawn from his SEP. At all times, he had unfettered control over the funds. He had access to the funds. He directed his SEP to distribute the funds into his account. Afterward, he transferred the funds between his accounts and eventually to his friend. These actions show he had unfettered control over the funds. Accordingly, he was not acting as a mere conduit or an agent when the funds were distributed to him.

Moreover, at no time has the note been held by the taxpayer’s SEP, and at all times the note has been payable to the taxpayer. He could receive a distribution regardless of whether he intended to make a loan to his friend. In the end, the taxpayer is entitled to the funds. He had control over the funds upon receipt and is entitled to control those funds upon repayment, as well.

Alternatively, the taxpayer argues that if this is a distribution, it was reinvested in the SEP within the prescribed 60-day period if we look at the substance of the transaction instead of the form. However, the substance of what occurred is entirely consistent with the form. The taxpayer received a distribution, exercised control over the funds, eventually lent funds to the Columbian company, and personally has a right to repayment on the note.

We will not disregard the various agreements. We hold that the taxpayer received a taxable distribution because he had a claim of right to the withdrawal and the distribution was not a nontaxable rollover.

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