Case — Individual Retirement Account Prohibited Transactions

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TL Case Summ

THE QUESTION

Is a taxpayer’s loan guarantee a prohibited transaction that causes an IRA to lose tax-favored status?

THE DISPUTE

Taxpayer Says: The loan guaranties were between themselves and an entity other than the plans. The personal guaranties were not prohibited transactions because they did not involve “the plan”.

Internal Revenue Service Says: The personal guaranties of the promissory note were prohibited transactions.

THE LAW

From Internal Revenue Code Section 408(e)(2)(A)6: IRAs are subject to special rules, including the provision in this section that an account ceases to qualify as an IRA if “the individual for whose benefit any individual retirement account is established * * * engages in any transaction prohibited by section 4975”.

From Internal Revenue Code Section 408(e)(2)(B): Provides: “In any case in which any account ceases to be an individual retirement account by reason of subparagraph (A) as of the first day of any taxable year, paragraph (1) of subsection (d) applies [i.e., “any amount paid or distributed * * * shall be included in gross income by the payee or distributee”] as if there were a distribution on such first day in an amount equal to the fair market value (on such first day) of all assets in the account (on such first day).”

From Internal Revenue Code Section 4975(c)(1): Enumerates categories of prohibited transactions, including “any direct or indirect– * * * (B) lending of money or other extension of credit between a plan and a disqualified person”.

From Internal Revenue Code Section 4975(e)(2)(A): Defines “disqualified person” as a “fiduciary,” which is itself defined in section 4975(e)(3) as “any person who * * * 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.”

From Janpol v. Commissioner, 101 T.C. 518, 527 (1993): A loan guaranty can fall within the prohibition, because, though it is not a direct extension of credit (i.e., a loan), it is an indirect extension of credit.

THE CAUSE OF THE DISPUTE

Using your IRA as security for a loan is one of six “prohibited transactions” listed in the Internal Revenue code. Prohibited transactions cause your IRA to lose tax-favored status, which means your account stops being an IRA as of the first day of the year in which you carry out the transaction. For tax purposes, it’s as if all the assets in your IRA were distributed to you at fair market value, and you will generally have taxable income to the extent that value exceeds your basis.

In this case, the taxpayers established self-directed traditional IRAs in 2001. They funded the IRAs with assets rolled over from existing retirement plans, then created a separate corporation as an investment vehicle. They used the assets in the new IRAs to buy all of the corporate stock, making the IRAs the owners of the investment corporation.

Later in 2001, the investment corporation used the proceeds from the stock sale to purchase the assets of another business. Buying the business required loans, including a promissory note from the investment corporation. The taxpayers personally guaranteed the promissory note.

In 2003 and 2004, the taxpayers rolled the stock of the investment corporation from the traditional IRAs to Roth IRAs, and reported the conversion income on their personal tax returns.

In 2006, the Roth IRAs sold the stock of the investment corporation for a profit.

The IRS says the 2006 sale of the investment corporation stock was a capital gain to the taxpayers, because the initial loan guaranties in 2001 were prohibited transactions–specifically, “any direct or indirect * * * lending of money or other extension of credit between a [retirement] plan and a disqualified person”.

Since the taxpayers each retained all authority and control over the IRAs and each used this discretion to direct their IRAs to invest in the investment company, they were “disqualified person[s]” as to their IRAs for purposes of section 4975(e)(2)(A).

Engaging in the prohibited transaction caused the IRAs to lose tax-favored status in 2001, and subsequent activity was no longer tax-deferred.

The taxpayers argue the loan guaranties are not prohibited transactions, because they were not between disqualified persons and the IRAs. Instead, the guaranties were between disqualified persons (the taxpayers) and an entity other than the plans–i.e., the investment corporation, which was an entity owned by the IRAs. They say the IRAs remained qualified plans, and the profit from the 2006 sale was not taxable.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 94KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

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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Sorry, wrong answer :(
Right answer!
For the IRS. The language of section 4975(c)(1)(B), when given its obvious and intended meaning, prohibited the taxpayers from making loans or loan guaranties either directly to their IRAs or indirectly to their IRAs by way of the entity owned by the IRAs. By its nature, the loan guaranty that each taxpayer made put the taxpayer and the account in an indirect lending relationship that would persist until the loan was paid off. Consequently, under section 408(e)(2)(A), each original account holding the corporate stock ceased to qualify as an IRA in 2001. (Editorial note: The court also assessed a 20% penalty.)
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