I blogged in the past (here and here) about decisions in which taxpayers have used assets in their IRA to finance a new business. This structure is sometimes known as a ROBS or rollover for business startups. In 2013, the tax court held that an IRA engaged in a prohibited transaction, thereby subjecting the value of the IRA to immediate taxation, where a taxpayer rolled assets from a 401(k) plan to an IRA and then used the IRA proceeds as the startup capital for a business that then hired the taxpayer as its general manager. The taxpayer appealed the tax court’s decision to the Eighth Circuit Court of Appeals which in early June upheld the tax court’s decision.

The Eighth Circuit concluded that a prohibited transaction occurred because the payment of compensation to the individual was essentially an indirect payment by the IRA to the individual. The taxpayer directed the IRA to invest most of its assets in the company with the understanding that he would be hired as general manager. He then directed the business to pay him a salary. This was an indirect transfer of the income and assets of the IRA for the benefit of the individual outside the investment return that the individual was otherwise entitled to receive through the IRA. The court said that the wages could not be justified as reasonable compensation, which is an exception to the prohibited transaction rules, because the reasonable compensation exception is available only for services performed for the IRA or qualified plan. In this case, the services were performed for the business, not for the IRA itself, so the exception did not apply. Note that the salary amounts were modest ($9,754 in 2005 and $29,263 in 2006); it was the act of directing the salary payments, not the amount of those payments, that was the prohibited transaction.

When an IRA engages in a prohibited transaction, the entire value of the IRA becomes taxable to the IRA owner. If the owner is not yet age 59½, then the owner must also pay the premature distribution tax of 10%. These taxes and penalties, as well as an understatement penalty of 20% were imposed on this taxpayer and now affirmed by the court of appeals.

Individuals contemplating using this strategy to finance a business may wish to think twice before doing so and will want to work with competent counsel before deciding to use their IRA to finance their new business.