On March 29, 2016, the United States Tax Court released another case illustrating the hazards associated with investing individual retirement account (“IRA”) assets in “non-traditional” investments. Upon retirement, some retirees consider starting a second career. In these situations, the retiree may be tempted to fund this second career through the purchase of a business with IRA assets. Thiessen v. Commissioner, 146 T.C. No. 7, illustrates the bad tax results that can happen.
James Thiessen studied metal fabrication in high school and worked at a metal fabricating plant upon graduation. He later worked for 30 years for a grocery store chain and participated in his employer’s qualified retirement plan. In 2002, his employer informed him that his job was being relocated from Colorado to Ohio.
Rather than moving to Ohio, Mr. Thiessen decided to retire and he began to search for a new job in metal fabrication (including looking for a metal fabrication business that he and his wife could purchase). In early 2003, Mr. Thiessen found a metal fabrication business that was for sale (“Ancona”).
The Seller’s broker informed the Thiessens that they could use IRA funds to buy the assets of Ancona. Following this advice, the Thiessens rolled their retirement funds into IRAs, caused the IRAs to purchase stock of a newly-formed corporation (“Elsara”) and caused Elsara to purchase the assets of Ancona. In connection with Elsara’s purchase of Ancona’s assets, Elsara entered into a promissory note with Ancona for $200,000 (i.e., Elsara financed $200,000 of the assets being purchased). The promissory note was personally guaranteed by both Mr. and Mrs. Thiessen.
The Tax Return and Examination
On their 2003 joint federal individual income tax return, the Thiessens reported the 2003 transaction (the rollovers to the IRAs, the IRAs’ purchase of the Elsara stock, and Elsara’s purchase of Ancona’s assets) as a tax-free rollover from their retirement plans to their IRAs.
The IRS audited the Thiessens’ 2003 return, and asserted the guarantee of the loan was a “prohibited transaction” (under Section 4975(a) of the Internal Revenue Code of 1986, as amended (the “Code”)) resulting in a “deemed distribution” of all the IRA assets to the Thiessens in 2003 (roughly $340,000). The Thiessens had to pay tax on this “deemed distribution” as income.
Prohibited Transaction Analysis
In its opinion, the Tax Court noted that an IRA ceases to be an IRA if the person for whose benefit the IRA is established (the “IRA owner”) or his or her beneficiary engages in a “prohibited transaction” with respect to the IRA. See Code Section 408(a)(2)(A).
Relevant to the Thiessens, a “prohibited transaction” generally includes “any direct or indirect” lending of money or other extension of credit between a plan and a “disqualified person”. See Code Section 4975(c)(1)(B). A “disqualified person” includes a “fiduciary”. See Code Section 4975(e)(2)(A). The Thiessens’ IRAs were “self-directed” IRAs and the Tax Court concluded the Thiessens were fiduciaries with respect to the IRAs (i.e., they exercised discretionary authority and control over the IRAs’ assets; see Code Section 4975(e)(3)).
In this case, the Tax Court noted where the “disqualified person” is also the IRA owner, the IRA owner is deemed to have received a distribution on the first day of the taxable year in which the “prohibited transaction” occurs in the amount of the fair market value of the IRA’s assets as of that day. Further, if the IRA owner has not attained the age of 59 and 1/2 years on such date, the 10% additional tax on early distributions may apply.
The IRS argued that the Thiessens’ guaranties of the loan were “prohibited transactions” under Code Section 4975(e)(1)(B) because the guaranties were an indirect extension of credit to the Thiessens’ IRAs and the Thiessens’ participation in the “prohibited transaction” resulted in a deemed distribution of the IRAs’ assets to the Thiessens.
The Tax Court agreed with the IRS and held that the loan guaranties resulted in a deemed distribution of the IRAs’ assets to the Thiessens in 2003 (income of approximately $340,000). Further, because the Thiessen’s had not attained age 59 and 1/2 in 2003, the Tax Court determined that the 10% early distribution penalty also applied.
The Thiessen case illustrates the hazards that can arise when IRA assets are not invested in traditional IRA investments (e.g., publicly traded stocks, bonds or mutual funds). Generally, most people would not consider a guaranty of a company’s debt to be the indirect extension of credit to the company’s shareholders. However, a close reading of the applicable tax laws, regulations and cases supports this conclusion.
Further, this analysis is not limited to the initial purchase or acquisition of a business by the IRA. This analysis should also apply to a guaranty made in connection with an IRA owned corporation’s subsequent acquisition of a piece of equipment (e.g., automobile, computer, or copy machine), acquisition of a building for the business, or entering into contracts for services.
In addition, there are a number of other “prohibited transaction” restrictions that have been broadly applied in connection with IRA investments. For example, Code Section 4975(c)(1)(D) provides that the direct or indirect transfer to, or use by or for the benefit of, any disqualified person of the income or assets of a plan is a “prohibited transaction”. The IRS has applied this restriction to assert that an IRA owner’s use of IRA funds to purchase a home intended to be a retirement residence was a “prohibited transaction”. See Gerald M. Harris, T.C. Memo. 1994-22. Thus, IRA owners need to exercise care and consult with competent tax advisors when they consider investing IRA assets in non-traditional IRA investments.