In our July 2013 newsletter, we discussed the consequences of an individual retirement account (IRA) engaging in a prohibited transaction, with the end result being the account ceases to be treated as an IRA on the first day of the taxable year in which the prohibited transaction occurs and the IRA’s assets are considered to be distributed to the IRA owner on that date. The prohibited transaction discussed in our July 2013 newsletter involved an indirect extension of credit by two IRA owners to their IRAs through the IRA owners’ guaranty of a promissory note from a corporation wholly owned by the IRAs. Two additional variations of a prohibited transaction involve (i) the direct or indirect transfer to an IRA owner of the income or assets of an IRA, and (ii) an act by an IRA owner whereby he directly or indirectly deals with the income or assets of the IRA in his own interest or for his own account.
In 2005, Terry Ellis formed CST, a Missouri limited liability company that elected to be taxed as a corporation. CST’s operating agreement listed a not-yet formed IRA owned by Ellis as owning 98 percent of the membership units in CST; the remaining 2 percent was owned by a person not involved in the case. Ellis subsequently established the IRA and rolled over $321,345.25 from his former employer’s 401(k) plan to the IRA, of which $319,500 was then contributed to CST in exchange for the IRA’s 98 percent membership interest. During 2005, Ellis served as manager for CST and received compensation of $9,754 from CST.
The IRS issued a notice of deficiency for Terry and Sheila Ellis’ 2005 income tax return (they filed a joint income tax return for 2005), raising alternative theories as to why a prohibited transaction had occurred with respect to the IRA, including that a prohibited transaction occurred when Mr. Ellis caused CST to pay him compensation. The tax court sided with the IRS. The tax court agreed that, by causing CST to pay him $9,754 in compensation, Mr. Ellis had (i) engaged in a transfer of the IRA’s income or assets to himself, and (ii) dealt with the IRA’s income or assets for his own interest. As a result, the account ceased to be treated as an IRA, and its assets were deemed to be distributed.
The Ellis case is only the most recent example of courts’ willingness to construe the term “indirect” broadly under the prohibited transaction rules. Under this view, any transactions between a company that is substantially owned by an IRA and the IRA owner are likely to be closely scrutinized. Those capitalizing a new business by utilizing IRA funds as part of a so-called rollover business start-up (or ROBS) do so at their own peril. Ellis v. Commissioner, TC Memo 2013-245