An individual retirement account (IRA) is exempt from tax unless the IRA ceases to be considered an IRA. One way an IRA ceases to be considered an IRA is if its owner engages in a prohibited transaction with respect to the IRA. The direct or indirect extension of credit between a disqualified person and an IRA constitutes a prohibited transaction. For this purpose, a “disqualified person” includes any person who exercises any authority or control over the management or disposition of IRA assets.
In 2001, two taxpayers, Fleck and Peek, established self-directed traditional individual retirement accounts (IRAs) by rolling amounts into those IRAs. Shortly thereafter, Fleck and Peek organized FP Company, Inc. for the purpose of acquiring the assets of Abbott Fire & Safety, Inc. (AFS), a company specializing in fire protection products and government-mandated compliance testing related to fire suppression and safety. Fleck and Peek each caused his traditional IRA to purchase 5,000 shares of the newly issued stock in FP Company for $309,000. FP Company then purchased the assets of AFS. A portion of the purchase price was evidenced by a promissory note from FP Company to AFS, with that promissory note guaranteed by Fleck and Peek (the “guaranty”).
In 2003 and 2004, both Fleck and Peek converted their traditional IRAs to Roth IRAs. The FP Company stock was the sole asset of the traditional IRA in both instances. Fleck and Peek each reported the fair market value of the converted portions of their accounts as taxable income in 2003 and 2004. In 2006, the Fleck and Peek Roth IRAs each sold the shares of FP Company owned by it in an installment sale, under which payments were to be received in 2006 and 2007.
The IRS examined Fleck and Peek’s 2006 and 2007 income tax returns and challenged the guaranty as causing the IRAs (both the traditional and Roth IRAs) to cease to be treated as IRAs. While conceding that a guaranty constitutes an extension of credit and that they constituted disqualified persons, Fleck and Peek countered that the extension of credit (i.e., the guaranty) was not between the IRAs and themselves, but involved FP Company and AFS.
The tax court agreed with the IRS that the prohibited transaction rules would be too easily sidestepped if a disqualified person were able to extend credit to a corporation wholly owned by his own IRA, as opposed to lending the money to the IRA itself. Accordingly, the court held that Congress’s use of the term “indirect” was broad enough to cover the guaranty and, thus, the IRAs ceased to be considered IRAs. The result of the court’s holding was that Fleck and Peek were liable for capital gains tax in 2006 and 2007. The court also sustained the IRS’s imposition of a 20-percent accuracy-related penalty. (Peek v. Commissioner, 140 T.C. No. 12)