A taxpayer who has a self-directed IRA and who guarantees a loan entered into by a company the shares of which are owned by the IRA runs afoul of the tax Code’s prohibited transaction rules, causing the account to fail to qualify as an IRA, according to the Tax Court in Peek v. Comr., 140 T.C. No. 12 (2013).

In Peek, two unrelated taxpayers identified an investment opportunity in a fire safety business. The broker handling the sale of the business put them in touch with a CPA who sold them a strategy that called for an individual to establish a self-directed IRA, transfer funds into that IRA from an existing IRA or 401(k) plan account, set up a corporation, sell shares in the corporation to the self-directed IRA, and use the funds from the sale of shares to purchase a business interest. Documentation for the strategy cautioned that prohibited transactions under Code §4975 would be detrimental to the strategy’s tax objectives, and an opinion letter from their accountant discussed the prohibited transaction rule. The documents did not address personal guaranties.

The taxpayers implemented the plan, and the company they formed used the funds from the sale of its shares to the IRAs to buy the assets of the fire safety business. As part of the asset purchase transaction, the taxpayers personally guaranteed a promissory note from the company to the sellers for a fifth of the sales price. Two years later, they rolled over amounts from their IRAs to Roth IRAs. A few years later, they sold the company and the payments went to the Roth IRAs.

The IRS adjusted the taxpayers’ income to include capital gain from the sale of company stock, reasoning that the personal guaranties were prohibited transactions and the IRAs’ assets were deemed to have been distributed to them. The Tax Court held that IRC §4975(c)(1)(B) prohibits taxpayers from making loans or loan guaranties indirectly to their IRAs through an entity owned by the IRAs; thus, the IRAs ceased to exist in the year the guaranties were made. The Roth IRAs ceased to be Roth IRAs when the accounts were funded with company stock, because the prohibited transactions continued as to those accounts.

In addition, the taxpayers had to pay a 20% understatement penalty for failing to report the income realized from the sale of the company. They could not show reasonable reliance on their advisor because the CPA was a promoter of the strategy they used and there was no indication that they informed him of their intention to personally guarantee the loans.

The case illustrates the importance of knowing what constitutes a prohibited transaction and when to walk away from an investment opportunity that involves retirement funds.

--Nadia Masri
Editor (Compensation Planning)