Volume 26 Issue 1 --January/February 2014
The Internet is filled with promoters touting the advantages of self-directed IRAs (SD-IRAs) and various schemes by which owners can supposedly do all sorts of “amazing” things with their IRAs. What many IRA owners may not realize when entering into one of these arrangements is that they are entering a veritable minefield of potential tax disasters.
The concept of the SD-IRA is certainly sound. In basic terms it involves investing the IRA in investments that are not offered by most IRA custodians.
Moving beyond the basic idea, however, things can get complex very quickly.
Previously we wrote about UBIT surprises.
A recent Tax Court decision, Ellis v. Commissioner, highlights an even greater risk for SD-IRAs. In that case, an IRA owner (Mr. Ellis) formed two new LLCs and had his IRA buy 98% of the interests in one of the LLCs that was taxed as a corporation. Using the money received from the IRA as capital, the LLC entered into an auto sales business on property leased from a second LLC owned by Ellis and some family members.
To the delight of SD-IRA promoters, the Tax Court ruled that the initial investment in the newly formed entity was not a prohibited transaction. That was the end of the good news for Mr. Ellis.
The court then held that when Mr. Ellis caused the LLC to pay himself less than $10,000 in compensation for managing the business he caused the IRA to commit a prohibited transaction.
That meant that the entire value of the IRA was treated as distributed to Mr. Ellis. In turn, that meant that the Ellises had to recognize the full value of the IRA as taxable income and, to make matters worse, pay the 10% early distribution penalty and a 20% accuracy penalty! The court did not even address all of the IRS’s prohibited transaction claims.
One check can cause the IRA to cease to be tax exempt! One can only imagine that when this tax bill hit, an IRA promoter who may have suggested the arrangement would not pay the additional taxes or the legal costs.
The Ellis case highlights the potential for disaster in many of these highly-touted SD-IRA arrangements. One problem with SD-IRA risks is that the consequences of being wrong can be enormous, financially.
Effectively Ellis started with an IRA of about $322,000. The combined tax of about $136,000 on the additional income, the 10% early withdrawal penalty (about $32,000), and the 20% accuracy penalty (about $27,000) totaled about $195,000, or almost 61% of the initial value of the IRA — not such a good investment after all. And this tally does not include the legal costs of fighting the IRS both through the audit and in court.
Second, the rules relating to prohibited transactions are at best subtle. Even lawyers familiar with the rules can disagree about what precisely they permit or prohibit in various situations. The statutory rules are written very broadly and can apply to a wide range of situations that are not specifically mentioned or suggested by the rules themselves. Official guidance in many situations is lacking, and the existing court decisions often seem to raise more questions than they answer.
Several points are fairly clear. The IRA owner is a “fiduciary” with respect to the IRA and thus a “disqualified person” (DP) under the prohibited transaction rules. This means that most transactions between the IRA and the IRA owner are explicitly prohibited.
Less specific are prohibitions on a transfer or use of plan assets by a DP and on any act by a DP who is a fiduciary where “he deals with the income or assets of a plan in his own interests or for his own account.” These were the provisions Ellis violated. Theoretically, any transaction in which the IRA owner has an “interest” (economic or otherwise) that potentially conflicts with the IRA could trigger a violation.
For example, a transaction between the IRA and a related person who is not a DP (such as the IRA owner’s sibling) could create a violation, even if it was otherwise fair and reasonable so long as the IRA owner has an any sort of “interest” in the transaction. The concept of “interest” here is not precisely defined.
Such rules open a wide range of situations to potential challenge as prohibited transactions. How is an IRA owner to know precisely what is permitted and what is prohibited? Reliance on a plan advisor or custodian, even if available, may be problematic.
Investing an SD-IRA in anything other than purely passive investments in which the IRA owner takes no part in the business or the investment entity puts the owner in a tax minefield, where it can be easy to step on one.
If you have questions about this subject please call the Tax & Business Professionals.
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.