Individual retirement accounts typically hold conventional investments such as publicly traded stocks, bonds, mutual funds and certificates of deposit. If you want it to hold something unusual, such as real estate or an interest in a business that isn’t publicly traded, you have to establish a self-directed IRA at a financial institution that will accept these entities. I’m not a fan of the idea, and a recent Tax Court case illustrates one of the dangers.
The case involved two individuals each of whom had his IRA purchase half of a corporation they had formed for $309,000. They acted as the corporation’s only officers and directors, and caused it to purchase a business using the cash from the IRAs together with borrowed money, some of which was secured by personal guaranties of the IRA owners. Subsequently they converted their IRAs to Roth accounts and, a few years later, sold the business that had been acquired in this arrangement at a substantial profit.
The IRS argued that the arrangement involved an indirect extension of credit to the IRAs by their owners, which is a prohibited transaction. The taxpayers argued that there was no extension of credit to the IRAs because they provided guaranties for debt of the corporation rather than debt of the IRAs. The Tax Court sided with the IRS, stressing that the words “directly or indirectly” are intended to have broad scope.
What are the tax consequences? On their original tax returns, the taxpayers reported no gain on their sale of the business because it was held in a Roth IRA at the time of the sale. However, when a prohibited transaction occurs, an IRA is treated as terminated, as of the first day of the first year of the prohibited transaction. The owners of the IRAs are then treated as owners of the assets, so the end result here is that the taxpayers had to pay tax on this gain, and were hit with a negligence penalty in addition.
- Things could have been worse, but there is no mention in the court’s decision of tax relating to the termination of the IRAs. It appears that the year this occurred was outside the statute of limitations. In any event, the taxpayers may have paid a similar amount when they converted the IRAs to Roth accounts.
Reference: Peek v. Commissioner (PDF)