Where an individual taxpayer had his IRA own the shares of his business, a limited liability company (LLC), the LLC’s payment of compensation to the taxpayer for his services to the LLC was a prohibited transaction resulting in disqualification of the IRA and a deemed distribution of its assets.
Facts. In May, 2005, Terry Ellis, organized CST, an LLC. The operating agreement of CST was signed by Ellis on behalf of the Terry Ellis IRA, an entity that did not yet exist. The agreement listed the original members of CST as the Terry Ellis IRA, owning 980,000 membership units or 98% in exchange for an initial capital contribution of $319,000, and a member not a party to the case owning the remaining 20,000 membership units or 2%.
CST was formed to engage in the business of used car sales. Ellis was the general manager of CST. In June, 2005, Ellis created the Terry Ellis IRA. Shortly thereafter, he transferred $319,000 from his 401(k) account with a former employer to the IRA and caused CST to issue the IRA the 980,000 units of CST.
CST elected to be treated as an association taxable as a corporation.
During tax year 2005, CST paid Ellis $9,754 as compensation for his role as general manager of CST. CST made these payments through checks issued from its corporate checking account, and not from the custodial account of Ellis’ IRA. CST deducted that amount on its corporation tax return.
Mr. and Mrs. Ellis’ 2005 return reported the $9,754 as taxable compensation. They also reported pension distributions from the 401(k) but did not report any portion of these distributions as taxable.
IRS issued Mr. and Mrs. Ellis a notice of deficiency. IRS’s determinations in the notice were based on the premise that at one of the following alternative points, Ellis engaged in a prohibited transaction under Code Sec. 4975 with his IRA: (1) when Ellis caused his IRA to engage in the sale and exchange of membership interests in CST; or (2) when Ellis caused CST, an entity owned by his IRA, to pay him compensation.
Background on whether there is a prohibited transaction. Code Sec. 4975 sets forth certain prohibited transactions with respect to qualified retirement plans, including IRAs. Code Sec. 4975(c) defines these prohibited transactions and includes as prohibited transactions any direct or indirect: (1) sale or exchange, or leasing, of any property between a plan and a disqualified person (Code Sec. 4975(c)(1)(A)); (2) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan (Code Sec. 4975(c)(1)(D)); and (3) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account.
The purpose of Code Sec. 4975, in part, is to prevent taxpayers involved in a qualified retirement plan from using the plan to engage in transactions for their own account that could place plan assets and income at risk of loss before retirement.
For the purposes of Code Sec. 4975, a fiduciary of a plan is defined as any person who: (1) exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets; (2) renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so; or (3) has any discretionary authority or discretionary responsibility in the administration of such plan. A fiduciary of a qualified retirement plan is also a disqualified person for the purposes of Code Sec. 4975.
In addition to a fiduciary as defined above, the term “disqualified person” under Code Sec. 4975(e)(2) also includes a corporation or a partnership of which 50% or more of (1) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation, or (2) the capital interest or profits interest of a partnership, is owned directly or indirectly or held by a fiduciary as described in Code Sec. Code Sec. 4975(e)(2)(G) incorporates the constructive ownership rule of Code Sec. 267(c)(1), which provides that “[s]tock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries.”
Background on ramifications of a taxpayer entering into a prohibited transaction. If, during any tax year of an individual for whose benefit any IRA is established, that individual or his beneficiary engages in a prohibited transaction under Code Sec. 4975 , the account will cease to be an IRA as of the first day of the tax year. In such a case, the IRA in question will no longer be exempt from tax under Code Sec. 408(e)(1). Further, where such an account ceases to be an IRA by reason of Code Sec. 408(e)(2)(A), the account is deemed to have been distributed on the first day of the tax year in an amount equal to the fair market value of all the assets of the account on that first day.
Except as otherwise provided in the income tax portion of the Code, gross income includes all income from whatever source derived. Under Code Sec. 408(d)(1), “[E]xcept as otherwise provided in this subsection, any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee, as the case may be, in the manner provided under Code Sec. 72.” Code Sec. 72(t) imposes a 10% additional tax on early distributions from qualified retirement plans unless the distribution falls within a statutory exemption.
Court rules on which of Ellis’s actions were prohibited transactions. The Court concluded that the formation of CST didn’t involve any prohibited transaction, but that the compensation that CST paid to Ellis was a prohibited transaction.
First, the Court said that Ellis exercised discretionary authority over his IRA and likewise exercised control over the disposition of its assets. Ellis exerted control over his IRA in causing it to engage in the purchase of membership units of CST. Accordingly, Ellis was a fiduciary of his IRA within the meaning of Code Sec. 4975 and consequently a disqualified person with respect to that plan.
Ellis argued that he did not engage in a prohibited transaction by causing his IRA to invest in CST. He cited Swanson, (1996) 106 TC 76, a case in which the taxpayer organized Worldwide, a corporation, then established an IRA and subsequently executed a subscription agreement for the exchange of IRA funds for shares of Worldwide original issue stock. In that opinion, the Court stated that a corporation without shares or shareholders does not fit within the definition of a disqualified person under Code Sec. 4975(e)(2)(G) . The Court concluded that it was only after Worldwide issued its stock to the taxpayer’s IRA that Worldwide had become a disqualified person under Code Sec. 4975(e)(2)(G).
In holding for Ellis in the instant case, the Tax Court said that an LLC that elects to be treated as a corporation and does not yet have members or membership interests is sufficiently analogous to a “corporation without shares or shareholders.” CST had no outstanding owners or ownership interests before the initial capital contribution and therefore could not be a disqualified person at the time of the investment by Ellis’ IRA.
But, the Court held for IRS with respect to the compensation paid by CST to Ellis. It said, by paying the compensation, he engaged in the prohibited transactions described in Code Sec. 4975(c)(1)(D) and Code Sec. 4975(c)(1)(E) (see above). Ellis was the sole individual for whose benefit the IRA was established and therefore the beneficial owner of 98% of the outstanding membership interests of CST. Because Ellis, a fiduciary of his IRA, was the beneficial shareholder of more than 50% of the outstanding ownership interest in CST, CST met the definition of a disqualified person under Code Sec. 4975(e)(2)(G). As the fiduciary of his IRA and the general manager of CST, Ellis ultimately had discretionary authority to determine the amount of his compensation.
Ellis argued that he did not engage in a prohibited transaction when he caused CST to pay him compensation because the amounts it paid to him did not consist of plan income or assets of his IRA but merely the income or assets of a company in which his IRA had invested. However, CST was funded almost exclusively by the assets of Ellis’ IRA. Furthermore, the assets of Ellis’ IRA consisted only of its ownership interest in CST. To say that CST was merely a company in which Ellis’ IRA invested was a complete mischaracterization when in reality CST and Ellis’ IRA were substantially the same entity. In causing CST to pay him compensation, Ellis engaged in the transfer of plan income or assets for his own benefit in violation of Code Sec. 4975(c)(1)(D). Furthermore, in authorizing and effecting this transfer, Ellis dealt with the income or assets of his IRA for his own interest or for his own account in violation of Code Sec. 4975(c)(1)(E).
Ellis also argued that Code Sec. 4975(d)(10) exempts the payment of compensation by CST to Ellis from being classified as a prohibited transaction. That section provides that the prohibited transactions set forth under Code Sec. 4975(c) do not apply to receipt by a disqualified person of any reasonable compensation for services rendered, or for the reimbursement of expenses properly and actually incurred, in the performance of his duties with the plan. However, the amounts CST paid as compensation to Ellis were not for services provided in the administration of a qualified retirement plan in managing its investments, but rather for his role as general manager of CST in connection with its used car business. Accordingly, the Court said, Code Sec. 4975(d)(10) did not apply.
Court rules on the effect of Ellis entering into a prohibited transaction. As a result of the payment of compensation being a prohibited transaction, the full amount that Ellis transferred to the IRA from his old 401(k) account was deemed distributed on Jan. 1, 2005, under Code Sec. 408(e)(2)(A). That amount was therefore includible in the Ellises’ gross income for tax year 2005 under Code Sec. 72(a) and Code Sec. 4975. And, when it found no exception to the 10% additional tax under Code Sec. 72(t), the Court also said that the Ellises were liable for that additional tax.
Moral of the story? Do NOT pay yourself any compensation out of your self-directed IRA… period!
Warmest regards,
Doug
© 2013 Douglas Rutherford, CPA, CGMA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.
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