When is a Business Partner a Disqualified Person to My Self-Directed IRA?

Image of a blank disqualified persons chart by Mat Sorensen with the text "When is a Business Partner a Disqualified Person to My Self-Directed IRA."Most self directed IRA owners know that their self directed IRA cannot conduct transactions with themselves or certain family members (e.g. spouse, kids, parents, etc.). Most self directed IRA owners also know that their self directed IRA cannot do business with a company they own or that their disqualified family members own 50% or more of. However, one of the most confusing areas of the prohibited transaction rules are the prohibited transaction rules which apply to business partners or officers, directors, and/or highly compensated employees of companies the IRA owner or family members are personally involved in. For example, what if I own a business with a partner? Can my IRA enter into a transaction with that business partner if we aren’t family? Well, it depends.

Disqualified Person Analysis

To analyze the rules you first need to determine whether the company in which the business partner (or officer, or director) is involved in is a company that is owned 50% or more by the IRA owner or their disqualified family members. IRC 4975 (e)(2)(E),(H), (I). So, for example, if my wife and I owned 60% of the business and our partner owned 40% of the business, then this company would be owned 50% or more by disqualified persons.

Once we know that the company is owned 50% or more by disqualified persons, we need to identify all of the officers, directors, highly compensated employees, and 10 % or more owners of that company. In sum, all of these persons are disqualified to the IRAs of the 50% or more owners. In the example above, since my business partner owned 40% of the company, he is a 10% or more owner and as a result he is a disqualified person to my IRA (since my wife and I own 50% or more of the company).

Let’s look at another example. Say that I am a 35% owner of a business with a few other partners who are not disqualified family members to me.  Since I do not own 50% or more of this company, it doesn’t matter who the other partners, officers, or directors, are, as they are not disqualified to my IRA as part of this rule since my ownership (and that of my disqualified family members) is below 50%.

As a final example, let’s say that I own 70% of a company and that I have a partner who owns 5%. Under the rule, my partner or fellow shareholder does not have 10% or greater ownership and as a result they are not disqualified to my IRA. However, if that 5% owner was the President of my company then they would be a disqualified person.

These rules can be tough to understand when you read the code, but if you take the two step analysis you can easily determine what partners, officer, directors, or highly compensated employees are disqualified to your IRA.

Here’s also a quick summary of the rule from my book where I took the text of the tax code and put it into plain language.

Key Persons in Company Owned 50% or More by Disqualified Persons

An officer, director, or 10% or more shareholder, or highly compensated employee (earns 10% or more of the company’s wages) of a company owned by the IRA owner or other disqualified persons. IRC § 4975 (e)(2)(H).

Before investing with someone who is an officer, director, highly compensated employee, or a shareholder/owner in a company you are involved in, please consult these rules and where you are un-clear, seek the advice of competent counsel.

Who is Prohibited to My Self-Directed IRA?

Image of a blank disqualified person tree with the text "Who is Prohibited to My Self-Directed IRA?"The prohibited transaction rules applicable to self directed IRAs prohibit not what your IRA can invest into but WHO your IRA may engage in a transaction with. For example, the prohibited transaction rules restrict my IRA from buying a rental property from my father. This is not because rental properties are prohibited to my IRA but because my father is prohibited by law from transaction with my IRA. My self directed IRA could buy a rental property from a third party seller whom I have no family or other business relationship with since there is nothing wrong in buying the rental property the question is just who am I buying it from.  Congress decided to restrict investments with certain persons who could potentially collude with the IRA owner to unfairly avoid taxes. As a result, transactions with certain family members and business partners of an IRA owner are prohibited.  The consequence for engaging in a prohibited transaction can be drastic (e.g. no longer have an IRA, penalties and taxes on distribution) so IRA owners must avoid them in all situations.

The prohibited transaction rules therefore provide the greatest restriction on using self directed IRA funds and must be understood by self directed IRA investors. These rules are found in IRC 4975 and state that a prohibited transaction occurs when an IRA engages in a transaction (e.g. buy, sell) with a disqualified person. The question immediately arises, who is a disqualified person to my IRA?

Categories of Persons Disqualified to Your SDIRA

There are essentially four categories of disqualified persons to your IRA and they are as follows.

  1. IRA Owner. The IRA owner is disqualified to his/her own IRA as the fiduciary making decisions for the account. IRC 4975(e)(2)(A), Harris v. Commissioner, 76 T.C.M. 748 (U.S. Tax Ct. 1994).
  2. Certain Family Members. Disqualified family members include the IRA owner’s spouse, children, spouses of children, grandchildren and their spouses, and the IRA owner’s parents and grandparents. Family member who are NOT disqualified persons are siblings (e.g. brothers and sisters), aunts and uncles, cousins, nieces and nephews, and parent in-laws (e.g. spouses parents). IRC 4975 (e)(2)(F), IRC 4975 (e)(6).
  3. Company Owned 50% or More by IRA Owner or Certain Family Members. Any Company that is owned 50% or more by the IRA Owner or Certain Family Members outlined above are disqualified to the IRA. For example, an LLC owned 30% by the IRA owner, 30% by the IRA owner’s spouse, and 40% by an un-related partner is a disqualified company to the IRA (owned 50% or more by disqualified persons) and any transaction between the IRA and the company would be a prohibited transaction.  IRC 4975 (e)(2)(G).
  4. Key Persons in Company Owned 50% or More by IRA Owner or Certain Family Members. Any person who is a 10% or more owner of a company owned 50% or more by disqualified persons (e.g. number 3 above) or any person who is an officer, director, or manager of a disqualified company (owned 50% or more by disqualified persons) is also disqualified. For example, if my wife and I own 60% of a company and if Julie is an officer of that company then Julies is a disqualified person to my IRA. Additionally, if Julie was a 15% or more owner of the company she would also be prohibited to my IRA.

When you are dealing with unrelated persons (not related as family or as business partners) the prohibited transaction rules do not need to be analyzed but once family members or business partners are involved in any part of the transaction, the IRA owner must ensure that the prohibited transaction rules are not being violated.

New Case Answers Important Questions About IRA/LLCs

Image of the US Tax Court logo with the text "New Case Answers Important Questions About IRA/LLCs"Can my IRA own substantially all of the ownership of an LLC? Can my IRA/LLC pay a salary to me for serving as the manager of the IRA/LLC? Last week the U.S. Tax Court issued an opinion in the case of Ellis v. Commissioner, T.C. Memo 2013-245 and answered both of these questions.

In Ellis, the Tax Court resolved two questions posed by the IRS. First, did Mr. Ellis engage in a prohibited transaction when his IRA acquired 98% of the membership interest in CST, LLC? And second, did Mr. Ellis engage in a prohibited transaction when CST, LLC (owned 98% by his IRA) paid him compensation for serving as the manager?

Analyzing Ellis v. Commissioner

As to the first question, the Tax Court held that Mr. Ellis’ IRA did NOT engage in a prohibited transaction when it acquired 98% of the ownership of a newly established LLC. The other 2% was owned by an un-related person who was not part of the case and whose ownership did not have an impact on the decision. The IRS contended that a prohibited transaction occurred when the IRA bought ownership of CST, LLC. The Court disagreed, however, and held that the IRA’s purchase of the initial membership interest of the LLC was NOT a prohibited transaction. The Court stated that the IRA’s purchase of membership interest in a new LLC is analogous to prior holdings of the Court whereby the Court held that an IRA does not engage in a prohibited transaction when it acquires the initial shares of a new corporation. Similarly, the court held that a new LLC is not a disqualified person to an IRA under the prohibited transaction rules and as a result an IRA may invest and own the ownership of the LLC. IRC § 4975(e)(2)(G), Swanson V. Commissioner, 106 T.C. 76, 88 (1996). Consequently, the Court’s ruling means that it is NOT a prohibited transaction for an IRA to acquire substantially all or all of the ownership of a new LLC.

As to the second question, the Tax Court held that it was a prohibited transaction for the LLC owned substantially by Mr. Ellis’ IRA to pay compensation to Mr. Ellis personally. The court reasoned that, “In causing CST [the IRA/LLC] to pay him [IRA owner] compensation, Mr. Ellis engaged in the transfer of plan income or assets for his own benefit in violation of section 4975 (c)(1)(d).” This type of prohibited transaction is often times referred to as a self dealing prohibited transaction and occurs when the IRA owner personally benefits from his IRA’s investments. The Court looked to the operating agreement of the LLC which authorized payment to Mr. Ellis for serving as the general manager and also the actual records of the LLC which showed the payments to Mr. Ellis. When using an IRA/LLC, one of the many important clauses in the operating agreement is one which restricts compensation to the IRA owner or any other disqualified person (e.g. IRA owner’s spouse or kids). Also, the actual payment and transaction records of the IRA/LLC will be analyzed so it is important that both the LLC documents and the actual payment records do not allow for or result in payment from the IRA/LLC to disqualified person (e.g. IRA owner).

It is also important to note that the Tax Court rejected Mr. Ellis’ argument that the payments were exempt from the prohibited transaction rules under section 4975 (d)(10). Section (d)(10) provides an exemption to the prohibited transaction rules for payments from an IRA to a disqualified person [e.g. IRA owner] for services rendered to manage the IRA. The Tax Court rejected this argument stating that the payments from the IRA/LLC were not for management of the IRA but for management of the IRA/LLC and its business activities. In this case, the IRA owner was actively involved as the general manager of the IRA/LLC which LLC bought and sold cars. As a result, the Court held that the payments were not exempt and constituted a prohibited transaction.

I was happy to read this case and find the Court’s conclusions because it matches the same opinion and advice we have been giving clients regarding IRA/LLCs for nearly ten years: that a newly established LLC owned by an IRA does not constitute a prohibited transaction but the IRA/LLC cannot pay the IRA owner (or any other disqualified person) compensation for managing the IRA/LLC.

IRA Owner Wins Appeal of Prohibited Transaction Ruling: What Can Self Directed IRA Investors Learn?

In Daley v. Mostoller, the U.S. Court of Appeals for the Sixth Circuit ruled that an IRA client account agreement which contains a “cross collateralization” or lien against the personal debts of the IRA owner does not constitute a prohibited transaction unless there is an actual execution or extension of credit based on the “cross collateralization” or lien against the IRA. Daley v. Mosteller (In re Daley), No. 12-6130 (6th Cir. June 17, 2013).

The case arose when Daley, the IRA account owner, filed Chapter 7 bankruptcy in Tennessee. Under the bankruptcy rules, Daley sought to exclude his IRA from the collection of the creditors as is typical and permissible under bankruptcy laws. The bankruptcy Trustee in the case sought to disqualify the IRA as an exempt asset of Daley by arguing that the Merrill Lynch IRA client agreement violated IRC § 4975(c)(1)(B) of the prohibited transaction rules because it contained language which created a lien in favor of Merrill Lynch for amounts which the IRA owner may personally owe to Merrill Lynch. The argument made by the Trustee was that by agreeing to offer the IRA as collateral to Merrill Lynch for personal accounts the IRA owner was thereby making an extension of credit between his IRA and debts he may personally owe. The result of prevailing on a prohibited transaction claim is that the IRA loses its status as an IRA which results in a loss of the creditor protections which typically allow IRA owners to keep their IRA outside the reach of creditors.

Following argument in the bankruptcy case, the Bankruptcy Court agreed with the Trustee in the case and ruled that even though no actual extension of credit or execution on the IRA assets occurred, the actual verbiage in the Merrill Lynch client agreement nonetheless was an extension of credit. Fortunately, the 6th Circuit disagreed and reversed the Bankruptcy Court by ruling that despite the language in the client agreement regarding a lien in favor of Merrill Lynch and the “cross collateralization” of the IRA, the 6th Circuit held that a prohibited transaction had not occurred because the actual language of the rule requires an actual extension of credit between the IRA and the IRA owner personally. The 6th Circuit held that the language in the client agreement did not in and of itself result in a prohibited transaction as not extension of credit actually occurred. While the case at first glance may not seem that applicable to self directed IRA investors it does make a number of important conclusions.

The important “take aways” from the case for self directed investors are as follows.

  1. The case held that a prohibited transaction only occurs when there is an actual transaction or actual extension of credit that violates the rule not just when there is language in a document allowing for such.
  2. The case reiterated that there is a presumption that an IRA is exempt, if properly established with a custodian, until proven otherwise. In other words, the burden of proving a prohibited transaction is on the agency or person (e.g. IRS or Bankruptcy Trustee) making the allegation. 11 U.S.C. § 522(b)(4)(A).
  3. The Court distinguished this case from cases where an actual extension of credit was made to the IRA owner personally based entirely or in part on a lien given against the IRA. All IRA owners need to be aware that they cannot personally receive an actual extension of credit nor should they actually obtain a loan whereby their IRA is pledged as an asset as those instances will likely result in a prohibited transaction.

IRA owners need to be careful to avoid situations where the IRAs assets are being pledged against the debts of an IRA owner. Additionally, IRA owners who have significant IRA accounts and whom are considering entering bankruptcy should carefully analyze their account activity, investments, and investment documents to determine whether there are potential prohibited transaction risks which could result in a bankruptcy trustee obtaining the assets of an IRA for the purpose of paying creditors.

Author: Mathew Sorensen is a partner at KKOS Lawyers and routinely advises clients on the prohibited transaction rules applicable to IRAs, on self directed IRA investment structures such as IRA/LLCs, and represents self directed IRA owners before the IRS and the U.S. Tax Court.

Self-Directed IRA Prohibited Transaction Costs Taxpayers Over $250K

The latest IRA prohibited transaction case is called Peek & Fleck v. Commissioner, U.S. Tax Court 140 T.C. No. 12 (March 8, 2013) and concerns two tax payers who used self directed IRAs to establish and fund a newly formed corporation which corporation purchased a fire and safety company that was for sale by third parties and was known as ASF Company.

Both Mr. Peek and Mr. Fleck funded the newly formed company with funds from their self directed IRAs and the company used those combined funds in the approximate amount of $400,000, as well as a bank loan for $450,000, and a loan from the sellers of the business of $200,000 to acquire all of the stock of ASF Company.  In entering into the $200,000 loan with the sellers, however, Mr. Peek and Mr. Fleck (who were not personally invested or owners in the transaction) signed personal guarantees and offered their personal residences as collateral as part of the terms of the loan with the sellers. This critical mistake, the personal extension of credit for their IRAs investment, resulted in the IRS alleging a prohibited transaction under IRC § 4975 (c)(1)(B).

The Tax Court agreed with the position of the IRS and disqualified the IRAs investment all the way back to when the prohibited transaction and the personal extension of credit for the IRAs occurred. This was extremely problematic for the self directed IRA owners as they were later able to turn their IRAs $200,000 investment into a return of over $1,500,000. However, the consequence of the prohibited transaction negated the IRAs tax favored status and resulted in the self directed IRA owners incurring taxes of over $250,000 per account owner. Using self directed IRAs in the investment was an excellent idea, however, the actions of using personal credit to solely benefit the IRAs clearly violated the prohibited transaction rules and literally cost the self directed IRA owners hundreds of thousands of dollars.

An alternative way to approach this issue would have been to avoid the personal guarantees and use of the IRA owner’s personal assets as collateral and to instead structure the loans used to purchase the business as non-recourse loans perhaps being secured in favor of the seller’s by the stock being sold. An additional alternative may have been to include other non-disqualified persons whose IRAs were not invested and to include them as partners and as possible personal guarantors to the loans. As a general rule of thumb, always avoid signing personal guarantees or offering personal assets as collateral when obtaining loans to fund self directed IRA investments. Seek out what are known as non-recourse loans where you do not have to offer your personal name or assets as collateral and you’ll keep your IRAs tax preferred status outside of scrutiny by the IRS.

Author, Mathew Sorensen is a partner at KKOS Lawyers and routinely advises clients on the prohibited transaction rules, on self directed IRA investment structures such as IRA/LLCs, and represents self directed IRA owners before the IRS and the U.S. Tax Court.

What Can My Self Directed Retirement Account Invest Into and The Prohibited Transaction Rule Basics

A self-directed retirement account, in short, is a retirement account administered by a custodian who allows your retirement account to invest into any investment allowed by law. The law applicable to retirement accounts allows retirement accounts (such as IRAs or 401(k)s) to invest into any investment so long as the investment is not one of the few that are restricted. This means a retirement account can invest into many “alternative” investments such as real estate, precious metals, or small business stock/membership.  Under current law, a retirement account is only restricted from investing in the following:

– Collectibles such as art, stamps, coins, alcoholic beverages, or antiques IRC 408(m);

– Life insurance IRC 408(a)(3);

– S-corporation stock, IRS Letter Ruling 199929029, April 27, 1999;

– And, any investment that constitutes a prohibited transaction pursuant to ERISA and/or IRC 4975 (e.g. purchase of any investment from a disqualified person such as a close family member to the retirement account owner).

Here is an example of some of the most popular self directed retirement account investments; rental real estate, secured loans to others for real estate, small business stock or LLC interest, precious metals such as gold, and foreign currency. These investments are all allowed by law and can be great assets for investors with experience in these areas.

When self directing your retirement account you must be aware of the prohibited transaction rules found in IRC 4975, which prevent your retirement account from engaging in a transaction with someone who is a disqualified person to your account. In short, a disqualified person to a retirement account includes the account owner, their spouse, children, parents, and 10% or more partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified under the rules. The rationale behind the prohibited transaction rule is that the federal government doesn’t want you conducting transactions between parties who are so close to the account owner that there could be a transaction designed to avoid or un-fairly minimize tax by altering the true fair market value/price of the investment. The consequence of a prohibited transaction is disqualification of the retirement account and potential excise taxes and penalties.

In a typical self directed IRA investment your IRA administrator holds your investment in their company name for your IRAs benefit (e.g. property is owned as Retirement Account Company FBO John Smith IRA)  and receives the income and pays the expenses for the investment at the account owner’s direction and instruction. Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC as the vehicle to hold their retirement account assets. An IRA/LLC is a special kind of LLC which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC in turn is managed by the IRA owner and the IRA owner then directs the LLC investments and the LLC takes title to the assets, pays the expenses to the investment, and receives the income from the investment. So, for example, a self directed IRA would invest its cash into an IRA/LLC. The IRA/LLC will then have a LLC bank account and that bank account will receive the IRA investment. The IRA/LLC in turn enters into a contract to buy real estate and then closes on the property with the IRA owner signing as manager of the LLC on the documents. There are many restrictions to the IRA owner being manager (such as not receiving compensation or personal benefit) and many laws to consider so please ensure you consult an attorney before establishing an IRA/LLC. Also, please note that I have two other blog articles on the IRA/LLC structure, which go into more detail on how the IRA/LLC structure may be used. Please contact us at the law firm at 435-586-9366 for a consult on using a self directed IRA or in setting up an IRA/LLC.