Court Rules in Favor of Self-Directed IRA Real Estate Investor in Prohibited Transaction Case

Photo of a gavel in front of empty seats in a courtroom with the text "Court Rules in Favor of Self-Directed IRA Real Estate Investor in Prohibited Transaction Case."A recent Bankruptcy Court decision dealt with prohibited transaction claims against a self directed IRA owner who was using their IRA to flip real estate for profit. The claims were brought by a bankruptcy trustee who argued that the protected IRA was no longer an IRA because it engaged in a number of prohibited transactions. If the trustee is successful in disqualifying the retirement account because of a prohibited transaction, then the funds and assets held in such retirement account are no longer protected from creditors and may be used to pay debtors involved in the bankruptcy. While most prohibited transaction cases arise in Tax Court, I’m seeing more cases on prohibited transactions in Bankruptcy Court as trustees are becoming more aggressive and as self directed IRAs are becoming more popular.

The case in question is known as In re Cherwenka, Case 13-57592-MGD (Bankr. N. D. GA 2014). The case included two important prohibited transaction analysis that are helpful to IRA owners.

Court Rules No Prohibited Transaction When Managing IRA Investment Properties Without Compensation

The first significant ruling from the Court was that there was no prohibited transaction when the IRA owner completed the following tasks related to the IRA owned property.

  • Research and identified properties to buy
  • Appointed and approved work on the properties
  • Oversaw payments on the property for work from the self-directed IRA.

The Court reasoned that these actions do no constitute a “transaction” as defined in IRC § 4975 and as a result they cannot constitute a prohibited transaction. The Court further stated that, “…self-directed IRAs as qualified IRAs, necessarily implies that a disqualified person (the owner as fiduciary) will make investment decisions regarding the plan. The Court distinguished this case from In re Williams, 2011 WL 10653865 (Bankr E.D. Cal 2011) a similar case in which the self-directed IRA owner was managing properties owned by the IRA because in Williams the IRA was paying the self-directed IRA owner for the services. The court stated that it was the payment from the IRA to the IRA owner in Williams that caused the prohibited transaction and not the mere provision of managing the IRAs investment owned by the IRA.

Court Ruled That No Prohibited Transaction Occurred When IRA and Owner Invested Into Property Together

The second significant ruling from the Court was that there was no prohibited transaction when the IRA owner and the IRA co-invested into a property together. The property in question was owned 45% by the IRA and 55% by the IRA owner. The Court rejected the bankruptcy Trustee’s argument that such co-investment purchase resulted in a prohibited transaction and stated that the interests appeared to have been treated distinctly and that the HUD documents from the sale of the property show that the IRA and the IRA owner’s proceeds from the sale were treated separately and that they were apportioned properly. As a result, the Court concluded that no prohibited transaction occurred since there was no evidence of un-fair benefit between the IRA owner and his IRA. In its reasoning, the Court referenced DOL Opinion 2000-10A which addressed an IRA and the IRA owner co-investing into a partnership. In the Opinion the DOL states that, “a violation of section 4975 (c)(1)(D) or (E) will not occur merely because the fiduciary [IRA owner] drives some incidental benefit from the transaction involving IRA assets.” The Court referenced this opinion and stated that unless there is evidence of some un-fair benefit that no prohibited transaction occurred merely because of co-investment into the same property.

There are two key take-away’s for self-directed IRA investors from this case.

First, never take compensation or payment from the IRA for services rendered. It is clear that the Courts will find a prohibited transaction if you do and that you will no longer have an IRA.

Second, if you are buying property or others assets (e.g. LLC interests) between your IRA and yourself personally (or another disqualified person) those interests must be carefully calculated and treated such that there is no benefit going unfairly between the IRA and the disqualified person (e.g. IRA owner). In sum, get advice and plan carefully as there are many land-mines you could encounter when investing IRA funds with your own personal funds. Bottom line, it can be done but it can easily be done incorrectly.

2014 Retirement Plan Contribution Deadlines: Start Planning Now & Don’t Get Left Behind

Photo of a clock on a wall with the text "2014 Retirement Plan Contribution Deadlines Start Planning Now & Don’t Get Left Behind."Retirement account/plan contributions are one of the most powerful tax strategies you can implement but you’ve got to make them by the deadline so that they can reduce this years tax liability. With the end of the year fast approaching, now is the time to make certain you are maximizing this important tax strategy for your 2014 tax planning. Please find below a table outlining the deadlines for 2014 retirement plan contributions according to your type of retirement account.  If you are self-employed, you’ll notice the deadline also may depend on the type of company you own (e.g. s-corp or LLC)  but also whether you are making contributions as an employee of your company and/or as the employer. First, let’s summarize the IRA contribution deadlines.

IRA Contribution Deadlines

Type of IRA Contribution Type Deadline Details
Traditional IRA Traditional, Deductible April 15, 2015, Due Date for Individual Tax Return Filing (not including extensions).  IRC § 219(f)(3); You can file your return claiming a contribution before the contribution is actually made.  Rev. Rul. 84-18.
Roth IRA Roth, Not Deductible April 15, 2015, Due Date for Individual Tax Return Filing (not including extensions). IRC § 408A(c)(7).
SEP IRA Employee N/A; employee contributions cannot be made to a SEP IRA plan.
Employer Contribution March 15/April 15th, Due Date for Company Tax Return Filing (including extensions).  IRC § 404(h)(1)(B).
Simple IRA  Employee Elective Deferral January 30, 2015.  IRC § 408(p)(5)(A)(i).
Employer Contribution March 15/April 15, Due Date for Company Tax Return Filing (including extensions).  IRC § 408(p)(5)(A)(ii).

 

In summary, for traditional and roth IRA contributions you have until the individual tax return deadline of April 15, 2015 to make 2014 contributions. SEP and SIMPLE IRA contribution deadlines are based on the company tax return deadline which could be March 15th if the company is a corporation and April 15th if it is a sole proprietorship or partnership. Keep in mind that this deadline does NOT include extensions so even if you extend your personal tax return filing to September 15, 2015, you still have a April 15, 2015, contribution deadline for Roth and Traditional IRAs.

401(k) Contribution Deadlines

Solo 401(k) Business Structure Type of Cont. Deadline Details
401(k), including self-directed Solo 401(k) (plan must be adopted by 12/31/14) Sole Proprietorship Employee Elective DeferralContribution April 15, 2015, contribution deadline is Due Date for Employer Tax Return (including extensions) but compensation must have been earned by December 31, 2014 and election should be made by December 31, 2014; IRS Publication 560.  Rev. Rul. 76-28; 90-105.
Employer Profit Sharing Contribution April 15, 2015, Due Date for Company Tax Return Filing, including extensions, however employee compensation must have been earned by December 31, 2014.  IRC § 404(a)(6).  Rev. Rul. 76-28; 90-105.
S-CorporationOr C-Corporation Employee Elective Deferral contribution March 15, 2015 (corporation filing deadline), contribution deadline is Due Date for Employer Tax Return (including extensions) but compensation must have been earned by December 31, 2014 and election should be made by December 31, 2014;  IRS Publication 560.  Rev. Rul. 76-28; 90-105.
Employer Profit Sharing Contribution March 15, 2015, Due Date for Company Tax Return Filing, including extensions, however employee compensation must have been earned by December 31, 2014.  IRC § 404(a)(6).  Rev. Rul. 76-28; 90-105
Partnership (e.g. partnership LLC) Employee Elective Deferral Contribution April 15, 2015 (partnership return filing deadline), contribution deadline is Due Date for Employer Tax Return (including extensions) but compensation must have been earned by December 31, 2014 and Election should be made by December 31, 2014;  IRS Publication 560.  Rev. Rul. 76-28; 90-105.
Employer Profit Sharing Contribution April 15, 2015, Due Date for Company Tax Return Filing, including extensions, however employee compensation must have been earned by December 31, 2014.  IRC § 404(a)(6).  Rev. Rul. 76-28; 90-105.

 

There are a few important things to keep in mind regarding 401(k) contributions.

401(k) Contribution Deadlines Can Be Extended

First, the contribution deadline for employer and employee contributions is the company tax return deadline INCUDLING extensions. So, if you have a solo 401(k) you can extend your company tax return and your contribution deadline is also automatically extended. For example, if you have a solo 401(k) plan adopted by your s-corporation, then your s-corporation tax return deadline is March 15, 2015, but that can be extended 6 months until September 15, 2015, upon filing an extension to extend the company tax return with the IRS. If you do this, you’d have until September 15, 2015, to make the 2014 employee and employer contributions. That being said, the employee contributions are taken from your salary/wages and if you make traditional 401(k) employee contributions those amounts are reported on your personal W-2 and reduce your taxable wages. The W-2 is effectively where your tax deduction for traditional employee contribution arises is it reduces your taxable wages on your W-2.  As a result, you’ll need to make or at least know the amount you intend to make for employee contributions by January 31, 2015 as that is the W-2 filing deadline for 2014.

New 401(k)s Must Be Adopted by December 31st

Second, if you are establishing a new Roth or Traditional IRA, you can create that new account at the time of the IRA contribution deadline. However, if you are establishing a new solo 401(k) plan, you must have the plan established by December 31, 2014. Because there are a number of documents and procedures required to create a new 401(k) plan, this is not something that can be left to the last minute and you should start immediately if you intend to open a 401(k) this year.

Make 2014 Contributions in 2014

And lastly, while the deadlines for most 2014 retirement plan contributions for IRAs and 401(k)s runs into 2015, to keep things simple and stress-free we recommend making 2014 contributions by December 31, 2014, when possible.

As you can see, the contribution deadlines vary depending on the type of account/plan but also on the type of contribution.  With respect to contributions to a self-directed solo 401(k), the contribution deadline also varies depending on the type of company you own that has adopted the plan.  Therefore, it is important that you understand these deadlines and don’t miss out on an opportunity to maximize your tax deductions.  For guidance on the contribution limits in 2014, please click here.

As previously stated, it is not too late to setup a retirement account/plan if you have not done so already.  The deadline to set up a 401(k) and to make contributions for 2014 is typically the last day of the year, although I wouldn’t wait until the last day or even the last week of the year to do so.  If you are interested in setting up a self-directed solo 401(k), please contact us immediately as we are helping clients establish these and so that we can get it set up before the end of the year.

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.