Self Directed IRAs, Prohibited Transactions, and the IRS Statute of Limitations: Thiessen v. Commissioner

SDIRA Prohibited TransactionIn the recent case of Thiessen v. Commissioner, 146 T.C. No. 7 (2016)the Tax Court considered how long the IRS has to allege a prohibited transaction against an IRA. In general, the IRS must allege a prohibited transaction against your IRA within three years after the return is filed. IRC 6501(a). However, that time-period may be extended another three years for a total of six years pursuant to IRC 6501(e)(1) when the taxpayer fails to report an amount that is in excess of 25% of the gross income stated in the return. For prohibited transaction rule violations, a failure to report occurs when you don’t disclose the prohibited transaction to the IRS or when you fail to claim the distribution that occurs from a prohibited transaction on your personal tax return. A prohibited transaction could be disclosed to the IRS though attachments to the return or other correspondence but the Tax Court first looks to see what was reported to the IRS on the IRA owner’s personal 1040 tax return for the years in question. In other words, if you don’t volunteer clear information of a prohibited transaction to the IRS then the limitation period can be extended up to a total of six years so long as the prohibited transaction would result in an gross income in excess of 25% of the taxpayer’s personal return. Note: IRS Form 5329 is used to declare a prohibited transaction on your personal return.

There are a few very important takeaways from the Tax Court’s ruling in Thiessen and from the IRS Internal Revenue Manual on Prohibited Transactions.

STATUTE OF LIMITATION TIPS

PRACTICAL THREE YEAR PERIOD

 

According to the IRS Agent Manual, Internal Revenue Manual, 4.72.11.6, IRS agents are instructed and trained to only review for prohibited transactions within a three-year window. In order to pursue a prohibited transaction past three years, an agent must receive approval from IRS Area Counsel. So, for practical purposes, the IRS is examining prohibited transactions within a three-year window.
FAILURE TO DISCLOSE SIX YEAR PERIOD

 

As had occurred in Thiessen, if any IRA owner fails to disclose a prohibited transaction to the IRS, the IRS may pursue a prohibited transaction for up to six years. This six-year clock runs six years after you filed your return in question. So, if you filed a 2010 personal return on April 15, 2011, and if the return did not include disclosure of a prohibited transaction, the IRS could pursue a prohibited transaction up until April 15, 2017. Keep in mind, this failure to report though must be a prohibited transaction that exceeds 25% of the gross income of the taxpayer for the year in question.

A final word to note is that the IRS may pursue prohibited transactions past six years and into an indefinite time-period when the prohibited transaction was fraudulent or a willful attempt to evade tax. IRC 6501(c)(1),(2),(3). I’m not aware of cases in this situation, nevertheless, don’t expect to be in safe waters if you fraudulently entered into a prohibited transaction as the statute of limitations never runs in those situations.

Prohibited Transaction Case Lesson: The Substance of the Transaction Matters

prohibited-transactioncase-studyA prohibited transaction case from 2015 taught an important lesson for self-directed IRA investors. That lesson is that the substance of the actual transaction matters and that you cannot avoid a prohibited transaction by creating entities or other artificial structures that create no business purpose. Summa Holdings, Inc., et al, v. Commissioner, T.C. Memo 2015-119 (2015)

In Summa, two brothers invested a minimal amount of funds from their Roth IRAs into a new corporation called JCH. JCH then established and owned 100% of another new company called JCE. This new company, JCE, then in turn contracted with and received income from a company owned and majority controlled by the Roth IRA owners’ father. Clearly, any transaction between the brother’s Roth IRAs and their father would be a prohibited transaction. The prohibited transaction rules restrict your IRA from transacting with a disqualified person and the list of disqualified persons includes the father of and IRA or Roth IRA owner. IRC 4975 (e)(2)(F).

The Tax Court, in Summa, had to determine if the transactions between companies the Roth IRAs owned and companies in which the Roth IRA owner’s father owned and controlled were a prohibited transaction. The Tax Court relied on what is known as the “Substance Over Form Doctrine” to find a prohibited transactions for the Roth IRAs receipt of income. The Substance Over Form doctrine provides that the substance and not the form of a transaction determines its tax consequences. So, despite all of the companies, three in total, that separated the brother’s Roth IRAs from their father there is still a prohibited transaction as the overall substance of the Roth IRAs transactions was to unfairly shift income and assets to the tax-free Roth IRA accounts.

In fact, the Roth IRA owners stipulated with the IRS  that the sole reason for their Roth IRAs investment into the companies and for the transactions was to accumulate income and assets tax-free. They conceded that there was no other business or investment purpose for the transactions. Consequently, the Tax Court rightly found a prohibited transaction and disqualified the Roth IRAs.

While careful planning and structuring is critical in your self-directed IRA transactions, no structure can overcome the lack of a legitimate investment or business interest for an IRAs investments. When investing your IRA into a deal, make sure your IRAs isn’t receiving any favorable treatment or benefit from a disqualified person (e.g. from the Roth IRA owner’s father). If your IRA is getting some favorable treatment or allocation of income or assets from a disqualified person, as was the case in Summa, you too could have a prohibited transaction.

 

 

What Not To Do With Your IRA/LLC or Checkbook Control IRA: Niemann v. Commissioner

niemann-v-commissioner-what-not-to-doThe recent case of Niemann v. Commissioner involves a successful real estate investor who unknowingly used his self-directed IRA owned LLC (aka, checkbook control IRA) in a way that caused a prohibited transaction under IRC § 4975. While the Tax Court’s holding and decision focused on other tax matters, the Court did outline the history of the case and the prohibited transactions that occurred and that disqualified Niemann’s IRA. Here are the pertinent facts regarding Niemann’s self directed IRA investments.

CASE FACTS

  • Neimann formed Real Estate Rabbit, LLC with his IRA as the sole member and himself as manager.
  • Neimann used Real Estate Rabbit, LLC for numerous real estate investments including buying homes at auction and slipping them for a profit. Real Estate Rabbit, LLC also bought mineral rights investments and held notes.
  • Neimann personally engaged in real estate investments in his own name and in the name of an LLC he personally owned called Magic, LLC. Neimann intended for Magic, LLC to be a multi-member LLC to be owned by himself, his personal LLC, and his IRA/LLC. This LLC was not properly established nor was it properly operated. He learned about it from a seminar and engaged a non-lawyer (“vendor”) to set up the LLC.
  • Neimann transferred properties from his Real Estate Rabbit, LLC (his IRA/LLC) to himself personally and to his personally owned LLC. These transfers caused a prohibited transaction and resulted in the entire distribution of Neimann’s self directed IRA.

It is quite clear from the case and from the Court’s analysis that Neimann was not intending to unfairly avoid tax nor was he attempting to improperly engage in a prohibited transactions. In fact, his real estate transactions were very successful. And if you were a successful real estate investor looking to illegally avoid taxes, you wouldn’t transfer properties from your IRA owned LLC (that pays no taxes on gains) to yourself personally (where you do pay taxes on the gains). If you were a tax cheat, you’d do the opposite and would transfer properties with gains from yourself personally to your IRA. It is quite clear instead, that Neimann was unaware of the rules and as a result he moved his real estate investments around between his LLCs and his personal name as he would with any property he owned. These transfers were made without regard to IRA rules which require IRA investments to be held separately from personal assets and which restrict transactions between the IRA (and IRA/LLC) and the IRA owner personally.

Neimann conceded with the Court and the IRS that he engaged in a prohibited transaction when his IRA owned LLC (Real Estate Rabbit, LLC) transferred property to himself personally and to his personally owned LLC.

LEARN THE RULES AND SEEK OUT QUALIFIED LICENSED PROFESSIONALS 

This case illustrates a critical point that self-directed IRA investors must first become acquainted with the self-directed IRA rules before they enter into real estate, LLC, or other transactions with their IRA. Neimann was a successful investor and a former engineer but he either received poor advice or he sought no professional legal or tax advice in the process.

Learning how to self-direct your IRA is like learning a new board game. At first, it takes some time to learn what you can and cannot do but once you understand the rules for the investments you intend to make it becomes second nature and you can proceed without having to consult the “rulebook” or a lawyer, or CPA, or other licensed advisor. So, if you’re new to self directing your IRA, make sure you’ve received competent advice from licensed professionals. Don’t rely on something you’ve heard at a seminar or by someone trying to sell you an investment. Instead, seek a specific consult with a licensed attorney or CPA who is competent in the rules effecting your self-directed IRA.

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.