On March 29, 2016, the United States Tax Court issued a decision in Thiessen v. Commissioner that affects business owners and other individuals who use their IRAs to finance investments. The court held that the taxpayers engaged in a prohibited transaction that resulted in a taxable distribution from their IRAs and a 10 percent addition to tax for a premature distribution.
The taxpayers engaged in a series of transactions to acquire an unincorporated business that specialized in the design, fabrication and installation of metal products. Upon the advice of a broker, they rolled their qualified retirement plan accounts into newly created self-directed IRAs, caused the IRAs to buy stock of a newly formed C corporation and caused the corporation to purchase the assets of the unincorporated business.
In this series of transactions, the taxpayers were the sole directors and officers of the corporation, and had discretion and control over the IRA investments. The taxpayers received a rollover amount of $432,076 from their retirement plans, and rolled over the entire amount into the newly formed IRAs. The taxpayers then directed the IRAs to purchase all of the stock of the newly formed corporation for $431,500. Shortly thereafter, the corporation (not the IRAs) purchased all of the business assets for $601,978, using cash proceeds provided by the corporation (from the issuance of stock to the IRAs) and the taxpayers, and seller financing in the amount of $200,000. The loan was secured by the business assets and was personally guaranteed by the taxpayers.
On their tax return, the taxpayers did not report any taxable IRA distributions and did not disclose their guarantee of the loan used by the IRA to purchase the unincorporated business, or the existence of the new corporation. The IRS issued an income tax deficiency in the amount of $180,129 for the 2003 tax year based on $431,500 in unreported IRA distributions.
Under section 4975(c)(1)(B), a prohibited transaction includes “any direct or indirect…lending of money or other extension of credit between a plan and a disqualified person.” A plan includes an IRA, and a disqualified person includes a person who “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.” If the disqualified person is also the IRA owner or his or her beneficiary, the IRA’s status as an IRA ceases as of the first day of the IRA owner’s taxable year in which the prohibited transaction occurs, and the IRA owner is deemed to receive a distribution on the first day of that year in an amount equal to the fair market value of the plan assets as of that first day. If the IRA owner is not yet 59-1/2 years old as of the date of distribution, an additional 10 percent tax is due.
In Thiessen,the court held that the arrangement was a prohibited transaction under section 4975(c)(1)(B) under the theory that the loan guarantees were an indirect extension of credit from the taxpayers to the IRAs. Consequently, the IRAs lost their status as IRAs and were deemed to distribute the entirety of their assets to the taxpayers in a taxable transaction. The court looked to its prior decision involving similar facts (including the same CPA and brokerage firm as advisors) in Peek v. Commissioner, in which petitioners rolled their funds into IRAs, caused the IRAs to purchase a newly formed C corporation, caused the C corporation to purchase the assets of a business with a loan from the seller, and petitioners guaranteed repayment of the loan. The Peek court held that the arrangement constituted a prohibited transaction as the guarantees of the loans were indirect extensions of credit between the taxpayers and the IRAs. Although the taxpayer attempted to distinguish Peek on various grounds, including arguing that it involved an IRA purchasing assets rather than stock, the court rejected these arguments and stated its decision was not dependent on whether the IRA was viewed as owner of the stock or the assets.
The Thiessen court also dismissed the taxpayer’s argument that under section 4975(d)(23), the prohibited transaction tax should not apply if they corrected the transaction within the correction period. The court reasoned that this limited ability to cure applied to certain guaranties of loans made to acquire, hold or dispose of a security, but determined that the guarantee in this instance was made to acquire the business assets rather than the stock of the newly formed corporation, and thus did not fit within the statute’s meaning of security. The court found the “aim of the transaction” to be the acquisition of the business assets, not the acquisition of the newly formed corporation’s stock.
The court also upheld the Service’s application of the extended six year statute of limitations for assessment because the taxpayers failed to report gross income in excess of 25 percent of the gross income reported on the return. Although gross income disclosed on a return is not taken into account for these purposes, the court held that petitioners did not disclose the amounts in the return or in a statement attached to the return in a manner sufficient to put the secretary on notice of the nature and amount of the income. The court rejected the argument that reporting the rollover amount on the return was sufficient, when they also reported it as nontaxable, because the undisclosed income related to a prohibited transaction (for which no facts were disclosed on the return), rather than to an improper rollover of retirement funds to the IRAs.
This decision involves a number of novel issues and shows the importance of carefully reviewing the prohibited transaction rules before using an IRA to purchase unconventional assets, such as business interests or assets. In this instance, the court looked through the structure to find that the taxpayers engaged in a prohibited transaction by guaranteeing a $200,000 loan, subjecting the entire value of the IRA ($431,500 as briefed by the IRS) to income tax and the 10 percent premature distribution excise tax.
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