Funding Strategy Afoul of Tax Regulations

Peek v. Commissioner, 2013 U.S. Tax Ct. LEXIS 13 (May 9, 2013)

It’s not uncommon for aspiring business owners to use their retirement accounts, including 401(k)s and IRAs, to start up businesses, as a September 13 report in the New York Times makes clear. But, as a recent tax court case illustrates, what may seem like a smart investment strategy can go awfully wrong when the budding investor disregards expert advice on the applicable tax rules.
Better watch out: Two taxpayers decided to buy an alarm and fire safety company for investment purposes. They hired an accountant to structure the transaction and perform due diligence. He developed a multistep strategy that used self-directed IRAs to defer until retirement any income tax liability on the gain they hoped to make on the asset. In 2001, each IRA acquired 50% of the stock of a new company (Newco) the taxpayers had formed to buy the target’s assets for $1.1 million, including cash from various loans and—critically—a $200,000 promissory note from Newco to the sellers. The note was secured by personal guaranties from the two taxpayers and remained in effect until the profitable sale of Newco to a third party.
At the outset of the transaction, the accountant provided an opinion letter that warned of the special tax rules applicable to IRAs. It said “the taxpayer could not engage in transactions with the IRA that the IRS would determine to be ‘prohibited transactions.’” Another letter cautioned that “any actions you take on behalf of the corporation must be taken by you as an agent for the corporation and not by you personally.” When the IRAs sold Newco in 2006 each received in total more than $1.6 million in proceeds during 2006 and 2007.
In their federal income tax returns for those two years, the taxpayers did not include capital gains related to the Newco stock sale. The IRS subsequently issued deficiency notices arguing that the taxpayers’ IRAs had stopped qualifying as IRAs from the moment the taxpayers made the personal loan guaranties in 2001. The guaranties were “prohibited transactions” under section 4975(c)(1)(B) of the Internal Revenue Code. On review, the Tax Court agreed with the IRS. The guaranties triggered a liquidation of the IRAs in 2001; their assets were distributed to the taxpayers, who owed income tax on the gain they made in 2006 and 2007, the court found.