Owning a closely-held business through your Individual Retirement Account has always been a high-wire act of tax compliance. The Tax Court snipped one end of the wire for many IRA-owned corporations yesterday.
The biggest danger of owning your business in an IRA has been the risk of having a “prohibited transaction.” The tax law has hair-trigger rules for pension funds and other exempt organizations to prevent abuse of the funds by related parties or trustees.
Prohibited transactions are foot-faults. If you have one, the 15% tax applies to the “amount involved” for each year of the transaction, even if you didn’t mean to do any harm — even if you in fact did no harm. There is no “good-faith” out. Worse, prohibited transactions terminate your IRA, triggering any untaxed income within the account.
In yesterday’s case, a taxpayer acquired a C corporation through an IRA. The taxpayer then guaranteed loans to the corporation. The Tax Court said this constituted an “indirect extension of credit” to the IRA (my emphasis):
As the Commissioner points out, if the statute prohibited only a loan or loan guaranty between a disqualified person and the IRA itself, then the prohibition could be easily and abusively avoided simply by having the IRA create a shell subsidiary to whom the disqualified person could then make a loan. That, however, is an obvious evasion that Congress intended to prevent by using the word “indirect”. The language of section 4975(c)(1)(B), when given its obvious and intended meaning, prohibited Mr. Fleck and Mr. Peek from making loans or loan guaranties either directly to their IRAs or indirectly to their IRAs by way of the entity owned by the IRAs.
That triggered both a prohibited transaction and the termination of the IRA. The corporation was sold in 2006. The termination of the IRA status meant the gain was taxable on the IRA-owner 1040s, rather than sheltered in an IRA. Worse, the court upheld “accuracy-related” penalties.
Have you ever tried to get a loan for a closely-held corporation without personal guarantees? It can be difficult, especially when you have a new business. Unfortunately, owners of startups are often sorely-tempted to use their IRAs as owners, as it may be their best source of equity capital. This case shows how dangerous IRA ownership of your business can be.
I suspect there are a lot of similar taxpayers out there, with much riding on any appeal of this case. The consequences to these folks will be catastrophic, in the same league as the ruin caused by Incentive Stock Options (ISOs) exercised just prior to the dot-com collapse. The ISO disaster was bad enough to get Congress to enact legislative relief. This could also get Congressional attention.
Cite: Peek, 140 T.C. No. 12.