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Circuit court decision reflects risks associated with self-directed IRA plans

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The Eighth Circuit Court of Appeals upheld a Tax Court decision sustaining deficiencies and penalties against taxpayers who sought to use their self-directed IRA plans to fund a business venture.

Under the facts of the case, Ellis v. Commissioner, No. 14-1310 (8th Cir. 2015), the taxpayers, a married couple, formed an LLC to engage in selling used automobiles. The LLC operating agreement listed two members: (1) a self-directed IRA belonging to the taxpayer-husband and (2) an unrelated person who worked full time for the LLC. The operating agreement outlined that the taxpayer’s IRA would provide an initial capital contribution of $319,500 in exchange for a 98% ownership interest and that the unrelated person would purchase the remaining 2% interest for $20.

The taxpayer was designated as the general manager and given “full authority to act on behalf of” the company. The operating agreement also stated that the “General Manager shall be entitled to such Guaranteed Payment as is Approved by the Members.” To compensate the taxpayer for his services as general manager, the LLC paid him a salary of $9,754 in 2005 and $29,263 in 2006. The wages were drawn from the LLC’s corporate checking account and were reported as income on the taxpayers’ joint tax returns for both years.

In 2011, the IRS issued a notice of a $135,936 income-tax deficiency for 2005 and imposed a $27,187 accuracy-related penalty. The IRS determined that taxpayer engaged in prohibited transactions by (1) directing his IRA to acquire a membership interest in the LLC with the expectation that the company would employ him and (2) receiving wages from the LLC. The notice explained that as a result of these transactions, the IRA lost its status as an individual retirement account and its entire fair market value was treated as taxable income. The taxpayer petitioned the Tax Court, which sided with the government.

On appeal, the Eighth Circuit upheld the Tax Court’s findings, holding that the Tax Court properly found that the taxpayer engaged in a prohibited transaction by directing the LLC to pay him a salary in 2005. The record established that the taxpayer caused his IRA to invest a substantial majority of its value in the business with the understanding that he would receive compensation for his services as general manager.

By directing the LLC to pay him wages from funds the company received almost exclusively from his IRA, the taxpayer engaged in the indirect transfer of the income and assets of the IRA for his own benefit and indirectly dealt with such income and assets for his own interest or his own account. These “prohibited transactions” caused the IRA to lose its qualified status and caused all its assets to be brought into taxable income.

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David Walser
+1 602 474 3410
david.walser@us.gt.com

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