In today’s cautionary tale, we hear about a doctor, his self-directed simplified employee pension (“SEP”) individual retirement account (“IRA”), the investment of IRA funds in a business, and the consequences of crossing over the perilous line between “direction” and “control.”
The Facts
Dr. V., an anesthesiologist, ran a medical practice with three partners (the “Practice”). Prior to the time of this case, the Practice had adopted a self-directed SEP plan arrangement with Investment Firm, through which the Practice made deductible contributions to the Plan, and the contributions were then placed in self-directed IRAs set up for each partner through the SEP plan arrangement. Investment Firm was the custodian of Dr. V.’s SEP-IRA. 
Historically, Dr. V. had instructed Investment Firm to invest the contents of his SEP-IRA in mutual funds and stocks. In 2011, however, upon hearing of an investment opportunity from a friend, Dr. V. decided to try a more adventurous vehicle for the contents of his SEP-IRA.
Dr. V.’s friend, Mr. C., was involved in a publicly-traded company, PubCo. PubCo was looking to raise capital in the short-term, as it expected to receive funding from a large company in the near future. Trusting his friend’s business sense and descriptions of X’s potential, Dr. V. agreed to loan X $125,000 from his SEP-IRA, and a contract memorializing the same was prepared (the “Agreement”).
The Agreement
The Agreement, titled “Corporate Loan Agreement/Promissory Note,” was between “PubCo or Mr. C.” as the borrower, and “Dr. V., SEP-IRA” as the lender. It specified that it was for $125,000, but not how that sum would be advanced. It did, however, provide specific details about the maturity date, interest payments, and late fees. Significantly, as it turned out, the Agreement provided that the borrower would repay the loan to “Dr. V.” at his personal residence, and Dr. V. and Mr. C. each signed the Agreement in their respective personal capacities. Dr. C. later testified that the Agreement was worded as such because he wanted Dr. V. to know that the funds were specifically for PubCo expenses, but that he, Mr. C., would be responsible for repayment.
Transfer of Funds
Dr. V. then signed a form titled “Retirement Distribution or Internal Transfer” requesting that Investment Firm distribute $125,000 from his SEP-IRA to his joint account with his wife at Investment Firm; wired that amount from the joint account to his personal account at Bank; and then wired the same amount from Bank to an account titled “Mr. C.” at a different bank.
Reporting the Distribution
Using the same accounting firm, M&M, that they had for over twenty years, Dr. V. and his wife (together, the “Taxpayers”) filed a joint Form 1040 for 2011. Dr. V. explained to the return preparer what had happened with the distribution from his SEP-IRA, and documentation reporting the sequence of events leading up to the loan. On the advice of the M&M accountant, Dr. V. and his wife reported that they had received $125,000 in pensions and annuities, but characterized it as a nontaxable rollover. They included with their return a copy of the Agreement, as well as a letter from M&M stating that the return preparer believed that the funds were directly rolled over from the SEP-IRA to either PubCo’s account or Mr. C.’s account.
Notice of Deficiency
Following examination of the return, the Commissioner issued a notice of deficiency determining a $52,682 deficiency in income tax, and determining an additional tax under section 72(t) of the Code and an accuracy-related penalty for a substantial understatement of income tax. The Taxpayers petitioned for a redetermination of the deficiency.
The Arguments
The Taxpayers argued that they did not receive a distribution from the SEP-IRA because the various transfers should be stepped together and treated as an investment by the SEP-IRA in PubCo. Alternatively, they contended that the withdrawal was a non-taxable rollover.
The Commissioner argued that the loan was a taxable distribution used to finance a loan from Dr. V. to Mr. C.
The Tax Court Weighs In
Under section 408(d)(1), any amount paid or distributed out of an IRA must be included in the gross income of the payee or distribute as provided in section 72. The Taxpayers argued that Dr. V. did not have a claim of right to the $125,000 withdrawn from the SEP-IRA because he was acting as a mere conduit in transmitting the funds to Mr. C.
Claim of Right
The Court stated that a taxpayer has a claim of right to income if the taxpayer:
- Receives the income;
- Controls the use and disposition of the income; and
- Asserts either a “claim or right” or entitlement to that income.
The Court found that Dr. V. met these requirements, as he had “unfettered control over the funds” at all times.
The Court rejected the Taxpayers’ reliance on two previous cases in which the Court had found taxpayers to be a “custodians” of funds coming out of their self-directed IRAs for various investments. In both of those cases, the taxpayers at issue were never the payees of the funds to be invested. Rather, they merely assisted in having the funds transferred. In the case at issue, the Court pointed out, at no time was the note held by Dr. V.’s IRA, and at all times it was payable to Dr. V. personally.
Rollover
Section 408(d)(3) of the Code provides an exception to the general rule that any amount paid or distributed out of an IRA must be included in gross income. It provides that the taxpayer does not have to include such an amount if the entire amount that he or she receives is paid into an IRA or other eligible retirement plan within 60 days of the distribution.
The Taxpayers argued that if the amount at issue was a distribution, it was reinvested in the SEP-IRA within the prescribed 60-day period. In this argument, the Taxpayer essentially asked the Court to disregard the various agreements executed in connection with the transaction, and to find that the distribution was made directly to Mr. C.
The Court also rejected this argument, applying a “strong proof” for the case when taxpayers attempt to disregard the form of their own transactions. The Court found that the substance of what had occurred was entirely consistent with the form.
Conclusion
Self-directed IRAs provide taxpayers with a great deal of freedom in choosing how their retirement funds are invested. Thus a taxpayer may, subject to certain limitations, direct that the IRA funds be invested in a business venture. It is critical, however, that a taxpayer know where his or her personal involvement must cease. As Dr. V. learned the hard way, sometimes (and, in the case of handling IRA funds, all the time), it is not enough for one’s transactions to have a permissible objective; that objective must also be reached through a permissible route, with no extra “assistance” to affect its path.