Having worked with many families in the administration of their loved ones’ estates, I can report anecdotally that over the last decade, tax-deferred retirement assets have constituted an ever-increasing share of individual wealth, even for those estates that fall below the estate tax exemption amount. Such tax-deferred assets come in many different forms; some of the more popular vehicles include the individual retirement account (IRA), the 401(k) account, and the 403(b) account.  As such assets are creatures of highly-technical tax statutes and regulations, dealing with them often requires a greater level of care and attention to detail than the “run of the mill” real estate, corporate, and partnership assets.  This reality is most often acknowledged by (and causes the most consternation to) my colleagues and me when planning for the testamentary disposition of retirement assets, such as ensuring that a trust named as beneficiary of a retirement asset satisfies the complex rules regarding continued income tax deferral. IRA

Although planning for the transfer of a decedent’s IRAs requires careful navigation around many mines, death is not the only time to be aware of the IRA rules. Indeed, many business owners have, over the years, viewed their IRAs as a ready source of funds.  In their haste to access these funds, they often discover, too late, that they have made a terrible mistake.  A recent U.S. Tax Court decision drives home the point that great care and attention is required where a business owner-IRA participant wants to use his or her IRA to fund a business.  The simple lesson to be learned is that participants are not as free to deal with their tax-deferred assets as they are with their other assets.

When reading the decision, the Taxpayers, husband and wife, both under 59 years of age, come across as sympathetic. The husband was a former 30-year employee of a grocery store chain who decided to pursue his dreams and follow his entrepreneurial spirit by investing in a metal fabrication business, a field he had long ago studied in college; the wife was an employee of the same company.  They seemingly did all the right things before taking the plunge into a new business: they consulted with an accountant, a lawyer, and an experienced business broker in order to ensure the deal was structured wisely.

The business broker advised Taxpayers that they could roll over the funds in their respective retirement accounts from the grocery store into new IRAs, cause the IRAs to acquire the initial stock of a newly-formed C corporation, and cause the C corporation to acquire the existing business. More than that, the brokerage company explained that it typically recommended to its clients acquiring companies that they borrow and issue a note to the seller as part of the consideration for the sale so that “the seller would have an interest in helping the buyer.”  In this context, that meant causing Taxpayers’ newly formed C corporation to “borrow” funds from, and issue a note to, the seller of the existing business (an installment sale).

Taxpayers then retained an accountant to advise them about the IRA funding structure. Incidentally, the accountant was referred to Taxpayers by a friend who had recently utilized the same IRA funding structure in his own business acquisition (query whether the friend’s structure was also scrutinized by the IRS).  They also retained legal counsel to establish the C corporation that acquired the target metal fabrication business.  Taxpayers were named as the sole officers and directors of the C corporation.  They then rolled over their retirement accounts at the grocery store, approximately $432,000 in the aggregate, to new, self-directed IRAs custodied at a local financial institution.  Because the IRAs were self-directed, Taxpayers retained all discretionary authority and control concerning the investment of their respective IRA’s assets.

Taxpayers directed the IRAs to purchase shares of the newly-formed C corporation, which, in turn, purchased the existing metal fabrication business. The consideration for the business consisted, in part, of a $200,000 promissory note issued by the C corporation to the seller.  The note was secured by the business’s assets and was personally guaranteed by the Taxpayers, i.e., the IRA participants.

All of the above-described transactions took place during the same tax year. On their personal income tax return filed for said tax year, Taxpayers reported the IRA rollovers, but did not disclose the guaranties of the loan or, as the Tax Court noted, “any other fact that would have put [the IRS] on notice of the nature and the amount of any deemed distribution resulting from the guaranties.”

The IRS nevertheless discovered the transaction and issued a notice of deficiency for approximately $180,000, primarily attributable to an understatement of income in the approximate amount of the IRAs that were rolled over, i.e., about $432,000 in the aggregate. At the Tax Court, the IRS argued that the IRAs ceased to be IRAs when the taxpayers guaranteed the note issued by the C corporation, which was wholly-owned by the IRAs.  The Tax Court agreed.

The Code provides that if an IRA participant engages in any “prohibited transaction” with respect to the IRA, such IRA ceases to be an IRA as of the first day of the taxable year in which such prohibited transaction took place. A “prohibited transaction” includes any “direct or indirect … lending of money or other extension of credit between a plan and a disqualified person….”  The Taxpayers fell within the meaning of “disqualified person.

The Tax Court, citing prior case law, agreed with the IRS’s argument that the Taxpayers’ guaranties constituted indirect extensions of credit to their respective IRAs. Thus, the Taxpayers’ entire IRAs were deemed to have been distributed to them in a taxable transaction.

Again, the simple lesson is that IRA participants are not as free to deal with their tax-deferred assets as they are with their other assets. There are myriad traps for the unwary.  Red flags should certainly be raised whenever either a loan or guaranty is being made, directly or indirectly, in connection with an IRA.  Taxpayers, and their advisors, are well-advised to seek the appropriate counsel to avoid such a terrible outcome as discussed above.