IRA Owners Lose Big for Loan Guarantees

Tax Court Sends Message: Don’t Mix IRAs With Business Deals

Self-directed IRAs have become popular in recent years because they give taxpayers more control over investment options and expand the types of investments an IRA can hold, such as real estate, promissory notes, private businesses and precious metals. With this flexibility, however, comes some pitfalls. Unscrupulous promoters have entered the market and can entice taxpayers into risky investments. Further, careless advisers can recommend investment structures that won’t withstand IRS scrutiny. A long-time Kroger employee who had amassed more than $400,000 in his employer plan that was later rolled over into self-directed IRAs found this out the hard way, as is shown by a recent Tax Court case, Thiessen v. Commissioner.

The problem was that the taxpayer-investors, James and Judith Thiessen, guaranteed a loan made to a corporation owned by their IRAs. The Tax Court agreed with the IRS that the Thiessens’ loan guarantee amounted to a prohibited transaction with their self-directed IRAs. As a result, the entire IRA balance was deemed to be distributed to them in the year of the loan guarantee. The IRA balance was not only fully taxable, but also was subject to an early distribution penalty.

Details of the Prohibited Transaction

James Thiessen worked for Kroger in Colorado for 30 years. When he left the company, he and his wife had over $430,000 in Kroger employee retirement plans. On the advice of a broker, the couple rolled their employer accounts into self-directed IRAS and formed a new C corporation, Elsara Enterprises, Inc. Elsara then bought an unincorporated metal fabrication company, Ancona, from Polk Investments, Inc. As part of the sale, Polk loaned Elsara about one-third of the purchase price, $200,000. The Thiessens personally guaranteed the note from Elsara to Polk. This was their fatal error.

Prohibited Transactions Rule

The Tax Court held that the taxpayers’ guaranties of the loan were prohibited transactions because the guaranties amounted to an indirect extension of credit between the taxpayers and their IRAs. Under the prohibited transaction rules for self-directed IRAs, “disqualified persons” may not borrow or lend money to an IRA. Disqualified persons include fiduciaries. Owners of self-directed IRAs are considered fiduciaries under the prohibited transaction rules because they direct how IRA funds are invested. Because the Thiessens guaranteed the loan from Polk to Elsara, the Court found that the Thiessens as fiduciaries had indirectly extended credit to their IRAs, with the harsh result that the IRA status terminated and the taxpayers became immediately liable for tax on the amount invested.

Tax and Penalties

How much did it cost them? The IRA termination and deemed distribution gave them a $432,076 addition to ordinary income. A 10% penalty was added for a premature IRA distribution because both taxpayers were under the age of 59 ½ when the IRA status terminated. This resulted in the taxpayers being assessed a deficiency of $180,129—a big hit on their life-long savings.

IRS Time to Collect Extended

The transaction took place in 2003, but the IRS did not assess the deficiency until over three years later. Although IRS usually has only three years to assess a deficiency after a return is filed, that period is extended to six years if the taxpayer’s omitted income is over 25% of the income shown on the tax return in question and the taxpayer has not adequately disclosed the income. The Tax Court applied the six-year limitations period because it found that the deemed distribution exceeded 25% of the income on the 2003 return and that the taxpayers had not adequately disclosed the loan on their 2003 return. While the taxpayers had disclosed that they rolled over funds into the IRAs, they did not disclose the loan guarantee.

The Tax Court also rejected the taxpayers’ argument that they should have been given a chance to cure the prohibited transaction because it involved a stock acquisition. The Court said the acquisition of Ancona was an asset acquisition, which is not one of the categories that can be cured under the prohibited transaction rules.

Observations

Self-directed IRAs are popular because of the increased control they give taxpayers over their retirement investments. However, the danger is that taxpayers may be tempted to use their IRAs for personal purposes or to invest in their own businesses. The prohibited transaction law is complicated, but the courts have been clear: transacting business with your self-directed IRA won’t be tolerated.