A recent tax court case illustrates the importance of understanding and abiding by Self-Directed IRA prohibited transaction rules that govern self-directed IRAs and other retirement accounts. Yes, on the surface, these rules seem simple enough. But the Devil, as always, in the details – and so we still see owners of self-directed IRAs run into problems as courts apply the rules in unexpected ways.

Here’s what happened:

Two taxpayers wanted to buy an existing business for their IRAs. The two taxpayers were not related. The two taxpayers founded a new corporation in August of 2001, then in the very next month, each of these taxpayers had their self-directed IRAs purchase 50 percent of the stock, and then within days directed the new corporation to acquire the assets of the older existing corporation.

They structured the purchase, in part, using a promissory note to the seller, which they secured via personal guarantees.

Over the next few years, these two taxpayers converted their self-directed IRAs from traditional to Roth accounts. In 2006, both individuals directed their IRAs to sell the company, at a profit, to a third party buyer, who was also unrelated.

Personal Guarantees on IRA Loans Lead to Trouble

The IRS took a close look at the transaction and found a problem: The personal guarantees, the IRS held, violated Self-Directed IRA prohibited transaction rules. As most of our clients are aware, if you do use leverage within your self-directed IRA, you cannot pledge anything outside of the IRA as collateral. The loan must be on a non-recourse basis. A personal guarantee, even if not tied to a specific asset, still provides recourse to the borrower – in this case against everything the guarantors own outside of the IRA.

The law defining a Self-Directed IRA prohibited transaction, in this case a loan, is pretty broad: Section 4975(c)(1)(B) prohibits lending of money “or other extension of credit,” whether direct or indirect. So even though the loan was not secured by any piece of property outside of the IRAs, the loan guarantees, the court held, still involved the indirect extension of credit by a prohibited third party.

That wasn’t all: The IRS claimed upheld that the company’s payment of wages and salary to the taxpayers was also a prohibited transaction, as was the shell company’s payment of rent on property that was owned by an entity controlled by the two taxpayers’ spouses. As it turned out, the issue was moot, because the court disqualified the IRAs as of the date of the loan guarantees. Had the guarantees not been an issue, though, the IRAs would still have been in significant jeopardy of disqualification on these two counts, as well.

The court also disallowed the use of a shell company as a defense: If a prohibition on a transaction between two disqualified entities could be “easily and abusively avoided simply by having the IRA create a shell subsidiary,” that would not cut the legal mustard. The protections against potential conflicts of interests posed by improper transactions with prohibited entities, the courts ruled, were substantive and not merely cosmetic.

The penalty, in this case, was substantial: The immediate disqualification of the IRA, and an immediate and heavy tax liability to the respondents – made worse because of penalties, interest, court costs and attorneys’ fees.

The Importance of a Qualified, Expert Custodian or Administrator

The case underscores the importance of having an experienced custodian or third-party administrator in the process of running your self-directed IRA. It also underscores one of the drawbacks of a pure ‘checkbook IRA’ approach: The checkbook IRA model advanced by some may be appropriate for some, but without some serious and frequent consultation with tax and legal experts, it leaves taxpayers too directly exposed to administration mistakes that can have disastrous consequences. Had these individuals used American IRA, LLC (that’s us!) or some other similarly qualified administrator or custodian to handle transactions on their behalf, some of these transactions may have raised a risk flag in time to correct the issue before the IRS got involved.

As it stands now, the taxpayers lost their IRA, wound up paying a substantial amount in taxes, fees and penalties, and have no recourse to recoup their losses.

If you want an independent review of your IRA strategy – especially if you currently include or are interested in using self-direction as part of your strategy, call us today at 866-7500-IRA(472), or visit us at www.AmericanIRA.com. We look forward to working with you.

Image by: presentermedia.com