Be careful about taking any kind of direct payments or benefits from a company you own within a Self-Directed IRA. You could cause the entire Self-Directed IRA to be disallowed in an instant, causing immediate and full distribution, along with all the unwanted taxes and penalties that go along with it.
In a 2013 ruling, the U.S. Tax Court ruled for the IRS and upheld the principle that Self-Directed IRA owners act as fiduciaries when they exercise direct control over their IRA investments – and therefore are included under the definition of “disqualified persons.”
Here’s how it went down: In 2005, an investor named Terry Ellis funded a Self-Directed IRA with two rollovers from a former employer. Terry then had the IRA invest its assets in 98 percent of the membership units of a limited liability company called CST Investments, LLC – almost $320,000 worth. The end result was that the IRA was almost fully invested in CST and had less than $2,000 in cash.
Ellis continued to directly manage CST and used the LLC to operate a car sales business. In so doing, Ellis had CST pay him $9,754 in compensation for all his work managing the used car business in 2005, and another $29,263 the following year.
The IRS didn’t buy it – and ruled that Ellis’s IRA’s payment to its own owner constituted a prohibited transaction. The IRS ruled that the payment entirely disqualified the IRA – and resulted in a distribution of the entire amount, which naturally resulted in income taxes and penalties.
Ellis contested the ruling, but as we mentioned, the court ruled for the IRS. Indeed, Ellis was a disqualified person, exercising constructive ownership of the LLC. The Tax court ruled that there was no real difference between CST dealing directly with Ellis and the IRA dealing with Ellis – and as most IRA investors know, IRAs cannot transact directly with their owners except in the form of contributions and distributions.
Interestingly, the court had no problem with the investment in the LLC itself – upholding the longstanding ability of IRA owners to invest their IRA assets in LLCs along with more traditional IRA assets. The court merely ruled that CST’s direct payment to Ellis constituted a prohibited transaction under Section 4975(c)(D) and (c)(1)(E). And therefore the court deemed that the entire IRA was distributed as of January 1, 2005. The court held that later transactions had no bearing on the nature of the LLC, which now became a taxable asset rather than an asset in a tax-advantaged account.
The court also ruled in favor of the IRS’s ruling that in addition to the income taxes, Ellis also owed 10 percent in early withdrawal penalties.
Naturally, Ellis will have to come up with the liquidity to pay the taxes and penalties associated with a distribution of some $320,000 in assets.
The takeaway, of course, is that Self-Directed IRA investors should be very careful of anything that smells – or could smell – of self-dealing in any way. Any arrangement that provides a tangible benefit to the IRA owner or another disqualified individual (self, spouse, parent, grandparent, child, grandchild, spouse of any of the above, and advisors providing services related to the IRA in a fiduciary capacity) should be considered suspect and handled with extreme caution.
Had Ellis been content to let the capital build up inside the IRA and lived on other funds, rather than try to draw a salary from his own IRA, he probably would have been fine. Alas, Mr. Ellis and his spouse will be scrambling to pay the taxes and penalties – and will miss out on many years of potential tax-deferred compounding.
For the full ruling, see Ellis, T.C. Memo 2013-245.
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