IRA’s Ownership of Taxpayer’s Business Resulted in Prohibited Transaction

Ellis, TC Memo 2013-245

In May, 2005, Terry Ellis, organized CST, an LLC. The operating agreement of CST was signed by Ellis on behalf of the Terry Ellis IRA, an entity that did not yet exist. The agreement listed the original members of CST as the Terry Ellis IRA, owning 980,000 membership units or 98% in exchange for an initial capital contribution of $319,000, and a member not a party to the case owning the remaining 20,000 membership units or 2%.

CST was formed to engage in the business of used car sales. Ellis was the general manager of CST. In June, 2005, Ellis created the Terry Ellis IRA. Shortly thereafter, he transferred $319,000 from his 401(k) account with a former employer to the IRA and caused CST to issue the IRA the 980,000 units of CST. CST elected to be treated as an association taxable as a corporation.

During tax year 2005, CST paid Ellis $9,754 as compensation for his role as general manager of CST. CST made these payments through checks issued from its corporate checking account, and not from the custodial account of Ellis’ IRA. CST deducted that amount on its corporation tax return.

Mr. and Mrs. Ellis’ 2005 return reported the $9,754 as taxable compensation. They also reported pension distributions from the 401(k) but did not report any portion of these distributions as taxable.

IRS issued Mr. and Mrs. Ellis a notice of deficiency. IRS’s determinations in the notice were based on the premise that at one of the following alternative points, Ellis engaged in a prohibited transaction under Code Sec. 4975 with his IRA: (1) when Ellis caused his IRA to engage in the sale and exchange of membership interests in CST; or (2) when Ellis caused CST, an entity owned by his IRA, to pay him compensation.

Code Sec. 4975 sets forth certain prohibited transactions with respect to qualified retirement plans, including IRAs. Code Sec. 4975(c) defines these prohibited transactions and includes as prohibited transactions any direct or indirect: (1) sale or exchange, or leasing, of any property between a plan and a disqualified person; (2) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; and (3) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account.

The purpose of Code Sec. 4975, in part, is to prevent taxpayers involved in a qualified retirement plan from using the plan to engage in transactions for their own account that could place plan assets and income at risk of loss before retirement.

For the purposes of Code Sec. 4975, a fiduciary of a plan is defined as any person who: (1) exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets; (2) renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so; or (3) has any discretionary authority or discretionary responsibility in the administration of such plan. A fiduciary of a qualified retirement plan is also a disqualified person for the purposes of Code Sec. 4975.

In addition to a fiduciary as defined above, the term “disqualified person” under Code Sec. 4975(e)(2) also includes a corporation or a partnership of which 50% or more of (1) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation, or (2) the capital interest or profits interest of a partnership, is owned directly or indirectly or held by a fiduciary as described in Code Sec. 4975(e)(2)(A). Code Sec. 4975(e)(2)(G) incorporates the constructive ownership rule of Code Sec. 267(c)(1), which provides that stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries.

If, during any tax year of an individual for whose benefit any IRA is established, that individual or his beneficiary engages in a prohibited transaction under Code Sec. 4975, the account will cease to be an IRA as of the first day of the tax year. In such a case, the IRA in question will no longer be exempt from tax under Code Sec. 408(e)(1). Further, where such an account ceases to be an IRA by reason of Code Sec. 408(e)(2)(A), the account is deemed to have been distributed on the first day of the tax year.

Except as otherwise provided in the income tax portion of the Code, gross income includes all income from whatever source derived including any amount paid or distributed out of an individual retirement plan, in the manner provided under Code Sec. 72. Code Sec. 72(t) imposes a 10% additional tax on early distributions from qualified retirement plans unless the distribution falls within a statutory exemption.

The Court concluded that the formation of CST didn’t involve any prohibited transaction, but that the compensation that CST paid to Ellis was a prohibited transaction.

As a result of the payment of compensation being a prohibited transaction, the full amount that Ellis transferred to the IRA from his old 401(k) account was deemed distributed on January 1, 2005, under Code Sec. 408(e)(2)(A). That amount was therefore includible in the Ellises’ gross income for tax year 2005 under Code Sec. 72(a) and Code Sec. 4975. And, when it found no exception to the 10% additional tax under Code Sec. 72(t), the Court also said that the Ellises were liable for that additional tax.

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