I blogged earlier this year about a tax court decision in which taxpayers used assets in their IRA to finance a new business in a structure sometimes known as ROBS or Rollover for Business Startups. Unfortunately, because of personal guarantees provided by the taxpayers at the time that the business owned by the IRA was sold, the IRA was held to have engaged in a prohibited transaction, thereby subjecting the value of the IRA, including the sales proceeds, to immediate taxation. Another recent tax court decision finds prohibited transactions in a similar situation but for a different reason.
In the recent tax court decision, an individual taxpayer rolled over proceeds from a prior employer’s plan into an IRA which then purchased the membership units of an LLC organized to operate a used car business. The IRA owed 98% of the LLC units. The LLC then elected to be treated as an association taxable as a corporation. That allowed the entity to avoid paying unrelated business income taxes which would have passed through to the IRA. The IRA owner was also the general manager of the business and was paid compensation for those services. The IRS claimed that the payment of that compensation constituted a prohibited transaction on the theory that the amounts paid to the individual constituted the use of plan (IRA) assets for the use of the IRA owner. The court determined that the taxpayer was the individual for whose benefit the IRA was established and controlled the investments within the IRA. Therefore, the taxpayer was a fiduciary of the IRA and in that capacity ultimately had discretionary authority to determine the amount of his own compensation. The court found that ability to be a form of self-dealing that was prohibited under the tax code.
The taxpayer argued that an exemption from the prohibited transaction rules allowed the payment of reasonable compensation for services rendered and that the amount of compensation he received was reasonable. The court concluded that the taxpayer could not rely on the reasonable compensation exception because that exception applied to reasonable compensation for services performed for the plan/IRA and the taxpayer’s services were not performed for the plan/IRA, but for the business itself. Therefore the exemption did not apply.
Because the payment of the compensation was a prohibited transaction, the value of the IRA was included in the taxable income of the taxpayer as of the date that the compensation was paid. The taxpayer also owed the 10% penalty tax on early distributions from an IRA since he was not yet 59½. The failure to report the IRA balance as income resulted in a substantial understatement of tax, creating an additional 20% penalty.
Individuals wanting to use their rollover IRAs as vehicles to finance new businesses have another reason to be cautious about proceeding with such an arrangement.