An individual had his IRA acquire 98% of the interests of a limited liability company (LLC) he formed to operate a used car business. The LLC’s paid him compensation for his services to the business. The United States tax Court held that the payment of compensation by the LLC to the IRA owner was a prohibited transaction resulting in disqualification of the IRA and a deemed distribution of its assets.
Facts. Terry Ellis created an IRA and rolled over $319,000 from a 401(k) plan from a previous employer. Ellis, organized LLC to operate a used car business. The IRA acquired 98% of the membership interests in the LLC in exchange for an initial capital contribution of $319,000, and a member not a party to the case acquired the remaining 2%. Ellis elected to have the LLC taxed as a corporation.
IRS determined that Ellis engaged in a prohibited transaction with his IRA: (1) when Ellis caused his IRA to engage in the sale and exchange of membership interests in the LLC; or (2) when Ellis caused the LLC to pay him compensation.
Prohibited Transactions. The Internal Revenue Code sets forth certain prohibited transactions with respect to qualified retirement plans, including IRAs. Prohibited Transactions include any direct or indirect: (1) sale or exchange, or leasing, of any property between a plan and a disqualified person; (2) the furnishing of goods or services between a plan and a disqualified person; (3) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; and (4) 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 these rules is to protect the plan from risk of loss.
A fiduciary of a plan is a disqualified person. Ellis was a fiduciary of his IRA because he could exercise control over the management of the IRA and the disposition of its assets. A “disqualified person” also includes an entity of which 50% or more of the ownership interests, is owned directly or indirectly or held by a fiduciary.
Court Holdings. The Court concluded that the formation of the LLC didn’t involve any prohibited transaction, because the LLC was not a disqualified person at the time it acquired issued the membership interests to Ellis. This was so because, until the membership interests were issued to the IRA, the IRA did not own any interest in the LLC.
But, the Court agreed with IRS that by paying Ellis compensation, he engaged in the prohibited transactions described in clauses (3) & (4) above. Ellis was the sole individual for whose benefit the IRA was established and therefore the beneficial owner of 98% of the outstanding membership interests of the LLC. Because Ellis, a fiduciary of his IRA, was the beneficial shareholder of more than 50% of the outstanding ownership interest in the LLC, the LLC was also a disqualified person.
Ellis argued that he did not engage in a prohibited transaction when he caused the LLC to pay him compensation because the amounts it paid to him did not consist of plan income or assets of his IRA but merely the income or assets of a company in which his IRA had invested. However, CST was funded almost exclusively (98%) by the assets of Ellis’ IRA. Furthermore, the assets of Ellis’ IRA consisted only of its ownership interest in the LLC. Therefore, the Court concluded that to say that the LLC was merely a company in which Ellis’ IRA invested was a complete mischaracterization when in reality the LLC and the IRA were substantially the same entity. In causing the LLC to pay him compensation, Ellis engaged in the transfer of plan income or assets for his own benefit and dealt with the income or assets of his IRA for his own interest or for his own account.
The prohibited transaction rules also contain several exemptions. One exemption states that the receipt by a disqualified person of any reasonable compensation for services rendered, or for the reimbursement of expenses properly and actually incurred, in the performance of his duties with the plan does not result in a prohibited transaction. The Court, however, held this exemption did not apply because the amounts the LLC paid as compensation to Ellis were not for services provided in the administration of a qualified retirement plan in managing its investments, but rather for his role as general manager of the LLC in connection with its used car business. This conclusion is questionable in light of the Court’s conclusion that the LLC and the IRA were “substantially the same entity.” If they are the same entity, services provided to the LLC should be considered services provided to the IRA.
The Effect of Ellis Entering into a Prohibited Transaction. As a result of the Court’s finding that a prohibited transaction had occurred the full amount that Ellis transferred to the IRA from his old 401(k) account was deemed distributed to him on Jan. 1, 2005. That amount was therefore includible in his gross income for 2005. And, when it found no exception to the 10% additional tax for an early distribution, the Court also found Ellis liable for that additional tax. The Court also found Ellis liable for a 20% substantial understatement penalty although he did not seek to assert any defense for that penalty.
Conclusion. One might question whether the result in this case would have been the same had the IRA owned other substantial assets. Nevertheless, the IRS publically announced several years ago that it will closely scrutinize transactions where the sole participant of a qualified plan causes the plan to acquire the assets of a business to be run by that participant. Moreover, in a prior case, the Tax Court held that an IRA owner’s guarantee of a loan to a corporation owned by the IRA was a prohibited transaction on the basis that the guarantee was an indirect extension of credit to the IRA since the IRA owned the corporation.
Therefore, anyone contemplating using a qualified plan or IRA to acquire a business in which they will work or to which they will loan funds or provide guaranties, should proceed cautiously after seeking appropriate professional advice.