The Tax Court held that two taxpayers’ personal guarantees of a loan to a company whose stock was owned by their individual retirement accounts (IRAs) were indirect extensions of credit to the IRAs, a prohibited transaction. Thus, the IRAs ceased to qualify as IRAs at the beginning of the tax year in which the taxpayers made the guarantees, and they were required to report the gain from the sale of the stock held in their terminated IRAs on their individual income tax returns.
An IRA loses its tax-advantaged status as of the first day of a tax year in which the owner or the owner’s beneficiary engages in any of the transactions prohibited by Sec. 4975. Sec. 4975(c)(1)(B) prohibits any direct or indirect “lending of money or other extension of credit between a plan and a disqualified person.” A disqualified person includes an IRA’s fiduciary, defined as any person who exercises any discretionary authority or control related to the management of the IRA or authority or control respecting management of or disposition of its assets.
In 2001, Lawrence Peek and Darrell Fleck each established a self-directed IRA that was funded with a rollover from a regular IRA and Sec. 401(k) account, respectively. Later that year, each IRA purchased 50% of the stock of FP Co. Inc., a new Colorado corporation formed by Peek and Fleck. FP Co. purchased most of the assets of Abbott Fire & Safety Inc. with cash from the IRAs and three loans, one of which Peek and Fleck personally guaranteed.
Both taxpayers converted their IRAs to Roth IRAs in 2003 and 2004, half in each year, reporting the fair market value of the converted amounts on their individual income tax returns in those years. In 2006, both Roth IRAs sold their FP stock at a substantial gain, each receiving payments in 2006 and 2007. In 2010, the IRS issued deficiency notices for 2006 and 2007 due to each taxpayer’s failure to report capital gain from the FP stock sale on his respective individual tax return. The IRS contended that the loan guarantees, a prohibited transaction, had terminated their IRAs as of Jan. 1, 2001, resulting in a distribution of the stock to the taxpayers. Thus, the taxpayers, not the IRAs, owned the stock when it was sold in 2006. Peek and Fleck petitioned the Tax Court for relief in 2011.
The taxpayers argued the prohibition applies only to credit extended between the IRA and a disqualified person and, although the taxpayers were disqualified persons, they extended credit to an entity owned by an IRA rather than to the IRA itself. According to the court, such an interpretation “would rob [Sec. 4975(c)(1)(B)] of its intended breadth,” and taxpayers could easily avoid the provision by having their IRAs establish a shell corporation and then personally loan money to that corporation. The court held that, given the intent of Sec. 4975(c)(1)(B), the taxpayers were prohibited “from making loans or loan guaranties … indirectly to their IRAs by way of the entity owned by the IRAs,” and their accounts did not qualify as IRAs in any tax year the indirect lending relationship remained in place, which included 2006, the year the FP stock was sold. Thus, when the FP stock was sold, it was the taxpayers who sold the stock, making any gain from the sales taxable to them, according to the court.
The court also upheld the IRS’s assessment of the 20% accuracy-related penalty.
Peek, 140 T.C. No. 12 (2013)
By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.