Prohibited transaction results in deemed IRA distribution

The Tax Court held that a loan guarantee accompanying an IRA-financed business acquisition was an indirect extension of credit.
By Charles J. Reichert, CPA

The Tax Court held that a married couple who guaranteed a loan to a company whose stock was owned by their respective individual retirement accounts (IRAs) engaged in a prohibited transaction resulting in a deemed distribution to each spouse. The court also held that the six-year statute-of-limitation period applied because the taxpayers failed to disclose the prohibited transaction on their income tax return.

Facts: In 2003, James and Judith Thiessen were interested in purchasing Ancona Job Shop, a metal products company owned by Polk Investments Inc., and they formed Elsara Enterprises Inc., a C corporation, as part of their purchase plan. A few days later, each spouse set up a self-directed IRA and transferred into them a total of $432,076 from their retirement plans as tax-free rollovers. The Thiessens then directed their IRAs to purchase a total of 10,000 shares of Elsara stock for $431,500. About 10 days later, Elsara purchased the assets of Ancona from Polk for $601,978, financed partially by Elsara's $200,000 note to Polk that the Thiessens personally guaranteed.

On their 2003 joint federal income tax return, the couple reported a tax-free rollover of $432,076 but failed to disclose the loan guarantee. The taxpayers petitioned the Tax Court for relief after they received a deficiency notice of $180,129 dated Feb. 18, 2010, slightly less than six years after they filed their 2003 return.

Issues: If the owner of an IRA or his or her beneficiary engages in a prohibited transaction during a tax year, the account ceases to be an IRA as of the first day of that year, and the account is treated as if all of the assets were distributed to the owner on the first day of the year. Prohibited transactions include selling property to the IRA, buying property for personal use with IRA funds, and any direct or indirect lending of money or other extension of credit between the IRA and a disqualified person. A disqualified person includes any person who exercises any control or authority over the management of the plan or its assets.

In Peek, 140 T.C. 216 (2013) (which involved the same CPA adviser and business brokerage firm as in this case; see "Tax Matters: Loan Guarantee Terminates IRA," JofA, Aug. 2013, page 61), the Tax Court held that a taxpayer, not his IRA, was the seller of stock because the taxpayer's loan guarantee was an indirect extension of credit, a prohibited transaction, that terminated the IRA prior to the stock sale. In this case, the IRS also argued the loan guarantee was an indirect extension of credit and thus a prohibited transaction.

If a taxpayer fails to report gross income in excess of 25% of the amount of gross income reported on the taxpayer's return, the six-year statute of limitation applies. In computing the amount of gross income omitted for this purpose, any amount disclosed in the return, or in a statement attached to the return, in a manner adequate to apprise the IRS of the nature and amount of such item is not taken into account. Whether a taxpayer has adequately disclosed an amount depends on whether a reasonable person looking at the return could determine that the disputed income was omitted. The IRS argued that the taxpayers' 2003 return did not meet this standard because it stated only that a $432,076 rollover had occurred and did not disclose the loan guarantee.

Holding: The court followed its decision in Peek and held that the loan guarantee was a prohibited transaction because it was an indirect extension of credit. As a result, the assets of the IRA were deemed to have been distributed to the taxpayers on the first day of 2003 and were subject to income tax and the 10% early withdrawal penalty. The court also held that Sec. 4975(d)(23)—which can exempt from treatment as a prohibited transaction the extension of credit between an IRA and a disqualified person in connection with the acquisition, holding, or disposition of a security or commodity—did not apply in this case because the taxpayers' loan guarantees were related to the purchase of Ancona's assets rather than the purchase of Elsara's stock.

The court also held that the six-year statute of limitation applied because the 2003 return, including any attachments, did not disclose that the taxpayers' loan guarantees might be prohibited transactions or create income from those transactions. According to the court, a reasonable person would be unable to determine from the information reported on the 2003 return whether any gross income had been omitted.

  • Thiessen, 146 T.C. No. 7 (2016)

—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.

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