IRA-owned LLC’s payment to owner results in retroactive tax and penalties

The Tax Court held that compensation received by a taxpayer from a limited liability company (LLC) that was almost entirely owned by the taxpayer’s individual retirement account (IRA) resulted in several types of self-dealing prohibited transactions. Thus, the IRA owning the LLC automatically terminated as of the first day of the tax year in which the prohibited transaction occurred (2005), resulting in income tax on the constructive IRA withdrawal of more than $320,000, plus a 10% early-distribution penalty and a 20% accuracy-related penalty. In addition, any income occurring within the IRA/LLC in future years was subsequently includible in the taxpayer’s personal income tax return in the applicable tax year, based on the deemed distribution of all of the IRA’s assets to the taxpayer on Jan. 1, 2005.

An IRA loses its tax-advantaged status as of the first day of the tax year in which a disqualified person engages in any transactions prohibited by Sec. 4975. Sec. 4975(c)(1)(D) prohibits transfers to, or use by or for the benefit of, a disqualified person of the income or assets of a plan, and Sec. 4975(c)(1)(E) prohibits a disqualified person who is a fiduciary from dealing with the income or assets of an IRA for his or her own interest or account. Under Sec. 4975(e)(2), a disqualified person includes an IRA’s fiduciary, which includes the IRA owner if he or she exercises any discretionary authority or control related to the management of the IRA, and a corporation or partnership of which 50% or more is owned directly or indirectly by a disqualified person. For more on prohibited transactions, see “Self-Directed IRAs: A Tax Compliance Black Hole,” JofA, Oct. 2013, page 44.

In 2005, Terry Ellis established a self-directed IRA that was subsequently funded using two rollovers from a Sec. 401(k) plan with his former employer. The IRA then purchased 98% of the membership units of CST Investments LLC for nearly $320,000—resulting in the IRA’s only assets being CST units and less than $2,000 of cash. CST, managed by Ellis, used its capital to operate a used-car business. CST paid Ellis $9,754 in compensation for his role as manager during tax year 2005 and $29,263 in 2006.

In March 2011, the IRS issued deficiency notices for tax years 2005 and 2006, based on the theory that Ellis’s IRA committed a prohibited transaction in either 2005 or 2006, thereby terminating the IRA in its entirety and resulting in a complete and retroactive distribution of the IRA’s assets to Ellis. Ellis petitioned the Tax Court for relief.

In its ruling, the court reinforced the principle that an IRA owner who exercises discretionary control over an IRA’s investments is a fiduciary under Sec. 4975(e)(3) and thus a disqualified person under Sec. 4975(e)(2)(A). For this reason, Ellis was a disqualified person. Further, under the disqualified person rule in Sec. 4975(e)(4) and the constructive ownership rule of Sec. 267(c)(1), the IRA was treated as proportionately owning the assets of CST, meaning that transactions between CST and Ellis were no different from transactions between the IRA and Ellis. Importantly, the court held that the initial purchase of LLC units by Ellis’s IRA was not a prohibited transaction. However, the payment of compensation to Ellis was prohibited under Secs. 4975(c)(1)(D) and (c)(1)(E), and thus a complete taxable distribution of all IRA assets (including units of CST) occurred on Jan. 1, 2005. All transactions in years after 2005 were deemed irrelevant.

Finally, the court upheld the IRS’s assessment of the 10% early-distribution penalty under Sec. 72(t) and the 20% substantial-understatement penalty under Sec. 6662(a).

  Ellis, T.C. Memo. 2013-245

By Warren L. Baker, J.D., LL.M., a tax attorney with Amicus Law Group PC in Seattle.