Loan Guarantees Violate Self-Dealing Rules, Strip IRAs of Tax-Deferred Status

A recent tax court case serves an important notice to retirement investors across the country. A pair of taxpayers discovered the hard way that, when they chose to place IRA funds into “alternative” assets, they engaged in prohibited transactions that terminated their IRAs’ tax-deferred status. The case serves as a reminder that taxpayers should only use alternative assets in their IRAs under very specific circumstances, and only after careful review by their tax professionals, or else run the risk of very severe penalties.

The two men managed to trigger exactly such an involuntary termination when they invested their traditional IRA funds in the purchase of FP Corp., a fire safety business. The men used rolled-over cash from their IRAs to purchase 100% of FP’s stock. FP took out certain loans as part of the purchase, which the men personally guaranteed. The taxpayers subsequently sought to roll over their FP stock from traditional to Roth IRAs. After a few years, with FP’s stock having appreciated substantially, the men sold their stock. The Internal Revenue Service contended that the men’s personal guarantees were prohibited under the rules and, therefore, the gain the men realized on their stock sale should count as income to them.

The US Tax Court issued a decision in Peek v. Commissioner that sided with the IRS. The tax code’s rules regarding IRAs specifically prohibit them from engaging in “any direct or indirect … lending of money or other extension of credit [to] a disqualified person,” including the IRA’s owner(s). In a nutshell, these “self-dealing” barriers prohibit an owner’s IRA from engaging in business transactions with the owner, the owner’s family or the owner’s business. Violating these rules causes the owner’s IRA to lose its tax-deferred status, creating an immediate tax liability and the likely imposition of penalties, as well. If the owner is younger than age 59½, then premature distribution rules also apply. The taxpayers argued that, because the guarantees were between the men and FP, they did not implicate the prohibited transactions rule. The court, however, rejected this interpretation, concluding that the guarantees constituted indirect credit activities. Allowing investors to use IRAs in the manner suggested by the taxpayers would create a massive loophole permitting an end-run around the statute’s intent, the court reasoned. The “prohibition could be easily and abusively avoided simply by having the IRA create a shell subsidiary to whom the disqualified person could then make a loan,” the court wrote.

With the volatility of the stock market in recent years, investors have aggressively sought alternate methods for investing their IRA funds. Seeking alternative vehicles for your IRA can offer great financial rewards, but must be done with the greatest of care and diligence, as the harm resulting from engaging in a prohibited transaction is so great. For the highest caliber of knowledgeable and personalized advice about your IRA, speak to the tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C., who have years of experience assisting investors throughout New York and New Jersey to ensure their IRA investments meet all the rules for maintaining tax-deferred status. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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