As self-directed Individual Retirement Accounts become more popular, their owners and beneficiaries need to be aware of the rules regarding prohibited transactions to avoid pitfalls. Failure to follow the rules for self-directed IRAs can risk the tax-deferred status of the IRA account, which could make the entire balance taxable to the owner in the year of the infraction. If the owner is not yet 59 ½ years old, the 10 percent penalty for early withdrawal will also apply.
A self-directed IRA is not a recent phenomenon. They’ve been around since the IRA was created in 1974, and the Internal Revenue Service has always allowed investments in alternatives to traditional stocks, bonds and mutual funds. There are only a few investments that are not allowed to be held by an IRA. The IRS does not provide guidance on what is permitted; it only lists the investments that are NOT allowed. Examples of prohibited IRA investments include collectibles such as artwork, antiques and certain coins. Life insurance is also a prohibited investment for an IRA. IRS Publication 590 provides more information regarding prohibited investments.
The IRS rules for IRAs also dictate what transactions involving an IRA are prohibited. Generally, a prohibited transaction is any improper use of an IRA account by the owner, the beneficiary or any “disqualified person.” Investments made with a self-directed IRA must be at arm’s length. Prohibited transactions include investments with disqualified persons, self-dealing, and receiving indirect benefits. Specific examples include selling property to the IRA, buying property for personal use with IRA funds, and any lending of money or extension of credit to disqualified persons.
Disqualified persons are defined as individuals or entities between whom (or which) an IRA is prohibited from engaging in any direct or indirect sale or exchange or leasing of any property; lending of money or other extension of credit; furnishing goods, services or facilities; or transferring to or permitting the use of IRA income or assets. Such persons include family members of the IRA owner, fiduciaries, service providers of the IRA (i.e., custodians and financial planners) and any entities of which 50 percent or more is owned directly or indirectly by the IRA owner.
If the IRA owner or his or her beneficiary engage in a prohibited transaction during a tax year, the account ceases to be an IRA as of the first day of that tax year, and the account is treated as if all the assets were distributed to the owner on the first day of the year. The distribution would then be subject to taxation at ordinary rates. The IRS imposes these strict rules on IRAs because the purpose of the IRA is to provide for future retirement. If the IRA is engaging in transactions that currently benefit the owner, it is considered to be an “indirect benefit,” which is prohibited under the IRA rules. Also, it is important to note that losses on investments held inside an IRA are not tax deductible for the owner.
James and Judith Thiessen learned about prohibited transactions the hard way. In 2003, they were interested in purchasing a metal products company. As part of their plan to purchase the company, they formed a C corporation. A few days later, each spouse set up self-directed IRAs and funded them with other retirement funds transferred via tax-free rollovers. The couple then directed their IRAs to purchase stock of the C corporation. About 10 days later, the C corporation purchased the metal products the company financed partially by a $200,000 note from the C corporation that the Thiessens personally guaranteed. The couple reported the tax-free rollover on their 2003 joint income tax return, but failed to disclose the loan guarantee. The IRS examined the return, discovered the prohibited transaction (the loan guarantee), disqualified the IRAs and assessed a deficiency of over $180,000.
The Thiessens petitioned the U.S. Tax Court for relief, but found none (see Thiessen v. Commissioner, 146 T.C. No. 7 2016). The Tax Court held that the loan guarantee was a prohibited transaction because it was an indirect extension of credit. As a result, the assets of the IRAs were deemed to have distributed to the Thiessens on the first day of 2003 and were subject to income tax and the 10 percent early withdrawal penalty. This mistake was likely the result of not properly analyzing the various phases of the transaction and applying the prohibited transaction rules.
If you are considering setting up a self-directed IRA, it is highly recommended that you consult with your CPA or financial adviser to be sure you don’t conflict with the rules regarding prohibited transactions. The rules are strict and the penalty for breaking them is harsh.•
• Samuel M. Pollom, JD, CPA is with BGBC Partners LLP — Litigation, Forensic and Business Valuation. Contact BGBC at 317-633-4700 or visit www.bgbc.com. The opinions expressed are those of the author.