An IRA-based rollover as a business startup style transaction produced disastrous consequences for the individual whose rollover was involved in the case of Ellis v. Commissioner, TC Memo 2013-245, affirmed CA8, 115 AFTR 2d ¶2015-805, No. 14-1310.
The issue in the case was whether the taxpayer had engaged in a prohibited transaction under IRC §4975 as part of his use of funds received from his previous employer’s 401(k) plan to have his IRA start a used car business. If an IRA engages in a prohibited transaction, the entire balance of the account is deemed distributed to the IRA beneficiary and tax is triggered.
The IRS saw four separate point at which a prohibited transaction under §4975 had occurred:
- When Mr. Ellis had his IRA purchase an initial interest in the newly formed LLC (which elected to be taxed as a corporation) that previously had no ownership interests issued
- When Mr. Ellis received compensation from the entity as an officer of that entity after formation in 2005
- When Mr. Ellis received compensation from the entity as an officer in 2006 and
- When Mr. Ellis had the corporation enter into a lease with an entity owned by Mr. Ellis, his spouse and their children in 2006.
The Tax Court found Mr. Ellis dodged the first bullet. The IRS argued that, as the corporation was constructively owned by Mr. Ellis, the original purchase of interests was a transaction with a disqualified person (the corporation controlled by Mr. Ellis). However, the Tax Court agreed with Mr. Ellis’ reliance on its decision in the case of Swanson v. Commissioner, 106 TC 76, which held that investing in a corporation with no shareholders was not a disqualified person. Only after the shares were issued (following the transaction) would the new entity become a disqualified person.
However, Mr. Ellis did not fare as well on the second issue. There, the Tax Court Mr. Ellis controlled the corporation and the payments it would make to him. The court noted that:
The direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan is a prohibited transaction under section 4975(c)(1)(D). Similarly, an act by a disqualified person who is a fiduciary whereby he directly or indirectly deals with the income or assets of a plan in his own interest or for his own account is a prohibited transaction under section 4975(c)(1)(E).
The Tax Court found that the payment of salary to Mr. Ellis violated this provision. While it paid Mr. Ellis from its own bank account and not that of the IRA, the IRA had virtually exclusively funded the entity. The Tax Court noted:
To say that CST was merely a company in which Mr. Ellis’ IRA invested is a complete mischaracterization when in reality CST and Mr. Ellis’ IRA were substantially the same entity. In causing CST to pay him compensation, Mr. Ellis engaged in the transfer of plan income or assets for his own benefit in violation of section 4975(c)(1)(D). Furthermore, in authorizing and effecting this transfer, Mr. Ellis dealt with the income or assets of his IRA for his own interest or for his own account in violation of section 4975(c)(1)(E).
The Tax Court also rejected the claim that §4975(d)(10) exempted the transaction. That provisions provides an exemption for reasonable compensation paid to a fiduciary for performance of duties of the plan. The Court found the payments were not for his duties of managing the investments of his IRA, but rather being the general manager of the car dealership.
The Tax Court concluded:
In essence, Mr. Ellis formulated a plan in which he would use his retirement savings as startup capital for a used car business. Mr. Ellis would operate this business and use it as his primary source of income by paying himself compensation for his role in its day-to-day operation. Mr. Ellis effected this plan by establishing the used car business as an investment of his IRA, attempting to preserve the integrity of the IRA as a qualified retirement plan. However, this is precisely the kind of self-dealing that section 4975 was enacted to prevent.
That language does not bode well for other ROBS transactions, especially where the individual maintains any sort of connection to the entity and is compensated as part of that connection.
Mr. Ellis appealed the Tax Court’s decision to the Eighth Circuit Court of Appeals. Mr. Ellis argued the Tax Court had erred by not applying DOL Plan Asset Regulation 29 C.F.R. §2510-3.101 to the transaction. Mr. Ellis noted that, under that regulation, the underlying assets of an operating company in which an IRA invests are not considered plan assets in determining if a prohibited transaction occurred. Thus, he argued, his salary was not paid from plan assets and, by extension, no form of prohibited self-dealing had taken place.
The Eighth Circuit disagreed. It noted the plain language of the statute prohibits both direct and indirect self-dealing of the income or assets of a plan (which includes an IRA for this purpose). The panel, citing the Supreme Court’s holding in the case of Commissioner v. Keystone Industries, 508 US 152, 159 (1993), notes this rule is to be read broadly.
The panel points out that related regulations provide that rules regarding a fiduciary’s responsibility with regard to the prohibited transaction rules are outside the scope of the Plan Asset Regulations. As well, the Department of Labor had specifically held in Department of Labor Opinion No. 2006-01A that “certain transactions between a disqualified person and a corporation in which a plan invests are prohibited regardless of whether they meet the plan asset regulation.”
The panel also rejected the taxpayer’s argument that IRC §4975(d)(10) exempted the payments from the prohibited transaction rules. That provision provides, in part, an exemption for “receipt by a disqualified person of any reasonable compensation for services rendered, or for the reimbursement of expenses properly and actually incurred, in the performance of his duties with the plan…” However, the Court noted that the Tax Court had properly found that Mr. Ellis had been reimbursed not for his duties to the plan, but for services as a general manager of the Company.
The structure of the transaction is very similar to ones marketed in “qualified plan” wrappers as ROBS (rollover as business start-up) programs. In such case rather an IRA being used to hold the funds, a retirement plan sponsored by the new company (often a §401(k) program) is used to hold the company stock. The IRS has indicated their displeasure with such programs as well.
The “good news” is the prohibited transaction penalties are not quite as draconian for a qualified plan—the plan is not immediately disqualified with all assets treated as immediately distributed. But the results are bad enough (especially if not corrected within one year) and the IRS has certainly suggested that they might go after general qualification issues due to various operational problems often found in such arrangement (including limiting such directed investments only to the owner by withdrawing the right immediately after the initial direction is made).
Certainly the Eighth Circuit’s reminder that, per the Supreme Court, the prohibited transaction rules should be read broadly raises concerns about such programs are “in effect” self-dealing. As well, the Eighth Circuit made clear that, in their view, neither the Plan Asset Regulations nor IRC §4975(d)(10) provide any protection for the transactions.
Advisers that encounter taxpayers who have programs that appear to have used rollover funds to create a business should consider advising the clients to have the structure reviewed by counsel skilled in ERISA matters not associated with those promoting such programs for possible exposure and any potential ways to mitigating any possible damages. And, clearly, a client considering adopting such a program to use their retirement funds to start a business should clearly seek independent counsel in this area.