Taxpayer Not Allowed to Use Step Transaction Doctrine to Escape Consequences of Prohibited Transaction With His IRA

Of the three issues raised in the case of Thiessen v. Commissioner, 146 TC No. 7, the first will likely evoke a sense of déjà vu in some readers.  And you will be right—the facts for the first issue (did the beneficiaries of two IRAs participate in prohibited transactions causing the entire IRA balances to be immediately taxable) are very similar to those the Tax Court had previously ruled upon in the case of Peek v. Commissioner, 140 TC 216 back in 2013.

However the taxpayer would introduce two defenses to the imposition of tax in this situation the court would view—but the Court would not use the step transaction doctrine to view the transaction in the taxpayer’s favor in these areas.

The case involved a taxpayer used a rollover of retirement funds from his former employer to establish an IRA.  Then he and his wife used the funds in their IRA to establish a new corporation (Elsara Enterprises, Inc.).  The new corporation used the cash to purchase an unincorporated business (Acona Job Shop).

As part of the purchase, Mr. and Mrs. Thiessen personally guaranteed the promissory note that was issued by Elsara to the seller as part of the purchase.  That guarantee the IRS argued was a prohibited transaction, being effectively identical to the structure the Court had found to be a prohibited transaction in the Peek case.

Part of the reason for the identical facts may arise from the fact that two of the advisers in this case were also advisers involved in the Peek case.  The business broker that arranged the purchase of Acona and suggested using the available funds from a rollover from Mr. Thiessen former employer’s plan was the same one who arranged a similar purchase in Peek.  When Mr. Thiessen discussed using this structure with a friend who had used this same structure to acquire a business, the friend referred him to the same CPA who had assisted in implementing the Peek structure as well.

Not surprisingly on this issue the Tax Court arrived at the same result as in Peek—the treatment of the entire balance of the IRA as distributed on the first day of the tax year in which the guarantee took place.

The “full distribution” rule for IRAs that participate in a prohibited transaction is found in IRC §408(e)(2) which provides:

(2) Loss of exemption of account where employee engages in prohibited transaction

(A) In general

If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year. For purposes of this paragraph—

(i) the individual for whose benefit any account was established is treated as the creator of such account, and

(ii) the separate account for any individual within an individual retirement account maintained by an employer or association of employees is treated as a separate individual retirement account.

(B) Account treated as distributing all its assets

In any case in which any account ceases to be an individual retirement account by reason of subparagraph (A) as of the first day of any taxable year, paragraph (1) of subsection (d) applies as if there were a distribution on such first day in an amount equal to the fair market value (on such first day) of all assets in the account (on such first day).

IRC §4975, cited above, defines various prohibited transactions.  In this case the IRS alleged that the guarantee violated the prohibited transaction defined at IRC §4975(c)(1)(B) as the “lending of money or other extension of credit between a plan and a disqualified person…”  A disqualified person includes a person (such as Mr. Thiessen in the case of this self-directed IRA) who “exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets.” [IRC §4975(e)(3)(A)]

The Court noted what it had held in the Peek case:

Our agreement with respondent’s primary argument is compelled by the Court’s Opinion in Peek v. Commissioner, 140 T.C. 216. There, Mr. Blees promoted the IRA funding structure to two unrelated taxpayers who, pursuant to that promotion, rolled over funds in their retirement plans to self-directed IRAs and caused the IRAs to establish and to wholly own a newly formed corporation. See id. at 218-220. The taxpayers then caused the corporation to purchase (through AJH) the assets of a business by, among other things, receiving from the seller a loan that the taxpayers personally guaranteed. See id. at 217, 220-221. The Court held that the taxpayers were “disqualified persons” within the meaning of section 4975(e)(3) and held that the taxpayers’ guaranties of the loan were prohibited transactions in that the guaranties constituted indirect extensions of credit between the taxpayers and the IRAs. See id. at 224-225; see also Janpol v. Commissioner, 101 T.C. 518, 527 (1993) (“An individual who guarantees repayment of a loan extended by a third party to a debtor is, although indirectly, extending credit to the debtor.”). The Court held that the taxpayers’ participation in the prohibited transactions caused the IRAs to cease qualifying as IRAs within the meaning of section 408(a) in the year in which the guaranties were made. Peek v. Commissioner, 140 T.C. at 227.

The Court was not moved by the taxpayers’ pleas that the Court should disregard the Peek decision or distinguish this case.  The Court rejected the taxpayers claim that only the Department of Labor could determine if a transaction was a prohibited transaction, noting that the ultimate resolution of the meaning of the law resides with the Court and not the executive branch agency.  The Court also noted that its interpretation of this provision was wholly consistent with the Department of Labor’s view as stated in DOL Advisory Op. 90-23A.  The Court also refused to find that the ruling in Peek relied on the fact that the corporation there wasn’t an operating corporation, noting the opinion never discussed that issue and that it was not relevant. 

As well, the fact that there wasn’t case law specifically interpreting this provision prior to when they entered the transaction wasn’t relevant—the law exists as of the day Congress enacts it, and its effectively is not held in a pending status until the first case is decided.

All well and good—but you may note this is a published Tax Court case which indicates it deals with a matter not previously decided by the Court.  And, as you will need, Peek was a published decision issued in 2013 that dealt with the above issues. 

In this case the taxpayers put forward two additional defenses that were not brought forth (and in one case not potentially applicable in any event) in Peek—did the taxpayers qualify for relief under the exemption found at IRC §4975(d)(23) who provides that a transaction is not a prohibited transaction, even though otherwise meeting the definition, if it is a transaction “in connection with the acquisition, holding, or disposition of any security or commodity, if the transaction is corrected before the end of the correction period.”

The taxpayers argue their guarantee is such a transaction which they should have the right to correct, since it was in connection with the acquisition of a security (Elsara stock in this case).  The Court held that while that provision can allow for correction of a prohibited transaction, in this case the guarantee was in connection with Elsara’s acquisition of assets, not in connection with the taxpayers’ acquisition of Elsara stock—they acquired that upon formation of the corporation and that was not the problem transaction in this case.

The taxpayers’ final argument was that the IRS had simply raised the issue after the statute of limitations had expired thus, even if the IRS was right, they could not collect tax from the year in which the transaction had taken place.  And the IRS had clearly not issued the assessment within three years after the return was filed as required by IRC §6501(a).

The IRS argued that, while this was the case, this situation was governed by the substantial understatement of income rule found at IRC §6501(e)(1)(A) that provides:

If the taxpayer omits from gross income an amount properly includible therein and—

(i) such amount is in excess of 25 percent of the amount of gross income stated in the return...

the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time within 6 years after the return was filed.

The taxpayers pointed that they had noted the amount of the rollover from Mr. Thiessen’s retirement plan on their Form 1040, so the income was not “omitted” from the return—the IRS had been put on notice that an event had occurred with regard to the IRA.

However, the Court points out it was not the rollover that was at issue here—the IRS never claimed the rollover from the employer plan to the IRA was flawed or that the IRA that was initially established was not an IRA.  Rather, as the Court continues:

As discussed above, the prohibited transactions are petitioners’ guaranteeing of the loan, and the unreported income arises from the resulting taxable deemed distribution to petitioners of the assets in petitioners’ IRAs (and not from petitioners’ rollover of the retirement funds into petitioners’ IRAs). Indeed, the deficiency notice states specifically that the unreported income stems from IRA distributions and makes no mention of the rollovers or the taxability thereof.

An important point to note on both of the “extra” defenses advanced beyond those offered in Peek is that the Court refused to “collapse” the entire transaction into a single transaction in applying either the “security” or “reporting of income” tests.  While the IRS can (and often does) make use of the step transaction doctrine in attacking an arrangement of the taxpayer, the taxpayer is far less likely to be allowed to view the transaction he/she structured as if it were different if that revised view gives a more favorable tax result than if each step in the transaction was treated as distinct.