Listen to the pitch, and then lose your shirt! Taxpayers are always looking for a means to reduce taxes and to use the Tax Code to their advantage. There is ABSOLUTELY nothing wrong with doing so. Unfortunately, many a taxpayer listens to the salesman’s pitch and does not consult with their tax advisor before implementing the strategy. After all, the sales pitch says that the promoter has an IRS private letter ruling (PLR) that these types of transactions are accepted by the IRS. Unfortunately, the PLR is only applicable to that particular taxpayer and not to any other party. Even so, if the facts are the same, why would the IRS allow one taxpayer to claim something and not another? These PLRs are fact specific, and if another taxpayer makes one slight deviation from the facts of the approved PLR, then the IRS is not being inconsistent.
It is then that the taxpayers learn that due to the various exceptions and pitfalls in the Code, that they find themselves worse off from a tax perspective.
Take the case of Thiessen (146 Tax Court 7, March 29, 2016). The taxpayers may have been told that there was a tax strategy where they could take money out of their IRAs without incurring a taxable event. The taxpayer and his spouse formed a C corporation. The taxpayers were named as the sole officers and directors of the corporation. The taxpayers established IRAs in their names, with the taxpayers retaining all discretionary authority and control concerning investments made by their IRAs (self-directed IRAs). These IRAs were established by rolling over funds from their previous employer’s retirement accounts. The taxpayers then directed their IRAs to purchase shares of stock in their C Corporation. These shares of stock were the only shares issued by the C Corporation during the years in question. The C Corporation purchased the assets of an unincorporated business. So far so good? No, not really. The purchase of the unincorporated business included cash from the taxpayer’s personal bank account, cash from the taxpayer’s IRAs, and a promissory note from the taxpayer’s C corporation stating that it would pay the principal amount of the note plus interest over 60 months. The promissory note stated that repayment was secured by all items of value used in the operation of the business. The promissory note also included a signed statement by the taxpayers that they were personally guaranteeing repayment of the note. This all sounds very business-like, so what was the IRS problem?
The IRS and the Tax Court ruled the taxpayers had received taxable distributions from their IRAs during because the taxpayer’s engaged in a prohibited transaction when they guaranteed the loan. As a prohibited transaction, the IRAs were thus deemed to be distributed to the taxpayers on January 1 of the year the loan was guaranteed. The guarantees of the loan were prohibited transactions because they were indirect extensions of credit to the taxpayer’s IRAs. Thus, the taxpayer’s participation in the prohibited transactions caused the IRAs to lose their status as IRAs.
What does the deemed distribution mean? It means that the fair market value of the IRAs was considered as if the taxpayers had taken the money out of their IRAs. They are subject to personal income tax on those deemed distributions, and if under 59 ½ years young, they are subject to the 10% early distribution penalty. Since the taxpayers used the IRA monies to purchase assets of an unincorporated business, they cannot pay their income tax liability using IRA monies (at least not from these IRA accounts). If the taxpayers do not have a source of funds to pay the IRS, then they enter the IRS world of collections (liens, levies, wage garnishments, etc.). If they had only consulted with an experienced tax advisor they could have avoided all of this.
We have previously written about IRAs and the traps for the uninformed. If you would like to read more about these IRA traps, you can read about IRAs Used to Purchase Vacation or Rental Properties and IRAs Used to Purchase Real Estate.
If you want to discuss your business or personal tax planning and tax preparation concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
