Upon retiring, many corporate executives and other employees decide to start a second career. In some cases, these people roll over funds from their corporate retirement accounts to an individual retirement account (IRA). The IRA then purchases a business that the person runs. The goal, of course, is to avoid currently paying tax on the funds from the corporate retirement plan. There are business brokers that advocate this strategy.
A recent Tax Court case illustrates the problems with this approach. While an IRA may invest in the securities of a closely-held company, there are many restrictions that apply. If the IRA violates one of these restrictions, the IRA is treated as distributing all of its funds to the IRS owner. Also, other penalties may apply as well.
A recent Tax Court case is a case study in how things can go wrong. In this case, Mr. Thiessen retired after 30 years as a grocery store executive. He rolled over his retirement account balance to an IRA. He then had the IRA purchase the stock of a newly-formed corporation (“Elsara”) for $431,500. Elsara used the cash to buy the assets of a metal fabrication business from another corporation (“Ancona”). In addition to paying cash to Ancona, Elsara also gave Ancona a $200,000 promissory note. Mr. Thiessen and his wife personally guaranteed the promissory note.
The IRS said Mr. Thiessen engaged in what is called a “prohibited transaction” when he guaranteed Elsara’s promissory note. As a result, Mr. Thiessen was treated as withdrawing all of the funds in the IRA. The taxpayer had income of $431,500 and owed tax and penalties of $180,129, plus interest.
Mr. Thiessen appealed the IRS determination to the Tax Court. The Tax Court affirmed the IRS’s position. The Tax Court said the statutes, regulations and prior cases are clear. It is a prohibited transaction for an IRA owner to extend credit to an IRA. Past court cases have held that guaranteeing the debt of an entity owned by an IRA is treated as guaranteeing the debt of the IRA. As a result, there is a prohibited transaction. The Court said it was not addressing other prohibited transactions that might be present in the transaction.
There are other problems with the transaction which the Tax Court did not address. Mr. Thiessen and his wife were officers of Elsara. This also gives rise to a prohibited transaction. The Tax Court stated that it did not need to address this issue since it had already found a prohibited transaction that cause a deemed distribution from the IRA.
Mr. Thiessen heard about using an IRA to acquire a business from the business broker who represented the seller in the transaction. Mr. Thiessen also consulted with a CPA and an attorney on the transaction. Nevertheless, the transaction did not work as intended.
Anyone considering an IRA investment in non-publicly traded securities should be very careful.