Entrust New Direction Blog

In some cases these rules appear intentionally broad and cryptic. Frequently, we look to tax court decisions, private letter rulings, and the pondering of experts to guide us in the quest to find the best investment offering the most control over the outcome while still steering clear of Prohibited Transaction pitfalls.

The recent court case Joseph R. Rollins vs. The Tax Commissioner – 11/15/2004 offers self-directed investors some clarification with regards to prohibited transactions and further clarification of the definition of “disqualified persons” with regards to one’s retirement plan investments. Briefly stated, the Rollins decision was based on the following set of circumstances:

Rollins was the administrator for his own 401(k) plan. He also owned less than a controlling interest in three legal entities. Each of these entities borrowed money and executed a promissory note with Rollin’s retirement plan at terms that would be considered fair market. Mr. Rollins acted as treasurer for these entities and was the signer on the promissory notes on behalf of the entities as well as directing the plan to fund the loans.

Definition of “Disqualified Persons”

A “disqualified person,” in most cases, includes the IRA holder, lineal ascendants and descendants of the IRA holder, as well as any entity where the aggregate ownership share of disqualified persons constitutes a controlling interest. For example, if the son and daughter of an IRA holder owned 50% of CrazyPants LLC, the IRA could not do business with CrazyPants LLC, regardless of the fairness of the terms of the transaction. Using these rules, it seemed permissible for Mr. Rollins’ plan to loan money to entities that were not “disqualified” as he did not own 50% of any of them.

While the definition covers employers, employee organizations such as collective bargaining units and other employer and family relationships, it is our experience that it is the IRA holder and his family members who are most often involved when deals are put together. The IRS has provided definitions of when transactions with these individuals will run afoul of the prohibited transaction rules. As a result, transactions are often designed with those definitions in mind in order to avoid a prohibited transaction issue. Mr. Rollins did exactly that in designing the plan loans. He acknowledged that he personally was disqualified but the transactions were with entities that were not. Yet the court determined that the loans gave him an indirect personal benefit and thus were prohibited transactions.

Disqualified Persons and The Rollins Decision

The Rollins Decisions caught some of us off guard because of the “controlling interest” definition we have carried around for so long. The resulting refinement of this definition has taught investors to look further into the structure of a transaction and examine: 1) Who is negotiating for each entity? 2) Who is responsible for carrying out the terms of the agreement/note? 3) Under what circumstances could the “use of” or “investment of” plan assets indirectly (or directly) benefit the interest of a disqualified person?
Judicial Observations:

Rollins, “the petitioner,” owned from 9% to 33% interest in the three entities involved. Although he did not hold a controlling interest of “50% or greater,” the judge made the following observations after ruling against the petitioner:

The petitioner was the single largest shareholder by a significant margin in all three entities. The comparison between his share and the shares of other shareholders was a focus of this decision.

The petitioner held the positions of president, secretary, and treasurer, as well as being the registered agent of all of the entities.

The treasurer, Rollins, was the signer on all the notes securing the indebtedness.

The notes were at higher than market value and there was no default. Mr. Rollins’ Plan benefited from the security and the income of the investment.

Mr. Rollins had the burden of proving that he did not use the plan assets for his own benefit. The court determined that Mr. Rollins failed to carry this burden, noting specifically the sparse evidence presented.

It is clear from this case that the substance of the transaction, “Was it a good or bad investment?” had no bearing on the ruling against Rollins. Simplistically defining “controlling interest” as a percentage owned by a disqualified person was not looking deep enough into the issue of whether or not there is self-dealing in the transaction. Disqualified persons involved in a transaction who are deemed to be receiving an indirect personal benefit, or “self-dealing,” results in the transaction being a prohibited transaction.

Self-directed plan investors planning investments where disqualified persons or entities are involved, even in a less than controlling status, should realize that the IRS Tax commissioner can, and obviously will, look deeper than the broad percentage guidelines. He will look for, among other things, convincing evidence that there is NO personal benefit derived from the transaction, directly or indirectly, by those disqualified. Furthermore, investors must recognize that decisions with regard to prohibited transactions will not be decided solely on the merits of the investment itself. Prohibited transactions are just that – prohibited. As stated by the judge and worth noting by all of us when structuring investments for our IRAs or Qualified Plans: “Good intentions and a pure heart are no defense”.

1. They rely entirely on the Swanson Case to justify the legality of the IRA/LLC arrangement
2. They capitalize on the IRA owners’ desire for complete control of IRA funds and disenchantment with the securities industry.
3. They promise “checkbook control” of these funds without the “interference” of an IRA custodian.
   

WHAT DID SWANSON DO?

Mr. Swanson caused a corporation called “Worldwide” to be created and his IRA purchased 100% of the outstanding shares of that corporation. After funding the IRA share purchase, Mr. Swanson was appointed president of the corporation which, in turn, did business with Swanson’s company, “Swanson Tool”. Swanson Tool paid sales commissions to Worldwide. Note: Worldwide had no employees. The Swanson case attracted attention primarily because a) it was a single member entity where the IRA owned all shares; b) Mr. Swanson was appointed the president with complete control over all monies of the corporation; and c) Worldwide made lots of money in this arrangement.

WHAT WAS THE SWANSON DECISION?

Very few understand what the Swanson Decision addressed. Many think that this was a decisive case that certified the legality of the single member LLC for IRAs. It was not.

The facts are:

The Swansons sought to recover legal fees from the IRS after a settlement with the IRS on a number of tax issues. The question put forth in this case was whether or not the IRS was overzealous in pursuing the Swansons during the negotiation and settlement process in resolution of these tax issues.

The entity purchased by the IRA was not an LLC at all but a foreign sales corporation.

The case was decided at the administrative or lowest tax court level and was not appealed by the IRS.

The IRS behaved badly in this case by misapplying the prohibited transaction rules and choosing to pursue the Swansons in spite of (The IRS admitted) hazy understanding of the facts of the case and application of the rules.

The IRS confined the defense of their actions to only three potential prohibited transaction areas. They chose wrong.

WHAT WAS DECIDED?

Only one issue was decided: the Swansons were entitled to monetary relief for excessive legal fees resulting from the long, entrenched battle with the IRS. The issues viewed as “key” to the advocates of “checkbook control” rest on the three arguments the IRS chose to pursue in defense of their actions during the settlement process.

The IRS believed that these three actions by Swanson constituted prohibited transactions under IRC 4975. These issues were:

Was the purchase of shares in the corporation by the IRA a prohibited transaction?

Was the appointment of Mr. Swanson as president/director of the entity a prohibited transaction?

Was the payment of dividends by Worldwide back to the IRA account a prohibited transaction?

The court decided that none of these three areas constituted a prohibited transaction.

WHAT WAS NOT REVEALED BY SWANSON

The following issues, which directly impact the operation of the IRA-owned entity, did not come up in the Swanson Case but are of importance to anyone attempting to operate an IRA-owned LLC:

Subsequent funding of entity following initial funding:

There appears to be no question that funding the LLC after the IRA’s initial purchase of shares constitutes a prohibited transaction because the LLC becomes a disqualified entity after funding.

IRA holder as manager: What can an IRA holder do as the manager of the LLC? This was not addressed in Swanson and still is not defined. The extent to which an IRA holder can work on behalf of the entity is still in question.

Arrangements: The IRS more recently has looked at entities set up specifically to avoid application of certain tests, such as fiduciary responsibility, and setting up entities as part of a pre-arrangement to avoid a prohibited transaction, as being invalid (C.F.R. § 2509.75-2(c)). What does the IRS view as an “arrangement”? What about circumvention of the custodian requirement set forth in IRC 408?

Arrangements: The IRS more recently has looked at entities set up specifically to avoid application of certain tests, such as fiduciary responsibility, and setting up entities as part of a pre-arrangement to avoid a prohibited transaction, as being invalid (C.F.R. § 2509.75-2(c)). What does the IRS view as an “arrangement”? What about circumvention of the custodian requirement set forth in IRC 408?

The IRA holder as manager and signer on the entity account can take money out of and put money into the entity and thus take distributions and make contributions to the IRA without the custodian reporting either of these activities to the IRS. The prohibited transaction rules, such as no personal use, no guaranteeing of credit, and no use of the IRA’s asset for the IRA holders benefit: all of these can happen without custodial involvement because they happen within the created entity.

WHAT CAN BE TAKEN FROM SWANSON

One thing we can rely on with regards to the Swanson Case is that the IRS is not going to make the same mistake twice. IRA investment in closely held or “checkbook control” LLCs, because of their high profile, will loom large as an IRS target. When (not if) the IRS decides to challenge “checkbook control” IRAs, they will be ready. The questions not answered by the Swanson Case will most likely be the focus of any future IRS court case.

Lastly, there is a limited understanding of prohibited transaction rules across the spectrum of IRA owners in self-directed investments. There is much inexperience with regards to the use and operation of business entities such as LLCs which may, in turn, result in inadvertent prohibited transactions because of confusion in the relationship between the individual, the LLC and the IRA member as three distinct entities.

In summary, the Swanson Case may only be the start of IRS scrutiny of self-directed IRA investments and single member LLCs in particular. Anyone entering into this type of IRA investment must understand the basis in law on which this type of investment structure is built, what the rules are with regards to both prohibited transactions and how to operate a registered business entity.

Lastly, everyone needs to know what the Swanson Case did not do for us!

Want to know more? Register for our webinar on single member LLCs.

Catherine Wynne is a principal in Entrust New Direction IRA, Inc., a licensee of The Entrust Group (TEG). TEG has been, since 1981, the leader in self-directed IRA, Roth, SEP and 401(k) administration. New Direction, in Lafayette, Colorado, provides administration services as well as continuing education for tax and investment professionals and the general public. Website: NewDirectionIRA.com.