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”.