Tax Court's Broad Application of Prohibited Transaction Rules May Hit Owners of Checkbook IRAs

First, let’s look at the decision. The U.S. Tax Court ruled that two individuals who set up an IRA-owned closely held corporation and provided it with personal loan guarantees violated Section 4975. The tax court emphasized that the “broad language” used by Congress in the prohibited transaction laws is intentional and aimed to prohibit a wider variety of acts than would be prohibited without it.

In specifically addressing a loan guarantee—which the two mean illegally provided—the court said:
“The language of section 4975(c)(1)(B), (lending of money or other extension of credit between a plan and a disqualified person) when given its obvious and intended meaning, prohibited the taxpayers from making loans … either directly or indirectly to their IRAs by the way of the entity owned by the IRAs.”

The ruling has ramifications for all IRA owners. Managers of IRA-owned structures, usually LLCs, may suffer similar treatment under a similar broad application of 4975(c)(1)(C). That clause prohibits “furnishing of goods, services, or facilities between a plan and a disqualified person.” 

Most IRA LLC advocates point to the Swanson v. Commissioner, 106 T.C. 76 (1996) tax court ruling as the decision that allows an IRA owner to be the President of an IRA-owned entity.  While the case indicates that being the President is not prohibited, neither the IRS code nor the Swanson case addresses what “services,” if any, that President/Manager can provide to the entity. This creates an ambiguity of which IRA/LLC owners should take notice.

There is little doubt that decision-making is always the responsibility of the IRA account holder, but far more than just decision-making is required for the operation of a business.

Thus, this Court ruling raises serious concerns that day to day running of the LLC business, including such things as recordkeeping, accounting, and financial reporting, as well as operational and administrative functions, could be prohibited under a broad definition provision of “services.”  All of these services are typically provided to a business at a cost.

IRA owners who are actively managing an IRA/LLC may want to explore having the LLC engaging outside providers of active “services” to avoid potential tax/penalty consequences.
 

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