Rollovers as Business Start-Up Transactions Are Under Attack by the IRS
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Rollovers as Business Start-Up
Transactions Are
Under Attack by the IRS
by Edward K. Zollars, CPA
Recent developments suggest the IRS is “getting serious” about challenging taxpayers who
have used their retirement fund rollovers to jumpstart a new business, having the business
owned by their individual retirement account. Such transactions, referred to as ROBS (rollover
as business startup) transactions may use either an IRA or a plan sponsored by the start-up
business.
The structure appears appealing to the taxpayer, as there is no tax paid on the distribution, so
100% of the funds available can be used to invest in the start-up business. As well, the entity
elects C corporation status and while it pays income tax on its income, it has access to the
lower tax brackets in most cases. And since the IRA itself does not pay tax upon a disposition
of the stock (such in a later liquidation of the entity), the arrangement reduces the “double tax”
disadvantage of the C corporation.
The IRS’s concerns have been directed at potential violation of the prohibited transaction rules
found in IRC §4975 by such arrangements. In the case of an IRA such a violation is particularly
bad news, since if the IRS succeeds in showing that any such prohibited transaction has taken
place (no matter how minor) all assets held in the IRA are treated as immediately distributed.
The list of “prohibited transactions” is found in IRC §4975(c)(1) and includes:
Sale or exchange, or leasing, of any property between a plan and a disqualified person;
Lending of money or other extension of credit between a plan and a disqualified person;
Furnishing of goods, services, or facilities between a plan and a disqualified person;
Transfer to, or use by or for the benefit of, a disqualified person of the income or assets
of a plan;
Act by a disqualified person who is a fiduciary whereby he deals with the income or
assets of a plan in his own interests or for his own account;
Receipt of any consideration for his own personal account by any disqualified person
who is a fiduciary from any party dealing with the plan in connection with a transaction
involving the income or assets of the plan.
In this article, we’ll take a look at two 2013 cases where the IRS prevailed on the §4975
argument. We’ll also look at relief the IRS granted to one taxpayer in unwinding such a
transaction, and a recent announcement that suggests the IRS is looking to obtain information
that will allow them to more easily uncover such arrangements.
ROLLOVERS AS BUSINESS START-UP TRANSACTIONS ARE UNDER ATTACK BY THE IRS 1SO YOU WANT TO BE PAID BY YOUR NEW COMPANY?
A ROBS (rollover as a business startup transaction) produced disastrous consequences for the
individual whose rollover was involved in the case of Ellis v. Commissioner, TC Memo 2013-
245, TC Memo 2013-245,
http://www.ustaxcourt.gov/InOpHistoric/EllisMemo.Paris.TCM.WPD.pdf.
The issue in the case was whether the taxpayer had engaged in a prohibited transaction under
IRC §4975 as part of his use of funds received from his previous employer’s 401(k) plan to have
his IRA start a used car business. If an IRA engages in a prohibited transaction, the entire
balance of the account is deemed distributed to the IRA beneficiary and tax is triggered.
The IRS saw four separate points at which a prohibited transaction under §4975 had occurred:
When Mr. Ellis had his IRA purchase an initial interest in the newly formed LLC (which
elected to be taxed as a corporation) that previously had no ownership interests issued
When Mr. Ellis received compensation from the entity as an officer of that entity after
formation in 2005
When Mr. Ellis received compensation from the entity as an officer in 2006 and
When Mr. Ellis had the corporation enter into a lease with an entity owned by Mr. Ellis,
his spouse and their children in 2006.
The Court found Mr. Ellis dodged the first bullet. The IRS argued that, as the corporation was
constructively owned by Mr. Ellis, the original purchase of interests was a transaction with a
disqualified person (the corporation controlled by Mr. Ellis). However, the Tax Court agreed
with Mr. Ellis’ reliance on its decision in the case of Swanson v. Commissioner, 106 TC 76,
which held that a corporation with no shareholders was not a disqualified person. Only after the
shares were issued (following the transaction) would the new entity become a disqualified
person.
However, Mr. Ellis did not fare as well on the second issue. There, the Court Mr. Ellis controlled
the corporation and the payments it would make to him. The court noted that:
The direct or indirect transfer to, or use by or for the benefit of, a disqualified person of
the income or assets of a plan is a prohibited transaction under section 4975(c)(1)(D).
Similarly, an act by a disqualified person who is a fiduciary whereby he directly or
indirectly deals with the income or assets of a plan in his own interest or for his own
account is a prohibited transaction under section 4975(c)(1)(E).
The Court found that the payment of salary to Mr. Ellis violated this provision. While it paid Mr.
Ellis from its own bank account and not that of the IRA, the IRA had virtually exclusively funded
the entity. The Court noted:
ROLLOVERS AS BUSINESS START-UP TRANSACTIONS ARE UNDER ATTACK BY THE IRS 2To say that CST was merely a company in which Mr. Ellis’ IRA invested is a complete
mischaracterization when in reality CST and Mr. Ellis’ IRA were substantially the same
entity. In causing CST to pay him compensation, Mr. Ellis engaged in the transfer of plan
income or assets for his own benefit in violation of section 4975(c)(1)(D). Furthermore, in
authorizing and effecting this transfer, Mr. Ellis dealt with the income or assets of his IRA
for his own interest or for his own account in violation of section 4975(c)(1)(E).
The Court also rejected the claim that §4975(d)(10) exempted the transaction. That provision
provides an exemption for reasonable compensation paid to a fiduciary for performance of
duties of the plan. The Court found the payments were not for his duties of managing the
investments of his IRA, but rather being the general manager of the car dealership.
The Court concluded:
In essence, Mr. Ellis formulated a plan in which he would use his retirement savings as
startup capital for a used car business. Mr. Ellis would operate this business and use it
as his primary source of income by paying himself compensation for his role in its day-
to-day operation. Mr. Ellis affected this plan by establishing the used car business as an
investment of his IRA, attempting to preserve the integrity of the IRA as a qualified
retirement plan. However, this is precisely the kind of self-dealing that section 4975 was
enacted to prevent.
That language does not bode well for other ROBS transactions, especially where the individual
maintains any sort of connection to the entity and is compensated as part of that connection.
DOES YOUR COMPANY NEED TO GET A BANK LOAN?
Many advisers have found clients who’ve heard of using a qualified plan rollover to an IRA to
acquire a business by having the new business stock acquired by a “self-directed” IRA held by
various custodians that market this service. While such transactions are not theoretically
prohibited, they bring substantial risks—as the taxpayers in Peek v. Commissioner, 140 TC No.
12 (http://www.ustaxcourt.gov/InOpHistoric/PeekandFleck.TC.WPD.pdf) discovered.
The issue that tripped up Mr. Peek and Mr. Fleck is one that is a potentially disastrous issue for
any such arrangement—running afoul of the prohibited transaction rules of IRC §4975.
In this case the taxpayer each rolled funds into self-directed IRAs established in consultation
with a CPA they consulted who advised them about the technique. The IRAs then transferred
the funds to a newly formed corporation in exchange for the corporation’s stock. The
corporation then acquired the assets of a business which Mr. Peek had been interested in
acquiring.
ROLLOVERS AS BUSINESS START-UP TRANSACTIONS ARE UNDER ATTACK BY THE IRS 3Mr. Peek and Mr. Fleck intended to serve as corporate officers and directors of the new company, and they took on those positions. The corporation then acquired the assets of the business in question, using the IRA funds as partial payment. In addition, the corporation signed notes with prior owners of the business and obtained bank credit. As part of the transactions, Mr. Peek and Mr. Fleck each provided personal guarantees on the notes to the old owners. These transactions took place in 2001. In 2006 there was a sale and merger of the company. The taxpayers treated that as taking place in their IRAs (now Roth IRAs) and not being subject to current tax. The IRS disagreed, holding that the guarantee of debt of the corporation in 2001 was an indirect provision of credit to the IRA, a prohibited transaction under IRC §4975(c)(1)(B). For an IRA participating in a prohibited transaction is a fatal mistake—the entire balance of the IRA in question is treated as distributed to the participant and the account is no longer treated as an IRA account. Rather, it becomes the personal asset of the beneficiary. The Tax Court agreed with the IRS, dismissing the taxpayer’s claims that since it was a guarantee of the debt of the corporation, there was no provision of credit to the plan. The Court found that this was rather clearly an indirect provision of debt to the plan, by providing the ability to obtain the credit for an entity held by the IRA. The Court found that to hold otherwise would gut this provision of the law by rendering ineffective the prohibition on indirect provisions of credit. The taxpayers next complained that since the problem occurred in 2001 the IRS was simply too late to complain about this in 2006. The Court found two problems with this view. First, the guarantees had continued to date, so the problem still existed and as long as it did any “IRA” holding this asset would cease to be an IRA. Second, the assets effectively were pushed out of an IRA in 2001. Though the Court didn’t mention it, even if the problem no longer existed, any attempt to put the stock into a new IRA account would run afoul of making an excess contribution to the IRA and contributing noncash assets to the IRA. Since the assets were not held by an IRA in 2006, the entire gain on sale was taxable to the individual taxpayers and not sheltered inside of an IRA. Note that this attack was not the only one the IRS had regarding prohibited transactions in this situation—rather, as the Tax Court noted, having decided the debt issue had already destroyed the IRA, there was no need to decide if other actions were also prohibited transactions. Specifically the IRS was alleging that, in this situation, the payment of wages to the IRA beneficiaries was a prohibited transaction under IRC §4975(c)(1)(D), the payment of rent to the shareholders was a prohibited transaction under IRC §4975(c)(1)(E) and that they would have been liable for the excise tax for excess contributions to successor IRAs under IRC §4973 (the taxpayers had been forced to find a new custodian when their old one left the business and had also converted to Roth IRAs during the time period from the original formation of the company). ROLLOVERS AS BUSINESS START-UP TRANSACTIONS ARE UNDER ATTACK BY THE IRS 4
It certainly is conceivable that even if the taxpayers had not guaranteed debt, the Tax Court might have found any of those arguments convincing enough to arrive at the same result. Advisers who have clients that express interest in these sorts of “self-directed” IRAs need to counsel clients about the fact that the IRS has clearly expressed grave concerns about the operation of such entities and that §4975 provides many opportunities for the IRS to find prohibited transactions. For instance, some advisers are concerned that IRC §4975(c)(1)(D) and (E)’s provisions can be read broadly to “catch” any transaction where there is the slightest benefit conferred to the beneficiary or someone/thing of interest to the beneficiary. That is, while a lease of property in such an IRA may not be to a “disqualified person” (and thus not trapped by §4975(c)(1)(A)), if the person or entity to whom it is leased has any sort of relationship to the beneficiary, the lease may be the “use by or for the benefit of” the disqualified person by providing the tenant with the leased property. UNWINDING A TRANSACTION The IRS in PLR 201236035 gave its blessing to an unwinding of a transaction for a taxpayer that appears to have initially entered into a rollover as business startup (“ROBS”) transaction. In such a transaction, a taxpayer looking to start a new business takes a rollover distribution from a former employer’s retirement plan, and then establishes a new business which sponsors a retirement plan with a provision allowing individual employees to direct their account investments. The individual, as the entity’s only employee, rolls over the distribution to the plan and has the plan invest all funds in stock or equity of the startup business. The IRS has been critical of such plans in the past. The IRS believes that, in many cases, the plans run afoul of a number of provisions governing qualified plan, including potential violations of prohibited transaction rules, not allowing other employees to have similar self-direction options and questions about how the value of the equity interest purchased was arrived at. In such cases, the IRS argues, the plan loses its qualified plan status. While the IRS has never indicated that every such plan will always end up disqualified, it’s clear they have serious reservations and such plans are not without significant risks to the taxpayers involved. In the case in this ruling the taxpayer had been let go by a former employer. He decided to buy a healthcare franchise. He had sufficient funds outside of his retirement plan balance to pay for the franchisor’s fees and start-up costs, but had concerns about future financing. The franchisor suggested he contact a company that was promoting establishing plans for such startup business. ROLLOVERS AS BUSINESS START-UP TRANSACTIONS ARE UNDER ATTACK BY THE IRS 5
The taxpayer obtained information from the company and submitted his application to the organization. After he received various plan and corporate documents, he met with an attorney with qualified plan experience. The taxpayer told the attorney he would not rollover to this plan unless she advised him that the IRS would approve the transaction. The attorney told the taxpayer that there were some “red flags” with the program, but that the IRS had not specifically issued a statement prohibiting such a transaction, and that he could safely proceed with the transaction. In March of the following year the taxpayer’s accountant, apparently just now discovering the plan the taxpayer had entered into, advised him to consult with another attorney regarding the issues surrounding this transaction and the franchising arrangement. That attorney advised him he needed to unwind the transactions and assisted the taxpayer in doing so. The transactions were unwound, resulting in rescinding the actions that had adopted the retirement plan and permitted the plan to purchase stock in the startup. That had the effect of retroactively making the transfer to that plan account no longer a rollover to a plan intended to be a qualified plan. With more than 60 days having passed, the taxpayer was now beyond the date when he could roll the funds into an IRA. The taxpayer requested, and the IRS granted him, an extension of time to complete a rollover to an IRA account. The IRS found that his reliance on the advice given by the promoter, the first attorney and the second attorney resulted in the funds being held by a plan that was not a qualified plan. Interestingly enough, this situation does not seem to fit squarely within the circumstances specifically mentioned in Revenue Procedure 2003-16, something that often seems to prove fatal to taxpayers seeking relief. However in this case, the fact that the taxpayer sought outside advice, followed the advice, and was trying to unwind a transaction that the IRS believes to be abusive probably all factored into the IRS’s decision to grant relief. PLEASE TELL US MORE ABOUT THAT IRA CCH Federal Tax Day reported on November 14, 2013 that the IRS is proposing more detailed information reporting requirements for IRAs with “hard to value” investments. The report indicated that the IRS will make such reporting option for 2014. Presumably such reporting will not be optional in following years. The IRS document cited in CCH’s Advance Release section indicated that the following types of investments are being considered for additional reporting: Non-publicly traded stock, Partnership or LLC interests, Real estate, options ROLLOVERS AS BUSINESS START-UP TRANSACTIONS ARE UNDER ATTACK BY THE IRS 6
As well as other unspecified “hard to value” investments. The changes would affect reporting on Form 5498 and Form 1099-R. More information on these requirements will be in the 2014 instructions for those forms, expected to be issued near the end of 2013. This reporting would make it much easier for the IRS to uncover such transactions. Presumably the additional information may also increase the cost of holding such transactions in IRA accounts even if there are not prohibited transaction issues. by Edward K. Zollars, CPA, Nichols Patrick CPE, Inc. Find CPE classes led by Ed Zollars here ROLLOVERS AS BUSINESS START-UP TRANSACTIONS ARE UNDER ATTACK BY THE IRS 7
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