Ellis, the case of a misdirected IRA.

• Author: O'Malley, William P.
• Position: 2013 Tax Court memorandum decision, individual retirement accounts

A simple internet search regarding how to use IRA funds as startup capital will generate many links to articles in the financial press, as well as to companies offering services to IRA owners interested in using IRA funds as a source of initial capital. However, not many of these articles or websites advise potential entrepreneurs of the tax complexities of investing retirement funds in such a manner.

IRA Investment Restrictions and Requirements

There are relatively few restrictions on the types of permissible IRA investments. Life insurance and certain collectibles are the only prohibited investments. In addition, an IRA may not, with limited exceptions, commingle its assets with other property. The other key requirements include:

1. All contributions (other than rollover contributions) must be in cash;

2. The trustee or custodian must be a bank or an IRS-approved nonbank custodian (in other words, while IRA owners can self-direct their IRA, they cannot appoint themselves trustee of the IRA);

3. An IRA owner cannot pledge his account as security for a loan; and

4. The trustee or custodian must annually report the activities of the IRA to the IRS.

These very limited exceptions aside, an IRA owner is free to choose from the whole world of investment opportunities. That has led many IRA owners and their advisers to conclude that it is permissible for IRA owners to use their IRA to make an equity investment in a business in which they will be involved.

Prohibited Transaction Considerations

When using IRA funds to invest in a business, an IRA owner needs to be aware of the Code's prohibited transaction rules. Sec. 4975 prohibits certain transactions between a plan and disqualified persons with respect to the plan. Sec. 4975(e)(1) defines a plan as including an IRA described in Sec. 408(a).

Prohibited transactions defined: The Code prohibits direct transactions and what are referred to as self-dealing transactions. Specifically, Sec. 4975(c) (1) prohibits any direct or indirect sale or exchange, or leasing, of any property between a plan and a disqualified person; any lending of money or other extension of credit between a plan and a disqualified person; any transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; and any act by a disqualified person who is a fiduciary whereby he or she deals with the income or assets of a plan in the fiduciary's own interest or for his or her own account.

Disqualified persons: With respect to an IRA, the long list of disqualified persons (Sec. 4975(e)(2)) includes any fiduciary to the plan (when acting outside his or her official capacity), service providers to the plan (when acting outside of their official capacity); any family members of any fiduciary or service provider to the plan; and any business in which a fiduciary or service provider has a 50%-ormore ownership stake (direct or indirect). In other words, virtually all parties involved in...