A Sampling of Prohibited Transactions, Required Minimum Distributions, and Creditor Issues for the Non-tax Lawyer
By Jeremy Graber
One of your long-time business clients comes to your office to discuss her planned business acquisition. As you are gathering information from her, she tells you the purchaser will be an entity to be formed, which will be funded by her IRAs. You raise your eyebrows. "No worries," she says, "my financial advisor put this structure together." You go back to drafting the letter of intent but not without hesitation and a note to follow-up later with her, and possibly her "advisor."
Later that day, a long-time friend and estate-planning client comes by your office to update his estate plan. Your client wants to leave money to a charity, and you have prepared a simple amendment to his trust document. Knowing the client has IRAs and life insurance, you ask him if he has updated his beneficiary designations. As you begin discussing the various options as well as offering to contact the financial institutions to ensure it is handled properly, your thrifty client tells you that he has everything taken care of. "I simply named my trust as beneficiary on all my accounts to protect my kids from their creditors, and to make sure that ex of mine doesn't get a penny." You try to interject, but he is already discussing Bill Self's next recruiting class.
At the end of 2014, assets owned in IRAs reached $7-4 trillion, representing 30 percent of all retirement assets in the country1 As IRAs grow and baby boomers age, issues concerning IRAs are becoming more prevalent. IRA owners want to tap the liquidity in their IRA to fund business start-ups or expand existing businesses. As IRA owners die, their spouses, heirs, beneficiaries, trustees, or executors may be faced with uncertain tax consequences and potentially complicated distribution rules to preserve the IRA's tax benefits. This article will attempt to address these issues at a high level to help non-tax lawyers identify potential tax and practical issues in dealing with IRAs. Specifically, this article will examine the prohibited transaction rules broadly forbidding self-dealing. Next, this article will examine the required minimum distribution rules with a focus on issues following the death of the IRA owner. Lastly, this article will touch on IRA creditor protection, its exceptions, and the tax implications of the division/transfer of IRAs in a divorce proceeding.
Transactions A. What is a prohibited transaction (in code-speak)?
Any direct or indirect: (A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
(B) lending of money or other extension of credit between a plan and a disqualified person;
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
(E) 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; or
(F) 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.
This broad definition covers almost all types of transactions between a "disqualified person" and the IRA.3 The Code defines a "disqualified person" as a person who is: (A) a fiduciary;
(B) a person providing services to the plan;
(C) an employer any of whose employees are covered by the plan;
(D) an employee organization any of whose members are covered by the plan;
(E) an owner, direct or indirect, of 50 percent or more of-
(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation,
(ii) the capital interest or the profits interest of a partnership, or
(iii) the beneficial interest of a trust or unincorpo rated enterprise, which is an employer or an employee organization described in subparagraph (C) or (D);
(F) a member of the family (as defined in paragraph (6))4 of any individual described in subparagraph (A), (B), (C), or (E);
(G) a corporation, partnership, or trust or estate of which (or in which) 50 percent or more of-
(i) the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,
(ii) the capital interest or profits interest of such partnership, or
(iii) the beneficial interest of such trust or estate, is owned directly or indirectly, or held by persons described in subparagraph (A), (B), (C), (D), or (E);
(H) an officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person described in subparagraph (C), (D), (E), or (G); or
(I) a 10 percent or more (in capital or profits) partner or joint venturer of a person described in subparagraph (C), (D), (E), or (G).
A "fiduciary" is generally a person who exercises any discretionary authority or control over plan assets or who renders investment advice for a fee.5 When determining entity interests, the attribution rules of Code Section 267 apply6
In short, a disqualified person includes the IRA owner, the owner's spouse, ancestors, lineal descendants and spouses of the lineal descendants. Corporations, partnerships, trusts and estates are disqualified persons if at least 50 percent of the entity or its interest is owned directly or indirectly by disqualified persons.
B. What is a prohibited transaction (in plain English)?
Under Code Section 4975(e)(2), there are nine subcategories of disqualified persons. The following charts summarize the basic definition of disqualified persons as to individuals and entities.7 When an IRA transacts with any one of these disqualified persons, directly or indirectly8, the IRA has likely engaged in a prohibited transaction under Code Section 4975- Whether a transaction was undertaken in good faith or beneficial to the IRA is inapplicable to the prohibited transactions analysis.
Companies & Directors/Officers/Partners
C. A prohibited transaction causes termination of the IRA and deemed distribution of its assets as of Jan. 1 of the year of the prohibited transaction
If a prohibited transaction occurs, the resulting effect is straightforward. The account (1) ceases to be an IRA, and (2) is treated as having distributed all of its assets on January 1 of the year of the prohibited transaction. Importantly, the entire IRA is deemed distributed as of January 1, not just the amount of the prohibited transaction.
Because distributions from IRAs are generally 100 percent taxable,10 the IRA owner realizes ordinary income of the entire IRAs value in the year of the prohibited transaction. In addition to ordinary income, the IRA owner may be subject to the 20 percent accuracy-related penalty under Code Section 6662, and the 10 percent early distribution penalty under Code Section 72(t). As illustrated in the Ellis case below, the effect of a seemingly small prohibited transaction can be quite extraordinary to the unsuspecting IRA owner.
D. Case studies and hypotheticals
i. Ellis v. Comm'r-Payment for services
Ellis,11 the taxpayer received distributions totaling $321,366 from his former employer's 401 (k) and deposited the proceeds into his newly-formed self-directed IRA. Ellis also formed an LLC called CST to engage in the used-car sales business. Ellis was its designated general manager. After forming CST and funding his new IRA, Ellis caused his IRA to acquire 98 percent of CST's membership units with the bulk of his IRA assets. During its first year of operation, CST paid Ellis $9,754 as compensation for his role as CST's general manager.
It was undisputed that Ellis was a disqualified person under 4975(e)(2)(A) because he was a fiduciary of his IRA under 4975(e)(3).12 The parties also agreed that CST was a disqualified person because Ellis was a beneficial owner of the IRA's membership interests in the company13 The sole issue was whether Ellis's $9,754 compensation-from the LLC-was a prohibited transaction.14
The 8th Circuit affirmed the Tax Court's holding that Ellis...