Loan guarantees were prohibited transactions that disqualified IRAs.

Author:Beavers, James A.
Position:Individual retirement accounts

The Tax Court held that the taxpayers' guarantees of a loan made to a company owned by the taxpayers' individual retirement accounts (IRAs) were prohibited transactions that caused the accounts to cease to be IRAs.



In 2001, Darrell Fleck and Lawrence Peek (the taxpayers) decided to buy Abbot Fire 8c Safety Inc. (AFS). On the advice of an accountant, the taxpayers chose to use IRAs to purchase the company. Each taxpayer established a self-directed traditional IRA to hold his share of the company's stock. They then formed FP Co. and directed the new IRAs to use rolled-over cash to purchase 100% of FP Co.'s newly issued stock. FP Co. subsequently acquired the assets of AFS, using the funds from the IRAs' purchases of its stock and a bank loan and notes from FP Co. to the broker and the sellers. The taxpayers personally guaranteed FP Co.'s bank loan.

In 2003 and 2004, the taxpayers rolled over the FP Co. stock from the traditional IRAs to Roth IRAs, including in their income the value of the stock rolled over in those years. In 2006 after the FP Co. stock had significantly appreciated in value, they directed their Roth IRAs to sell all of the FP Co. stock, and they received payments for the stock in 2006 and 2007. The taxpayers did not report the gain from the sale on their respective individual income tax returns for 2006 and 2007.

The IRS disagreed with how the taxpayers reported the results of this series of transactions. The IRS contended that the taxpayers' personal guarantees of the FP Co. loan were prohibited transactions under Sec. 4975(c)(1)(B), which prohibits a direct or indirect lending of money between a retirement plan and a disqualified person. Under Sec. 408(e)(2)(A), because the loan guarantees were prohibited transactions, the taxpayers' original IRAs ceased to qualify as IRAs, resulting in a distribution of the assets in the IRAs to the taxpayers. From that point forward, the IRS treated the FP Co. stock as personally owned by the taxpayers. The IRS adjusted each taxpayer's income for 2006 and 2007 to include capital gain from the sale of his share of the FP Co. stock.

The taxpayers challenged the IRS's determination in Tax Court. While the taxpayers' acknowledged that their loan guarantees were indirect loans and that they were disqualified persons for purposes of Sec. 4975(c)(1)(B), they argued that the guarantees were not loans between the plans (i.e., the IRAs) and disqualified persons...

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