Self directed IRAs - ownership of business that pays compensation to taxpayer results in a prohibited transaction : 2013/11/07

In Ellis v. Commissioner, T.C. Memo. 2013-245 (2013), the United States Tax Court held that the payment of compensation to a taxpayer from a business that was owned by the taxpayer's individual retirement account ("IRA") was a prohibited transaction.  The consequence of the prohibited transaction was that the entire amount of the taxpayer's IRA was treated as taxable, and the taxpayer was responsible for tax penalties and interest. 


The basic facts of the case are as follows:  Mr. Ellis wanted to use funds held by his 401k for the purpose of starting a used car business.  In order to effect this plan, he caused a new limited liability company ("LLC") to be organized and elect to be classified as a corporation for federal income tax purposes. Mr. Ellis also transferred approximately $321,000 from his 401k to a new self-directed IRA, and caused the IRS to acquire 98% of the LLC's membership interests in exchange for capital contributions totaling $319,500.  The LLC then conducted a used car sales business where Mr. Ellis acted as the general manager and was paid total compensation of $9,754 for the year at issue.


The Tax Court held that the organization of the LLC and the IRA's acquisition of the membership interests did not result in a prohibited transaction based on Swanson v. Commissioner, 106 T.C. 76 (1996).  However, the Tax Court held that the payment of compensation to Mr. Ellis by the LLC was a prohibited transaction because Mr. Ellis was in control of the IRA and had discretionary authority over the compensation paid to him by the LLC.


The end result was that Mr. Ellis was required to treat the entire amount transferred from his 401k to the IRA as taxable income (over $321,000).  The taxes and penalties Mr. Ellis was required to pay totalled over $150,000.


As has been reported here before, using funds held in a 401k or IRA to finance a business is very risky and could result in additional taxes, penalties, and interest.  Always seek advice of a competent tax advisor.