Losing IRA Status Under IRC § 408(e)(2)

Owners of Self-Directed IRAs which engage in certain types of “prohibited transactions” or invest in life insurance, foreign investments or collectibles may risk losing the tax-deferred status of their IRA accounts. If the owner (or beneficiary) of an individual retirement account, as described in I.R.C. §408(a), engages in any transaction that is prohibited under IRC §4975, the entire value of the IRA, determined as of the first day of the taxable year for which the account or annuity ceases to be an IRA, is treated as distributed to the IRA owner. See I.R.C. §408(e)(2)(B).

In Thiessen v. Commissioner, 146 TC No. 7, a taxpayer used a rollover of retirement funds from his former employer to establish an IRA. He and his spouse then used IRA funds to establish a new corporation, which used the IRA monies to purchase an unincorporated business. As part of the purchase, Mr. and Mrs. Thiessen personally guaranteed the promissory note that was issued by the new corporation to the seller.

However, the IRS considered the personal guarantee to be a prohibited transaction, being effectively identical to the structure the Court had found to be a prohibited transaction in Peek v. Commissioner, 140 TC 216. Thus, it is not surprising that the Tax Court arrived at the same result in Thiessen as it did in Peek, which was that the entire balance of the IRA was treated for tax purposes as distributed on the first day of the tax year in which the Thiessens made their personal guarantee.

This IRA “full distribution” rule is found in IRC §408(e)(2), which provides:

(2) Loss of exemption of account where employee engages in prohibited transaction

(A) In general

If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year. For purposes of this paragraph—

(i) the individual for whose benefit any account was established is treated as the creator of such account, and

(ii) the separate account for any individual within an individual retirement account maintained by an employer or association of employees is treated as a separate individual retirement account.

(B) Account treated as distributing all its assets

In any case in which any account ceases to be an individual retirement account by reason of subparagraph (A) as of the first day of any taxable year, paragraph (1) of subsection (d) applies as if there were a distribution on such first day in an amount equal to the fair market value (on such first day) of all assets in the account (on such first day).

I.R.C. §4975 defines six types of prohibited transactions, including §4975(c)(1)(B) which defines one type as the “[direct or indirect] lending of money or other extension of credit between a plan and a disqualified person…” A disqualified person may be an individual who “exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets.” [IRC §4975(e)(3)(A)]

The Court referred to Peek in making its decision in Thiessen, holding that the taxpayers were “disqualified persons” within the meaning of §4975(e)(3) and that the taxpayers’ guaranties of the loan were prohibited transactions as indirect extensions of credit between the taxpayers and the IRAs. See Peek at 224-225; see also Janpol v. Commissioner, 101 T.C. 518, 527 (1993) (“An individual who guarantees repayment of a loan extended by a third party to a debtor is, although indirectly, extending credit to the debtor.”). See Peek at 227.

The Court held that the taxpayers’ participation in the prohibited transactions caused the IRAs to cease qualifying as IRAs within the meaning of §408(a) in the year in which the guaranties were made. See Peek at 227. As the entire value of the IRA was therefore established as of the first day of the taxable year for which the account or annuity ceased being an IRA, it was treated as a distribution to the IRA owner. Thus, the taxpayers lost all tax benefits of their IRA, disqualified under §408(e)(2). This is a valuable lesson for all IRA owners.

If you own an IRA and wish to utilize it in some fashion for further investment purposes but are concerned about participating in a prohibited transaction under §4975 of the Internal Revenue Code, call THE TAX EXPERTS at the Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704Losing IRA Status Under IRC § 408(e)(2)

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