U.S. Tax Court decision provides an example of the dangers of uninformed self-directed IRA investors and the severity of the prohibited transaction rules.
The taxpayers in Peek v. Commissioner (140 T.C. No. 12) used their self directed IRAs to buy a combined 100% ownership of a newly-formed corporation. The corporation then used the IRA funds, in addition to a bank loan and promissory notes, to purchase a fire safety business. The sellers of the business required the taxpayers (i.e. the IRA owners) to personally guarantee the promissory notes.
Presumably, the taxpayers were unaware that this guarantee constituted a “direct or indirect extension of credit between a plan [an IRA] and a disqualified person [the IRA owners]”, despite an identical fact-pattern being described as a prohibited transaction in a Department of Labor Advisory Opinion more than 20 years earlier (90-23A, July 3, 1990).
The end result is that the taxpayers’ IRAs were retroactively invalidated and the significant gain from the subsequent sale of the fire and safety business was taxable to the taxpayer’s personally – because the IRAs were deemed to no longer exist. Each taxpayer now owes hundreds of thousands of dollars in back taxes = not fun.
Self-Directed IRAs: A Tax Compliance Black Hole
My article on the inherent tax compliance problems with self directed IRAs was published in the October edition of the Journal of Accountancy. This article discusses several example client case studies and describes how the structural nature of the self-directed IRA marketplace is leading to a massive amount of non-compliance.
For example, if an IRA-owned LLC invests into an active business and the income is thus currently taxable to the IRA, if the Manager of the LLC does not realize that the tax consequence is occurring, no IRA tax return will be filed (partly because the LLC’s investments are not even within the view of the IRA custodian). In addition, even if an IRA custodian is aware of a potential tax problem, these companies often do not alert their clients to the potential problem out of fear of providing “legal and/or tax advice”. This leads to very dangerous situations for uninformed IRA owners (see the Peek case referenced above).