In a recent U.S. Tax Court decision the plaintiffs (Ps) lost to the tune of $94,645.20. This serves as a reminder about the costly consequences of making inappropriate transactions within a client’s IRA.
In 2001 Ps established traditional IRAs. Ps formed FP Corp. and directed their new IRAs to use rolled-over cash to purchase 100% of FP Corp.’s newly issued stock. Ps used FP Corp. to acquire the assets of AFS Corp. Ps personally guaranteed loans of FP Corp. that arose out of the asset purchase. In 2003 and 2004 Ps undertook to roll over the FP Corp. stock from their traditional IRAs to Roth IRAs, including in Ps’ income the value of the stock rolled over in those years. In 2006 after the FP Corp. stock had significantly appreciated in value, Ps directed their Roth IRAs to sell all of the FP stock. Ps’ personal guaranties on the loans of FP Corp. persisted up to the stock sale in 2006. R contends that Ps’ personal guaranties of the FP Corp. loan were prohibited transactions, and, as a result, the gains realized in 2006 and 2007 from the 2006 sales of FP stock should be included in Ps’ income.
The court ruled that the IRAs of two business partners were disqualified under the prohibited transaction rule Internal Revenue Code § 408(e) because they guaranteed loans to a company owned by their IRAs. Moreover, they were liable for an accuracy-related penalty under Internal Revenue Code § 6662. As a result of this action, they owed taxes on the capital gains when the stock of the company was later sold inside their disqualified Roth IRAs. As a result of the disqualification, the court found that the taxpayers were negligent for failing to report the sale of the stock they personally owned.
This case is a reminder that advisers should discuss with their clients the potential tax nightmares that can arise if they get too creative with their IRA investments.
Thanks to Gerry W. Beyer at the Law Professor Blogs Network for bringing this to my attention.