The Siren Song of Self-Directed IRAs.

Judging from some slick financial advice circulating and from court opinions issued, it has been something of a cottage industry to counsel affluent persons to invest the funds held in their brimming self-directed Individual Retirement Accounts (IRAs) in companies with which those persons are intimately involved. Invest in what you know, right? So what better place to invest than your own company. It’s a creative and nontraditional option for wealth creation. Part of the sales pitch appears to be to minimize the possible dangers of the IRS auditing the plan and discovering a “prohibited transaction” under IRC §?4975. One blogger has even scoffed that the “prohibited transaction rules are not as complicated as some make them out to be.”?Can I be an Officer of a Company my IRA will Invest In?, IRA Financial Blog, Feb. 21, 2023. This observation wisely comes with the disclaimer that the blogger does not provide legal services.

Now, the IRS itself abetted to a degree enthusiasm for the investment possibilities of self-directed IRAs when it blessed the approach of having an IRA fund a newly established entity, see FSA 200128011, which position is now treated as a safe harbor.

Other commentators are more guarded about the area, especially noting the harsh consequences of disallowance of the status of the IRA.?See?No, No, No, No. . . . Prohibited Transactions and Disqualified Persons in Self-Directed IRAs, Diosdi & Liu, LLP, Feb. 7, 2024. The greatest such consequence is the truly?draconian?one of the deemed distribution to the owner of an amount equal to the fair market value of all assets of the IRA as of the first day of the taxable year in which the prohibited transaction occurred. Nota bene: an amount equal to?all?assets, not just what was involved in the prohibited transaction.?See?IRC §?408(e)(2)(B). Further, the IRS has been known in these cases to assert an addition to tax under IRC § 6662. And of course, if the owner is under the age of 59 ?, the addition to tax under IRC §?72(t)?applies.

As in many other contexts, follow-through is critical. Once the IRA holds the stock, will it remain a purely passive investor, or will the IRA take steps that could arguably benefit the owner? The owners of self-directed IRAs commonly forget that they are still, technically, “fiduciaries” of those funds, even though the money all originally came out of their pockets. Once the new entity is set up, will the owner take care to remember a few years down the road what they can and can't do? What will happen when the company's managers ask for loans or ask the owner to become a director or an officer?

The case of?Ellis v. Commissioner,?787 F.3d 1213 (8th?Cir. 2015)?aff’g?T.C. Memo. 2013-245, provides a cautionary tale. Mr. Ellis directed his IRA to acquire a 98 percent interest in a recently formed used-car dealership with the expectation of his employment by that business. As the Tax Court phrased it, he “formulated a plan in which he would use startup capital for a used car business.” Because he directed his compensation from that business to himself, Mr. Ellis was found to have engaged in the transfer of plan assets for his own benefit in violation of IRC §§ 4975(c)(1)(D) and (E).

Another foot fault to be minded is in the area of loans, direct or indirect. In Peek v. Commissioner, 140 T.C. 216 (2013), a Mr. Fleck and his attorney Mr. Peek (they sound like characters from Dickens) pursued what they considered an attractive business opportunity in the fire-protection industry. In the summer of 2001, they funded an acquisition company with their IRAs and personally guaranteed the loans to that company. In 2006, they sold the company at a tidy profit. At that point, the IRS materialized, ultimately asserting the loan guarantees were prohibited transactions, and thus causing the IRAs to cease being qualified as such as of January 1, 2001. The Tax Court upheld the IRS determination and imposed the addition to tax under IRC § 6662. The Peek case also highlights how prohibited transactions may lie doggo for years.

(Interesting also in the Peek case was that the specific argument about the loan guarantees was raised in litigation, not in the notice of deficiency, suggesting that some diligent soul in Appeals or Counsel sank their teeth into the file. Let us hope such employees do not take the Musk buyout—for the sake of the nation.)

Mr. Ellis and Mr. Fleck and Mr. Peek all should all have kept in mind that Congress passed the Employee Retirement Income Security Act of 1974, commonly known as ERISA, with the intention of helping Americans save for retirement. Tax advantages were offered to encourage participation in such plans. But Congress incorporated the prohibited transaction rules into the act to prevent taxpayers from taking unfair advantage of these specialized retirement accounts. They are not meant, in other words, to be vehicles for wheeling and dealing.?