We have talked before about ROBS. This
is when one borrows money from his/her IRA to start a business. ROBS have become increasingly popular, and I
have wandered in tax Siberia by being negative on them. I know a CPA in New
Jersey who even used a ROBS to start his practice. I gave him some slack (but just
a little) as he is a general accounting practitioner and not a tax specialist.
Here is the question I hear: what is one’s
downside if it goes south? They can’t eat me, right?
My answer: you have blown up your IRA
via a prohibited transaction. A prohibited is nothing to take lightly. It
contaminates your IRA. All of it. Even the monies you leave behind in the IRA. This
is a severe case of terminal.
Now I have a case to share with my
clients: Ellis v Commissioner.
Mr. Ellis accumulated a sizable
401(k). In 2005 he formed an LLC (CST) to sell used cars. He moved $319,500
from his 401(k) to an IRA to acquire the initial membership units of CST. He
worked there as general manager and received a modest W-2. CST made a tax
election to be taxed as a corporation. It did this to facilitate the ROBS tax
planning.
Mr. Ellis, his wife and children also
formed another LLC (CDJ LLC) in 2005 to acquire real estate. Mr. Ellis did not
use his IRA to fund this transaction.
In 2006 CDJ LLC leased its real
estate to CST for $21,800. No surprise.
Mr. Ellis also received a larger –
but still modest – W-2 for 2006.
The IRS swooped in on 2005 and 2006.
They wanted:
·
Income
taxes of $135,936 for 2005
·
Alternatively,
income taxes of $133,067 for 2006
·
Early
distribution penalties of 10%
·
Accuracy-related
penalties of $27,187 for 2005 or $26,613 for 2006
What set off the IRS?
·
Mr.
Ellis engaged in “prohibited transactions” with his IRA.
·
When
that happened, his IRA ceased to be an “eligible retirement plan” as of the
first day of that taxable year.
·
Failure
to be an “eligible retirement plan” means that that the IRA was deemed
distributed to him.
·
As
he was not yet 59 ½ there would be early distribution penalties in addition to
income tax.
When did this happen? Take your pick:
·
When
Mr. Ellis used his IRA to buy membership interests in CST in 2005
·
When
CST paid him a W-2 in 2005
·
When
CST paid him a W-2 in 2006
·
When
CST paid CDJ LLC (an entity owned by him and his family) rent in 2006
OBSERVATION: Do you see the danger with the ROBS? Chances are
that you will be giving the IRS multiple points at which to breach your tax
planning. You have to defend all points. Failure to defend one – just one –
means the IRS wins.
Code section 4975 defines “prohibited
transactions” with respect to a retirement plan, including IRAs. Its purpose is
to prevent taxpayers from self-dealing with their retirement plan. The purpose
of a retirement plan is to save for retirement. The government did not allow
tax breaks intending for the plan to be a piggybank or an alternative to
traditional bank loans.
Self-dealing with one’s retirement
plan is per-se prohibited. It is of no consequence whether the deal is prudent,
in the best-interest-of or outrageously profitable. Prohibited means prohibited,
and the penalties are correspondingly harsh.
The Court proceeds step-by-step:
(1) CST did not have any shares or units
outstanding when Mr. Ellis invested in 2005. Fortunately, there was precedent
(in Swanson v Commissioner) that a corporation
without shareholders is not a disqualified person for this purpose.
Mr. Ellis won this one.
(2) Mr. Ellis, feeling emboldened, argued
that Code section 4975(c) did not apply because he was paid reasonable
compensation for services rendered, or for the reimbursement of expenses
incurred, in the performance of his duties with the plan.
The Court dryly notes that he was
paid for being the general manager of CST, not for administrating the plan. Code
section 4975(c) did not apply. Ellis was a disqualified person, and transfers
of plan assets to a disqualified person are prohibited.
Mr. Ellis argued that the payment was
from the business and not from his plan. The Court observed that the business
was such a large piece of his IRA that, in reality, the business and his IRA
were the same entity.
Mr. Ellis lost this one.
(3) Having determined the W-2 a
prohibited transaction, it was not necessary for the Court again to consider
whether the rent payment was also prohibited.
The Court goes through the
consequences of Mr. Ellis blowing-up his IRA:
(1) Whatever he moved from his 401(k) to
his IRA in 2005 is deemed distributed to him. He had to pay income taxes on it.
a. The Court did observe that – since
the IRA erupted in 2005 - it couldn’t again erupt in 2006. Thank goodness for
small favors.
(2) Since Mr. Ellis was not age 59 ½, the
10% early distribution penalty applied.
(3) Since we are talking big bucks, the
substantial underpayment penalty also applied for 2005. Ellis could avoid the
penalty by showing reasonable cause. He
didn’t.
I suppose one could avoid IRA/business
unity argument by limiting the ROBS to a small portion of one’s IRA. That would
likely require a very sizeable IRA, and what would “small” mean in this
context?
I disagree with the Court on the
reasonable cause argument. ROBS are relatively recent, and takes a while for a
body of law, including case law, to be developed. I find it chilling that the Court
thought that the law and its Regulations were sufficiently clear that Mr. Ellis
should have known better. Whereas I disagree with many of the ROBS arguments, I
acknowledge that they are reasonable arguments. The Court evidently did not
feel the same.
OBSERVATION: How long do you think it will be before ROBS are
a “reportable transaction,” bringing disclosure to its promoters and attention
to the taxpayer?
My thoughts? I intend to give this case to any client or
potential client who is considering a ROBS. I can see situations where a ROBS
can still pass muster – if the taxpayer is a true and passive investor, for
example. Problem is, that is not how ROBS are promoted. They are marketed to
the prematurely and involuntarily unemployed, and as a way to fund a Five Guys
Burgers and Fries franchise or that accounting practice in New Jersey. Odds are
you will be working there, as you are too young to retire. You will not be
passive. If you were passive, why not just buy Altria or Proctor & Gamble
stock? You don’t need a ROBS for that.
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