IRAs and Nonqualified Compensation Plans

Can an erroneous Form 1099 save you from tax and penalties?

It’s an oddball question, methinks. I anticipate the other side of that see-saw is whether one knew, or should have known, better.

Let’s look at the Clair Couturier case.

Clair is a man, by the way. His wife’s is named Vicki.

Clair used to be the president of Noll Manufacturing (Noll).

Clair and Noll had varieties of deferred compensation going on: 

(1)   He owned shares in the company employee stock ownership program (ESOP).

(2)   He had a deferred compensation arrangement (his “Compensation Continuation Agreement”) wherein he would receive monthly payments of $30 grand when he retired.

(3)   He participated in an incentive stock option plan.

(4)   He also participated in another that sounds like a phantom stock arrangement or its cousin. The plan flavor doesn’t matter; no matter what flavor you select Clair is being served nonqualified deferred compensation in a cone.

Sounds to me like Noll was taking care of Clair.

There was a corporate reorganization in 2004.

Someone wanted Clair out.

COMMENT: Let’s talk about an ESOP briefly, as it is germane to what happened here. AN ESOP is a retirement plan. Think of it as 401(k), except that you own stock in the company sponsoring the ESOP and not mutual funds at Fidelity or Vanguard. In this case, Noll sponsored the ESOP, so the ESOP would own Noll stock. How much Noll stock would it own? It can vary. It doesn’t have to be 100%, but it might be. Let’s say that it was 100% for this conversation. In that case, Clair would not own any Noll stock directly, but he would own a ton of stock indirectly through the ESOP.

If someone wanted him out, they would have to buy him out through the ESOP.

Somebody bought out Clair for $26 million.

COMMENT: I wish.

The ESOP sent Clair a Form 1099 reporting a distribution of $26 million. The 1099 indicated that he rolled-over this amount to an IRA.

Clair reported the roll-over on his 2004 tax return. It was just reporting; there is no tax on a roll-over unless someone blows it.

QUESTION: Did someone blow it?

Let’s go back. Clair had four pieces to his deferred compensation, of which the ESOP was but one. What happened to the other three?

Well, I suppose the deal might have been altered. Maybe Clair forfeited the other three. If you pay me enough, I will go away.

Problem:

         § 409 Qualifications for tax credit employee stock ownership plans

So?

        (p)  Prohibited allocations of securities in an S corporation

                      (4)  Disqualified person

Clair was a disqualified person to the ESOP. He couldn’t just make-up whatever deal he wanted. Well, technically he could, but the government reserved the right to drop the hammer.

The government dropped the hammer.

The Department of Labor got involved. The DOL referred the case to the IRS Employee Plan Division. The IRS was looking for prohibited transactions.

Found something close enough.

Clair was paid $26 million for his stock.

The IRS determined that the stock was worth less than a million.

QUESTION: What about that 1099 for the rollover?

ANSWER: You mean the 1099 that apparently was never sent to the IRS?

What was the remaining $25 million about?

It was about those three nonqualified compensation plans.

Oh, oh.

This is going to cost.

Why?

Because only funds in a qualified plan can be rolled to an IRA.

Funds in a nonqualified plan cannot.

Clair rolled $26 million. He should have rolled less than a million.

Wait. In what year did the IRS drop the hammer?

In 2016.

Wasn’t that outside the three-year window for auditing Clair’s return?

Yep.

So Clair was scot-free?

Nope.

The IRS could not adjust Clair’s income tax for 2004. It could however tag him with a penalty for overfunding his IRA by $25 million.

Potato, poetawtoe. Both would clock out under the statute of limitations, right?

Nope.

There is an excise tax (normal folk call it a “penalty”) in the Code for overfunding an IRA. The tax is 6 percent. That doesn’t sound so bad, until you realize that the tax is 6 percent per year until you take the excess contribution out of the IRA.

Clair never took anything out of his IRA.

This thing has been compounding at 6 percent per year for … how many years?

The IRS wanted around $8.5 million.

The Tax Court agreed.

Clair owed.

Big.

Our case this time was Couturier v Commissioner, T.C. Memo 2022-69.

Blowing Up An IRA

I am not a fan of using retirement funds to address day-to-day financial stresses.

That is not to downplay financial stresses; it is instead to point out that using retirement funds too easily can open yet another set of problems.

Those who have followed me for a while know that I disapprove of using retirement funds to start a business: the so-called Rollovers as Business Startups, whose humorous acronym is ROBS. I know that – in a seminar setting – it is possible to mitigate the tax risks that ROBS pose. I do not however practice in a seminar setting. Heck, I am lucky if a client calls in advance to discuss whatever he/she is getting ready to do.

Let me give you a couple of ROBS pitfalls:

(1) You have your IRA buy a fourplex. You spend time cleaning, doing maintenance and repairs and routinely running to Home Depot.

Question: Is there a tax risk here?

(2) You have your IRA buy a business. You have your son and daughter run the business. You work there part-time and draw a paycheck.

Question: Is there a tax risk here?

The answer to both is yes. Consider:

(1) You are buying stuff at Home Depot, stuff that the IRA should have been buying - as the IRA owns the fourplex, not you. If you are over age 50, you can contribute $6,500 to the IRA annually. Say that you have already written that check for the year. You are now overfunding the IRA every time you go to Home Depot. Granted, one trip is not a big deal, but make routine trips – or incur a major repair – and the facts change. That triggers a 6% penalty – every year - until you take the money back out.

(2) There are restrictions on direct and indirect benefits from an IRA. You are receiving a paycheck from an asset the IRA owns. While arguable, I am confident that your paycheck is a prohibited benefit.

I am looking a Tax Court case where the taxpayer had her IRA lend $40,000 to her dad in 2005. A few years went by and she had the IRA lend $60,000 to a friend.

In 2013 she changed IRA custodians. The new custodian saw those two loans, and she had problems. Perhaps the custodian could not transfer the promissory notes. Perhaps there were no notes. Perhaps the custodian realized that a loan to one’s dad is not allowed. This part of the case is not clear.

COMMENT: It is possible to have an IRA lend money. I have a client who does so on a regular basis. Think however of acting like a bank, with due diligence, promissory notes, periodic interest and lending to nonrelated independent third-parties.

The IRS saw easy money:

(1)  There was a taxable distribution in 2013;

(2)  … and a 10% penalty for early distribution;

(3)  … and the “substantial understatement” penalty because the tax numbers changed enough to rise to the level of “substantial.”

How do you think it turned out for our tax protagonist?

Go back to the dates.

She loaned money to her dad in 2005.

Let’s glance over IRC Section 408(e)(2)

 (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.

The loan was a prohibited transaction. She blew up her IRA as of January 1, 2005. This means that she should have reported ALL of her IRA as taxable income in 2005, of which we can be quite sure she did not.

Can the IRS assess taxes for 2005?

Nope. Too many years have gone by. The standard statute of limitations for assessments is three years.

So, the IRS will tag her in 2013, right?

Nope, they cannot. For one thing, the prohibited transaction did not occur in 2013, and the IRS is not allowed to time-travel just because it serves their purpose.

But there is a bigger reason. Read the last part of Sec 408(e)(2) again.

There was no IRA in 2013. There could be no distribution, no 10% penalty, none of that, as “that” would require the existence of an IRA.

And there was no IRA.

The name of the case for the home gamers is Marks v Commissioner.

A Rollover As Business Startup Got “ROB”bed

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.

Peek-ing Into "Rollover As Business Startup" IRAs

They are called ROBS – an acronym for “Rollovers as Business Startups.” The idea is to own a business through your IRA. Perhaps your IRA could be the bank in the transaction. Perhaps the business will go exponential, which would do wonders for your IRA balance.

Me? I do not particularly care for them. 

Why? This field is so fraught with landmines I cannot help wonder why I would want to cross it. And like Al Pacino in Godfather 3, “just when I thought I was out, they pull me back in.” “They” would be a client whom we will call Jay. We were discussing a biomedical startup on the east side of Cincinnati. High risk, high reward: that type of thing. Should it hit he would be having breakfast on his yacht off the coast of St. Augustine. Maybe I could visit.

“If it goes wrong,” said Jay, “I lose my investment. There is still plenty of time for me to recover.”

In this case, Jay was right. Jay would not be working at the business. He would not be renting property or equipment to the business. He would be a passive investor, which reduces his tax risk considerably. 

But what if the business had to borrow money? What do you think the odds are that a small business, with little or no track record, would be able to borrow without the owner’s guarantee? Remember, Jay (or rather, Jay’s IRA) would be an owner. 

This is a trap. Let’s discuss how someone fell into the trap.

In 2001, Lawrence Peek (Peek) and Darrell Fleck (Fleck) decided to buy a fire protection company, Abbott Fire & Safety, Inc (AFS). The brokerage firm facilitating the deal introduced them to Christian Blees, a CPA. Mr. Blees presented a tax strategy, which he called “IACC.” IACC involved establishing a self-directed IRA, transferring money into it from another IRA or 401(k), setting up a new corporation and having the self-directed IRA purchase shares in the new corporation.

In other words, a ROBS.

There is also something subtle here. Mr. Blees had structured a tax strategy, and he sold the strategy to clients. What was his role here? We will come back to this.

Anyway, reams of paperwork were exchanged and signed, with all the waivers and exculpatories and whatnots. Peek and Fleck set up their self directed IRAs. Each puts in $309,000 for a 50% share in a new company (FP). FP in turn acquires Abbott (AFS).

Problem. AFS cost $1,100,000. FP had only $618,000 in cash. What to do? Easy! FP borrows money. Peek and Fleck give personal guarantees.

Peek and Fleck were well advised. In 2003, they each converted one-half of their IRA into a Roth. They each converted the remaining half in 2004. Remember that there is no tax in the future when money comes out of a Roth. FP is going to the stars, and Peek and Fleck are going to make a tax-free bundle.

In 2006, they sell the company for approximately $1.7 million, to be collected over two years.

The IRS examines the 2006 and 2007 tax returns. The IRS voids the IRAs. This means the IRS includes the gain from the sale of FP stock on their personal returns. The IRS also assesses the substantial understatement (20%) penalty. As backup bombardment, the IRS imposes excise taxes for excess contributions to the IRAs.

What…? 

Let’s walk through this.

An IRA is (generally) exempt from tax under Section 408(e)(1). A tax pro however will continue reading. A little further, Section 408(e)(2)(A) says that an account will cease to be an IRA if “the individual for whose benefit any individual retirement account is established… engages in any transaction prohibited by Section 4975.”

It behooves us to review Section 4975 and to stay as far away from it as possible.

Let us look at this ticking bomb defining a prohibited transaction:

4975(c)(1)(B)  (the) lending of money or other extension of credit between a plan and a disqualified person

So what? There was a guarantee, not a loan, right?

However, a guarantee is considered an indirect extension of credit (this is the Janpol case).

Peek and Fleck argued that the guarantee was between them and FP, not between them and the IRAs.

The Court pointed out the obvious: FP was owned by the IRAS, so - in the end – Peek and Fleck were transacting with their IRAs.

Oh,oh…  a prohibited transaction.

The Court noted that the guarantees existed without interruption since 2001. This meant that the IRAs ceased to be IRAs in 2001, when Peek and Fleck signed the guarantees. Yipes!

The Court now addressed the “substantial underpayment” penalty. Peek and Fleck immediately defended themselves by arguing that they had relied upon a CPA: Christian Blees. Reliance on a pro has long been accepted as reasonable cause to sidestep the penalty.

Too bad, said the Court. Mr. Blees was not a disinterested professional. He was selling a financial product. Heck, he had given it a name: “IACC.” He was not functioning as an independent CPA in this matter. No, he was functioning  as a “promoter.” Reliance on a promoter is not grounds for reasonable cause.

The Court affirmed the substantial understatement penalty.

What about the Roth conversions in 2003 and 2004? Each man would have paid tax upon conversion. Can they now get that money back?

The Court did not address this. Why? Remember that, after three years, a tax year will close. This means that the IRS cannot amend it. It also means that you cannot amend it. This case was decided in May 2013, so unless Peek and Fleck did something special to keep the 2003 and 2004 years open, there was no way to amend those years. They would simply have been out the tax they paid.

And have to pay tax again.

What else could go wrong?

The Court mused on the following questions:

(1) Did wage payments to Peek and Fleck constitute prohibited transactions?

(2) Did rent payments by FP to a company owned by Mrs. Peek and Mrs. Fleck constitute prohibited transactions?

(3) Did Peek and Fleck put too much money into their (Roth) IRAs, thereby triggering the excise tax for excess contributions?

The Court reviewed the wasteland after the nuclear blast of retroactively disqualifying the IRAs and decided that it did not need to consider these issues. Perhaps it felt the bodies were sufficiently dead.

As I said, I do not especially care for ROBS. They can detonate in a hundred different ways. Today we talked about just one of them.