Getting ROBbed

I was skimming a Tax Court decision that leads with:

“… respondent issued a notice of deficiency … of $249,263.62, additions to tax … of $20,228.76 and $22,476.41, respectively and an enhanced accuracy-related penalty … of $63,918.33”

It was Roth IRA decision.

We have spoken before about putting a business in an IRA, and a Roth is just a type of IRA. This tax structure is sometimes referred to as a “ROBS” – roll-over as business start-up. 

Odds are the only one who is going to get robbed is you. I had earlier looked into and decided that I did not like the ROBS structure. There are too many ways that it can detonate. I do not practice high-wire tax.  

I have also noticed the IRS pursuing this area more aggressively. There often is complacency when a “new” tax idea takes, as the IRS may not respond immediately. That lag is not an imprimatur by the IRS, although self-interested parties may present it as such. I have been in practice long enough to have heard that sales pitch more than once.

Let’s discuss Polowniak v Commissioner.

Polowniak had over 35 years of marketing experience with Fortune 500 companies, including Proctor & Gamble, Johnson & Johnson and Kimberly Services. In 1997 he formed his own company – Solution Strategies, Inc. (Strategies). He was the sole shareholder and its only consultant.

In 2001 he received a nice contract - $680,000 – from Delphi Automotive Systems – which had him travel extensively to Europe, Asia and South America. 

Now the turn. His financial advisor recommended an attorney who pitched the idea of “privately owned Roth IRA corporations,” also known as PIRACs. These things are not rocket science. In most cases an individual already has an existing company, likely profitable or soon to be. Said individual sets up a Roth IRA. Said Roth purchases the stock of a new corporation (NewCo), which amazingly does exactly the same thing that the existing corporation did, and likely with the same customers, vendors, employee, office space and so on.

The idea of course is that NewCo is going to be very profitable, which allows the opportunity to stuff a lot of money into the Roth in a very short period of time.

So Polowniak sets up a NewCo, which he names Bevco Investments, Inc. (Bevco). There is a little flutter in the story as Bevco selects a January year-end, meaning that a sharp tax advisor may have the opportunity to move things back-and-forth between a calendar-year taxpayer and an entity that doesn’t file its tax return until a year later.

This is fairly routine tax work.

Polowniak owned 98 percent and his administrative assistant owned 2 percent.  His wife later purchased 6% of Bevco.

Strategies and Bevco entered into an agreement whereby it would receive 75% of Strategies revenues for 2002.

By the way, Delphi was never informed of Bevco. Neither was the administrative assistant.

The years passed. Polowniak let the subcontract with Bevco lapse.

And he started depositing all the Strategies revenue from Delphi into Bevco. There was no more pretense of 75 percent.

Bevco was finally dissolved in 2006.

And then came the IRS.

It went after Solutions, which did not report the $680,000 from Delhi. You remember, the same amount it was to share 75% with Bevco.

Sheesh.

It also came after Polowniak personally. The IRS wanted penalties for excess funding into a Roth.

Huh?

There are limits for funding a Roth. For example, the 2015 limit for someone age-50-and-over (ahem) is $6,500. If you go over, then there is a 6% penalty. Mind you, the 6% doesn’t sound like much, but it becomes pernicious, as it compounds on itself every year. Tax practitioners refer to this as “cascading,” and the math can be surprising.

How did he overfund?

Simple. He took existing money from Solutions and put it into Bevco. It is the equivalent of you depositing money at Key Bank rather than Fifth Third.

Polowniak’s job right now was to convince the Court that was a substantive reason for the Solutions –Bevco structure. If Bevco was just an alter ego, he was going to lose and lose big.

He trotted put Hellweg, a tax case featuring Roth IRAs and Domestic International Sales Corporations (DISCs). Whereas the taxpayer won that case, there was some arcane tax reasoning behind it, likely exacerbated by those DISCs.

The Court did not think Hellweg was on point. It thought that Repetto was much more applicable, pointing out:

·        All the services performed by Bevco had previously been performed by Polowniak through Strategies

·        Polowniak performed all the services under the contract with Delphi

·        Since he was the only person performing services, the transfer of payments between Strategies and Bevco had no substantive effect on the Delphi contract

·        Delphi did not know of the contract with Bevco; in fact, neither did the administrative assistant

·        The business dealing between Strategies and Bevco were not business-normative. For example, Bevco never kept time or accounting records of its services, nor did it ever invoice Strategies.

The Court decided against Polowniak. It did not respect the PIRAC, and as far as it was concerned all the Delphi money put into Bevco was an overfunding.

And that is how you blow through a third of a million dollars.

Is there something Polowniak could have done?

He could of course have respected business norms and treated both as separate companies with their own accounting systems, phone numbers, contracts and so forth. It would have helped had Strategies not been depositing and withdrawing monies from Bevco’s bank account.

Still, I do not think that would have been enough.

There are two major problems that I see:

(1) There was an existing contract in place with Delphi. This is not the same as starting Bevco and pounding the streets for work. There is a very strong assignment of income feel, and I suspect just about any Court would have been disquieted by it.

(2) There were not enough players on the field. If I own a company with 75 employees, I may be able to take a slice of its various activities and place it inside a PIRAC or ROBS or whatever, without the thing being seen as my alter ego. Polowniak however was a one-man show. This made it much easier for the IRS to argue substance over form, which the IRS successfully argued here.

 

My advice? Leave these things alone. There are a hundred ways that these IRA-owned companies can blow up, and the IRS has sounded the trumpet that it is pursuing them.

IRS Relaxes Debt Repayment Program

Yesterday the IRS announced that it was relaxing its rules under the offer in compromise (OIC) program. This is part of the IRS’ “Fresh Start” program, and is in response to the ongoing unemployment and financial crisis.

For example:

(1) The IRS will look at one year’s future income for offers paid in five or fewer months. This is down from four years.

(2) The IRS will look at two years of future income for offers paid in six to 24 months. This is down from five years.

Fewer months means a reduced collection potential. You can negotiate a smaller payment now. These offers must be paid within 24 months, however. This may exclude some taxpayers, but it will open the door to many others.

Many practitioners, including me, have been frustrated by the IRS’ unwillingness to acknowledge certain expenses and payments when evaluating installment agreements and OICs. The classic is credit card payments. We are presently negotiating child care payments with a revenue officer, as another example. The IRS has now expanded the National Standard miscellaneous allowance to allow for bank fees and credit card payments.

The IRS is also relaxing how it handles student loan payments when evaluating offers. It intends to do the same with state income tax obligations.

There is good stuff here.

IRAs and Nontraditional Investments

We have received several inquiries over the last year or so about using IRAs for nontraditional investments. This frequently means real estate, perhaps commercial real estate to house a closely-held business. It might also mean using the IRA to start the business itself.

These types of transactions are not without risk. One has the risk of business failure or decline in property value, of course, but also the risk of disqualifying the IRA itself. This would be very bad, as this makes the IRA immediately taxable. To protect against this, one should roll-over the required funds from the “main” IRA into a separate IRA. Should the unfortunate occur, only the roll-over IRA will blow-up. One has contained the damage.

A nontraditional investment requires a self-directed IRA. You will need to find a custodian that will permit nontraditional investments. Most will not. Let’s say you found one. Let’s use the acronym SDIRA for a self-directed IRA in our discussion.

A SDIRA can invest in a privately-owned business. We already know that an IRA can invest in a non-private business, as these are the publicly-traded companies whose stocks are in your IRA or are in the mutual funds in your IRA. This is your Google stock or your Fidelity Contrafund.

The type of business entity is important. The SDIRA can invest in a C corporation but not in an S corporation. Why not? Because the IRS does not permit an IRA to be a shareholder in an S corporation.

The level of involvement in the business owned by the SDIRA is also critical. There are two key tax issues here:

·         The SDIRA cannot enter into a “prohibited transaction.” This is a death sentence. The SDIRA will lose its tax-exempt status and become immediately taxable. If you are under age 59 ½, there will also be penalties.

·         The SDIRA might enter into investments which themselves trigger a tax. This is not as bad as a prohibited transaction, as the overall SDIRA does not become taxable. There is tax only on the income. If the deal is good enough, paying tax may be acceptable.

Prohibited Transactions

The IRS defines a disqualified person as

·         The IRA account holder

·         A family member of the account holder.

o   This goes vertical: grandparents, parents, children and spouses

·         An entity owned 50% or more by the account holder

Think about that last one. Here at Kruse & Crawford, I could theoretically use my IRA, buy an office building and rent it to the firm, as I am not a 50%-or-more owner. Rick Kruse however could not.

Let’s go though the prohibited transactions:

(A) Sale, exchange or leasing of any property between an IRA and a disqualified person

Example 1: My SDIRA purchases property from me or my wife.  This is prohibited. It doesn’t matter if it purchases the property in a “commercially reasonable” manner – i.e. obtain an appraisal. It is not allowed. Period.

Example 2: My SDIRA pays my daughter twenty-five dollars to mow the lawn on the property.  My daughter is a family member. It is prohibited. The amount of money is irrelevant. 

(B) Lending of money or other extension of credit between an IRA and a disqualified person

Example 3: I lend you $10,000 from my IRA.

Example 4: I personally guarantee a bank loan to my IRA.

Example 5: My IRA loans money to me. 

(C) furnishing of goods, services, or facilities between an IRA and a disqualified person

Example 6: I buy a piece of property through my SDIRA and hire my wife to manage the property.

(D) transfer to, use by or for the benefit of a disqualified person of IRA income or assets

Example 7: My SDIRA purchases real estate in Ireland. The SDIRA rents out the property for most of the year. However, my wife and I use the property for one week twice a year.   Even if my wife and I pay fair-market-value rent, this is a prohibited transaction.

(E) Act by a disqualified person who is a fiduciary whereby he deals with IRA income or assets in his own interest or for his own account

Example 8: I charge my SDIRA a fee to manage its stocks, bonds, mutual funds or other investments.

(F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the IRA in connection with a transaction involving IRA income or assets.

Example 9:  My SDIRA purchase a vacation house is in Augusta. I am offered the use of a Wyoming condo in exchange for use of the Augusta property during the Master’s tournament.

IRA Taxes

(1) Active Business Income (UBTI)

Earnings within an IRA are generally tax exempt. However, certain investments can create taxable income called “unrelated business taxable income” (UBTI).  Generally, UBTI is trade or business income which is not otherwise related to the tax-exempt purpose of the IRA. The idea here is that Congress does not want a tax-exempt entity competing with the taxable business enterprise next door to it.

So if you buy a Panera’s or a Caribou Coffee, you have UBTI.

There are some exceptions to UBTI, including but not limited to:

·         dividends

·         interest

·         royalties

·         rent from real property (however see debt-financed below)

·         sales of real property, if the property is not held as inventory or held in the ordinary course of business

Dividends and interest make immediate sense, as this means stocks and bonds - the traditional investments in an IRA.

UBTI Examples:

Example 1:  The SDIRA purchases a restaurant.  The income from the restaurant will be treated as UBTI.

Example 2:  The SDIRA purchases 25% of an LLC that flips (buys, fixes and sells) real estate. Since the real estate is considered inventory, the income to the SDIRA will be UBTI. 

(2) Debt-Financed Income ( UDFI)

If there is debt involved there will likely be UDFI.

Fortunately, UDFI refers only to the percentage of income resulting from the debt-financed portion of the property,

UDFI Example:

Example 3: My SDIRA purchases a B&B in Ireland putting down 75% and borrowing 25%. 

Note that if there was no debt, the rent would be tax-free to the SDIRA.

But there is 25% debt. This means that 25% of the rent is taxable to the SDIRA. The SDIRA does get to claim rental expenses, however.

Wealth Planning

You may have read that nontraditional IRAs are being used for wealth planning. For example, Max Levchin, the chairman of the social review site Yelp, sold over 3 million shares of Yelp held in his Roth IRA. There is no tax on Roth withdrawals if one waits until age 59 ½. Levchin is in his mid-30s. He will have to wait a while, but the money will be tax-free when it comes out.

Peter Thiel did a similar transaction. He bought shares of PayPal for approximately 30 cents per share while he was CEO of the company. In 2002 eBay bought PayPal for $19 a share. 

Now how did Levchin and Thiel avoid the prohibited transaction rules? Actually, it is very simple. You have to control the company to get into a prohibited transaction. Control is usually defined as at-least-50%. When you drain your IRA to buy that Five Guys Burgers and Fries location, chances are you will own 100%. Compare that to a publicly-traded company with tens if not hundreds of millions of shares. Neither Levchin nor Thiel came close to owning 50%. 

Is this fair? I would lead off by noting that “fair” is subjective, somewhat like asking what music one likes. Levchin and Thiel played the game between the lines. You or I could do the same. It might take a new skill set and a tractor-trailer load of luck, but you or I could (theoretically) do it.

Congress has noted these transactions. There is debate about whether this type of wealth accumulation should be permitted. Discussion has sometimes involved a “ceiling” on the amount invested/deferred in the Roth, but until now nothing has developed.

IRS Offers Penalty Relief for 2011

The IRS last week expanded its relief provisions for financially distressed taxpayers. Effective immediately, the IRS will abate its failure- to-pay penalties for 2011 taxpayers, as long as all taxes are paid by October 15, 2015. To qualify for this relief, you have to be:

·        A W-2 employee and unemployed for at least 30 consecutive days in 2011 or during the 3 ½ months ending April 15,2012, or

·        Self-employed and experiencing a contraction of at least 25% in 2011 business income.

The IRS was very quick to point out that this abatement is for the failure- to-pay penalty only. You still have to file a return by April 15, 2012.

NOTE: There are two “big” penalties when you do not file a return. The first is the failure-to-file penalty. The second is the failure-to-pay. Most tax advisors will counsel you to always file, even if you cannot pay. The failure-to-file penalty is 5% a month, ten times the failure-to-pay penalty of 1/2% a month.

There is a new form to request the abatement (Form 1127-A). The relief is also limited to incomes of $100,000 if you are single and $200,000 if you are married.

The other thing the IRS did is to double the income limitation for a streamlined installment agreement. The streamlined is a payment plan with the IRS. You now qualify if your assessed taxes are $50,000 or less. This is an increase from $25,000, which itself had recently been raised from $10,000. The advantage to the streamlined is that you do not have to provide financial information to the IRS.

The payment term for the streamlined was also increased – from five years to six.