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. 

IRS Apologizes For Targeting Tax-Exempt Applications By Conservative Groups

This has been a difficult few weeks for the IRS.

In March Rep. Charles Boustany (R-La.), chairman of the House Ways and Means oversight subcommittee chastised the agency upon discovering a series of IRS training videos that parodied “Star Trek” and “Gilligan’s Island.” The videos cost the IRS approximately $60,000. The IRS initially refused to make the videos public. They later did after mounting criticism.

In April the American Civil Liberties Union released documents obtained under the Freedom of Information Act showing that the IRS criminal tax division believed the agency could access e-mails and text messages without obtaining a warrant. Rep. Charles Boustany demanded the IRS present its policies for when search warrants are needed to review private e-mails and communications.

Last week the IRS announced that it was changing its policy to require search warrants both for criminal and civil tax proceedings.

Last week we found out that an IRS employee at the Covington campus had been charged with destroying at least 800 fiduciary income tax returns. “Fiduciary” is a fancy term for a trust, and the term includes an estate which receives income and has to pay income tax. The employee – Brady James – is only 30 years old, and he could be facing a maximum prison term of 20 years.

One has to wonder what Brady James was thinking.

Last Friday an IRS employee – Lois Lerner, head of the IRS tax-exempt division – responded to a question concerning tax-exempt applications by conservative groups at an American Bar Association conference. A firestorm ignited, and the IRS quickly scheduled a media conference call for the same day.

She apologized for “inappropriate” targeting of conservative political groups during the 2012 election. IRS employees in Cincinnati singled out approximately 75 organizations using “patriot” or “tea party” in their name. The IRS was trying to get ahead of an AP news report, as well as an expected report by the Treasury Inspector General for Tax Administration.

Why Cincinnati? The IRS breaks up its work functions into units, and these units are located throughout the country. The unit under discussion handles the review of applications for tax-exempt status, and that unit is located in Cincinnati.

The number of organizations filing for tax-exempt status has more than doubled since 2010. To handle the volume, the IRS centralized its review of the applications in Cincinnati. Makes sense, as it allows the development of expertise within the unit and consistency in the process.

Until it goes wrong. Terribly wrong.

The IRS for example responded to the Richmond (VA) Tea Party’s application by requiring additional documentation on 17 different matters. When it did so, the IRS responded by requiring documentation on 53 additional matters. Oh, and the Richmond Tea Party had two weeks to respond.

 “We made some mistakes,” said Lois Lerner. “Some people didn’t use good judgment. For that we are apologetic.”

Heartfelt apology, isn’t it?

Lerner went on to explain that low-level employees initiated the IRS practice. It was not motivated by bias, she said.

COMMENT: Who would even think of bias? Do not pay attention to the fact that groups with words like “progressive” in their name did not receive the same scrutiny.

"It's the line people that did it without talking to managers," Lerner continued. "They're IRS workers, they're revenue agents."

COMMENT: Are there no supervisors in Cincinnati? She makes it sound like her revenue agents are doing whatever they want, without review and apparently without accountability.  I am throwing the B.S. flag on Ms. Lerner.

Lerner told the AP that no high-level IRS officials knew about the practice.

COMMENT: This means some non high-level will take the fall, of course. Hey, there are perks to being a high-level.

Friday was not Lerner’s best moment. At one point she said, "I'm not good at math." Granted, she is an attorney and not an accountant, but still.  That is not a comforting comment from an IRS high-level.

Good grief.

Judge Rips Into The IRS Over Prosecution Of Widow

You may be aware that the IRS has been going after people with overseas accounts. I have little sympathy for deliberate tax evaders, but the IRS approach can be described as erratic. Very ordinary people are terrorized with outrageous penalties while bigger fish are allowed to swim away.

Therefore, I was very glad to see the resolution of the case against Mary Estelle Curran.

Let us start by saying that Mrs. Curran is very wealthy. Her husband inherited money from an aunt who lived in Monte Carlo. He left the money in a Lichtenstein foundation. There were never any additional deposits into this account. Over the years, the account grew into a sizeable sum, which Mrs. Curran inherited after his death. She then had to learn money management, as her husband had done that for more than 40 years.

This was not chump change: she inherited over $40 million.

She is not a natural object for our sympathy, right?

Not so fast. Having money does not make one guilty any more than being left-handed does.

She asked her accountants and lawyers in Europe how to handle and report the money. Unfortunately, she did not inform her U.S. accountants. She kept this up for several years.

The IRS eventually came out with an amnesty program, and Mrs. Curran decided to do the right thing.  She contacted her European bankers, who put her in touch with a U.S. tax lawyer. She gave the attorney all the information for voluntary disclosure with the IRS.

It took about a month to review and assemble the information and contact the IRS. Would you believe that – in that month - UBS had provided approximately 250 names to the IRS? By the time she submitted her disclosure, the IRS had already had her name for approximately 3 weeks.

The IRS had a rule: if they found out about you before you disclosed, you were not eligible for the voluntary disclosure program. There was a glitch, though: Mrs. Curran had submitted her disclosure seven days before the start of the amnesty program. Too bad, screeched the IRS. No amnesty for you!

Mrs. Curran goes to Court on criminal charges. She pleads guilty to tax evasion and filing false tax returns. She was fined over $26 million for failing to remit approximately $670,000 in tax to the IRS over the years.

OBSERVATION: How much Kool-Aid does one have to drink to think that a fine of $26 million is fair balance for $670,000 in unpaid taxes? If the government applied this ratio to all the earned income tax credit cheats and tax refund thieves we could balance the federal budget. The IRS was not interested in just bringing a noncompliant taxpayer into compliance. No, it had an agenda. 

Mrs. Curran could have even have gone to jail. Her niece – who is blind – offered to serve jail time in place of her 79-year old aunt.

Here is her attorney pleading before the Court:

... 38,000 people went through the three offshore voluntary programs after her and received immunity from prosecution. They were also treated and penalized far different than her. They were penalized mainly at the rate of 20 percent for the FBAR violation of the largest amount of money in the account. She was penalized 50 percent.”

She has been prosecuted criminally, indicted and arrested, and those 38,000 were not. And she has been adjudicated a felon, and all those 38,000 people did not suffer that designation.  

Every one of these 38,000 people were given a second chance..., yet Mrs. Curran never received a second chance at all.”

U.S District Court Judge Kenneth Ryskamp was presiding. Here is the Judge and an IRS (i.e., Justice Department) attorney:

JUDGE: Based upon those facts, did it ever occur to the government that this case ought to be dismissed and let this thing go?

IRS: No, your Honor.

IRS: Your Honor, there is a certain level of randomness to the level of government prosecution...

JUDGE: ... (her) lawyer detained it (the disclosure), and she would have qualified under it (the IRS program).

IRS: ... the government has to draw bright lines as to where...

JUDGE: I don’t know if the government has to do anything. It seems to me that the government has a lot of discretion and the government decided to make a felon out of this woman.

IRS: ... there were numerous articles in the Wall Street Journal, in the New York Times about the government’s investigation of foreign bankers.

JUDGE: This case is totally out of scope of all your other cases where people are skimming, were trying to hide funds. I mean, there was an inheritance over there, and al lot of reasonable people would think you don’t have to report this.”

The Court passes sentence:

A term of imprisonment would be unnecessarily harsh.

It is the finding of the Court that the defendant is not able to pay a fine.

It is the judgment of the Court that the defendant, Mary Estelle Curran, is placed on probation for a period of one year.”

The Court was clearly miffed by the IRS’s behavior.

I’m now revoking probation. Probation is terminated. You were on probation for about five seconds there.

The law requires me to put you on – if I don’t put you in jail – I’ve got to put you on probation. It doesn’t say how long you have to stay there.”

Wow!

The Court continued:

I would urge you to file a petition for a pardon with the executive branch. You can tell them the Court thinks this woman’s felony should be removed. And if the government doesn’t join it, then it’s just spiteful.”

Judge Ryskamp is now famous with tax practitioners. He can count me a fan.