IRS Addresses Prohibited Transactions In ROBS Transactions
In recent years, the Internal Revenue Service has been closely examining transactions in which taxpayers use tax-deferred retirement funds to fund business start-ups. These transactions are ominously referred to as Roll Over Business Startup (ROBS) transactions by the IRS. These transactions have been aggressively marketed by promoters as a means for potential business owners to access tax-deferred funds and to allow business profits to escape immediate taxation. The IRS has stated that although the ROBS transactions are not an abusive tax avoidance scheme and are not non-compliant per se, they are often administered in a manner that results in prohibited discrimination or a prohibited transaction. The consequences of engaging in a prohibited transaction are catastrophic as the IRA will cease to be an IRA as of the first day of the tax year in which the transaction occurs.
In Lawrence F. Peek, et ux., et al. v. Commissioner, 140 T.C. No. 12 (May 9, 2013), the Tax Court again addressed the issue of prohibited transactions in the context of a ROBS transaction. In this case, the taxpayers established self-directed IRAs and elected to roll-over funds from an existing 401(k) plan to the newly formed IRAs. Subsequently, they incorporated FP Corp and directed their new IRAs to use the rolled-over cash to purchase 100 percent of FP Corp’s newly issued stock. The taxpayers also used FP Corp to acquire the assets of AFS Corp. The taxpayers personally guaranteed loans of FP Corp that arose out of the asset purchase. At issue was whether the taxpayers’ personal guarantee of the asset purchase obligation constituted a “prohibited transaction”.
In general, IRAs are subject to special rules, including the provision in section 408(e)(2)(A) that an account ceases to qualify as an IRA if “the individual for whose benefit any individual retirement account is established engages in any transaction prohibited by section 4975”. Section 4975(c)(1)(B) prohibits “any direct or indirect lending of money or other extension of credit between a [retirement] plan and a disqualified person”.
The taxpayers argued that the personal guarantees were not prohibited transactions because they did not involve “the plan” (i.e., in this case, the IRAs), whereas the extension of credit prohibited under section 4975(c)(1)(B) is “between a plan and a disqualified person”. Instead, the personal guarantees related to FP Corp., and not the plan.
The Tax Court disagreed and stated that “This reading of the statute, however, would rob it of its intended breadth. Section 4975(c)(1)(B) prohibits ‘any direct or indirect extension of credit between a plan and a disqualified person’.” They reasoned that if the statute prohibited only a loan or loan guarantee between a disqualified person and the IRA itself, then the prohibition could be easily and abusively avoided simply by having the IRA create a shell subsidiary to whom the disqualified person could then make a loan. That, however, is an obvious evasion that Congress intended to prevent by using the word ‘indirect’.
Because the Tax Court held that the loan guarantees were prohibited transactions, it did not address two additional IRS alleged prohibited transactions: (1) payments of compensation to the taxpayers, and (2) payment of rent to an entity owned by the taxpayers’ wives. The IRS had argued that the first transaction was a prohibited transaction under Section 4975(c)(1)(D) (a transfer to or use for the benefit of a disqualified person of the income or assets of the plan) and that the second transaction was a prohibited transaction under Section 4975(c)(1)(E) (act of a disqualified person who is a fiduciary whereby he or she deals with the income or assets of the plan for his or her own interest, or for his or her own account).
While these arguments were not addressed by the Tax Court, they underscore the danger of engaging in a ROBS transaction without fully understanding the potential pitfalls. It is commonplace for a taxpayer to receive compensation for services provided to a small business that he or she owns, either directly or indirectly. It is similarly common for a taxpayer to lease real estate to a business entity that they own. However, even these simple and common transactions can lead to catastrophe if the company is owned by a self-directed IRA.
