What Goes In Your IRA? None of Your Small Business!

Can you operate your own small business inside your IRA? From 1974 to 2013 that question was in a gray area--the answer was a definite "maybe." But the multiple shades of gray have recently turned to black and white. The new answer looks like, "No, you can't."

The issue is whether operating your own small business inside your IRA would constitute, or lead to, a "prohibited transaction." If an individual engages in a prohibited transaction involving his own IRA, the IRA is disqualified. It ceases to be an IRA and is deemed to be distributed to the individual as of the first day of the taxable year in which the transaction occurred (§ 408(e)(2)). In other words, a tax disaster--the death penalty for your IRA.

According to the Tax Court in the 2013 Ellis case, if an IRA owns a business, and the business pays a salary to the owner of the IRA, that is a prohibited transaction, disqualifying the IRA. Unbelievably, this is the first case to specifically address and answer the question of whether payment of compensation to the IRA owner from an IRA-owned business is or is not a prohibited transaction. Unfortunately, the Court's answer means there are a lot of IRAs out there that are in trouble.

Some History For many years, optimistic promoters have helped IRA owners establish businesses inside their IRAs and averred that such businesses could pay the IRA owner "reasonable compensation" without causing any problem. ERISA and the prohibited transaction rules were enacted in 1974. Why did it take 39 years to find out that this assertion was erroneous, at least according to the Tax Court?

Here's how we got there. The prohibited transaction rules were added to the Code as part of ERISA. From the date ERISA was enacted (41 years ago--Labor Day 1974) until now, the prohibited transaction rules have been in the Code, and it's been clear they apply to IRAs, and the rules haven't been amended one little bit since 1974.

Over the years the IRS made sporadic attempts to attack IRAs on prohibited transaction grounds, but for some reason the IRS almost always lost. They always had the wrong facts, the wrong theory, the wrong judge. In one IRA/prohibited transaction case, the judge was so disgusted with the IRS, the poor defenseless IRA owner was awarded attorneys' fees! The IRS became gun shy about prohibited transactions. As of just a couple of years ago, I could truthfully say that if the IRS wanted to attack your IRA, they were likely to use income taxes, excess contributions, or gift taxes--anything other than prohibited transactions.

No More Wishful Thinking This 39-year "grace period" allowed people to engage in what turned out to be wishful thinking about the IRA prohibited transaction rules.

Code section 4975 establishes what is a "prohibited transaction"--basically, just about any financial transaction involving the IRA and a "disqualified person." But because § 4975 does not explicitly include "the IRA owner" in its definition of disqualified persons, some speculated that the IRA owner could avoid being a "disqualified person" as long as he or she was not a "fiduciary" of the IRA. Unfortunately, it is pretty hard for the IRA owner not to be a "fiduciary" of his or her own IRA; no case yet has allowed the IRA owner to escape prohibited transaction problems on this basis.

Another example of wishful thinking (it turns out) is related to "services rendered." One type of prohibited transaction is the "transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan." One exception to this: § 4975(d)(10) excepts "receipt by a disqualified person of any reasonable compensation for services rendered...in the performance of his duties with the plan...." Some asserted that this exception allowed the IRA owner to work for his or her own business inside the IRA and take a salary as long as it was reasonable. Even the IRS seemed to go along: IRS Publication 590 for many years stated that payment of "unreasonable compensation" from the IRA would be a prohibited transaction, which seems to imply that payment of reasonable compensation is not a prohibited transaction.

But the reasonable compensation exception had some problems. For one thing, it was not clear it was available at all for IRAs. For another, it arguably applied only to compensation for plan-related services, such as managing the plan's investments or record-keeping. Ominously, the IRS recently removed the reference to reasonable compensation from IRS Publication 590.

The Ellis Decision The blow fell in 2013 with the Ellis case. Mr. Ellis purchased a used-car dealership inside his IRA, and ran the business as general manager. The business paid him compensation for that. The IRS said that was a prohibited transaction and the Tax Court agreed.

The Court had no trouble finding that Mr. Ellis was a "fiduciary" of his IRA, because he totally controlled it. And they ruled that the "reasonable compensation" exception was only for plan-related services, not for services as a manager of a business the IRA happened to own. The IRA was accordingly deemed distributed to Mr. Ellis, so he was immediately liable for taxes on its entire value. And he owed the additional 10% tax on distributions prior to age 59 1/2, plus penalties.

According to the Tax Court, Mr. Ellis' operation of a business inside his retirement plan, a business that would pay him compensation for services, was "precisely the kind of self-dealing that section 4975 was enacted to prevent."

If your IRA-owned business cannot pay you compensation, you really can't run a small business inside your IRA. If you work with no compensation, there is a risk of an "assignment of income" problem.

The Tax Court is not necessarily the last word. Conceivably someone will get that holding overturned in another case in another court. But for now, if you're thinking about operating a small business inside your IRA, think again!

Ironically, Mr. Ellis might have been able to realize his dream of financing his used car dealership with pretax money had he chosen a different route--establishing a corporation, having the corporation adopt an "ESOP" (employee stock ownership plan), rolling his IRA into the ESOP, and having the ESOP buy the used car business. The IRS doesn't like that approach either but, unlike with the IRA-owned business, the IRS hasn't figured out how to successfully challenge it.

Where to read more: For the Ellis case, see Ellis v. Comm'r, T.C. Memo 2013-245 (10/29/13). The prohibited transaction rules are in Internal Revenue Code sections 408(e)(2) and 4975 and Dept. Of Labor (DOL) regulations thereunder; see the DOL website. For a complete discussion of how the prohibited transaction rules apply to IRAs, see the Natalie Choate Special Report: Buyer Beware! Self-Directed IRAs and Prohibited Transactions (76 pages) downloadable at http://www.ataxplan.com.

Natalie Choate will be speaking at a location near you if you live in Lafayette (10/1/15) or San Diego (10/24/15), CA; Mystic, CT (10/7/15); Orlando (1/14-15/16), St. Petersburg (10/15/15), or Palm Beach Gardens (2/4/16), FL; Rosemont (10/5/15) or Chicago (5/3/16), IL; Albany (10/20/15) or New York (11/4/15), NY; South Bend (9/17/15) or Indianapolis (6/3/16), IN; Missoula, MT (10/23/15); Atlanta, GA (10/22/15); Honolulu, HI (10/26/15); Dallas (11/5/15) or Austin (1/25/16), TX; Birmingham, AL (11/6/15); Boston, MA (11/17/15); Omaha, NE (12/4/15); Minneapolis, MN (12/8/15); Toledo, OH (5/19/16); or Scottsdale, AZ (11/11/16). See all of Natalie's upcoming speaking events at http://www.ataxplan.com/seminars/schedule.cfm.