In court case Lawrence F. Peek et ux. et al. v. Commissioner
140 T.C. No. 12, Nos. 5951-11, 6481-11 May 9, 2013 the the Court ruled that two business partners’ IRAs were disqualified under the prohibited transaction rules when they personally guaranteed loans to a company that was owned by their IRAs.
Don’t confuse this court case with a ROBS (rollovers as business start-ups) transaction as that type of transaction involves a 401k that allows for investing in one’s own business, whereas neither an IRA nor a solo 401k can be invested in your own business.
Summary of Key Points from the Court Case
- Darrell Fleck and Lawrence Peek wanted to purchase Abbott Fire & Safety (AFS), a company that specialized in providing alarms and fire protection systems.
- Fleck and Peek each set up self-directed IRAs and funded them with rollover funds from their existing retirement funds.
- FP Company was formed as a new company. Fleck and Peek had full control over the company as officers and directors.
- Fleck and Peek each self-directed their self-directed IRAs to buy 5,000 shares of the newly issued stock in FP Company for $309,000. This resulted in each IRA owing a 50% ownership interest in FP Company.
- FP Company bought most of the assets of AFS for $1,100,000. The purchase price was satisfied, in part, with a $200,000 promissory note from FP Company that was personally guaranteed by both Peek and Fleck. THIS IS WHAT LED TO THE PROHIBITED TRANSACTION.
- In 2003 and 2004 Fleck and Peek each converted their self-directed IRAs to self-directed Roth IRAs. In 2006, Fleck’s and Peek’s respective Roth IRAs sold all of FP Company for almost $1.7 million dollars each (roughly $3.4 million total).
- IRS examined Fleck’s and Peek’s respective tax returns for 2006 and 2007 and determined that the personal guarantees of the loans were prohibited transactions. Accordingly, IRS increased their personal income to include capital gains from the sale of FP Company.
- The total tax and penalties assessed by IRS exceeded a half million dollars.
- Fleck and Peek argued in Tax Court that since the loan they were guaranteeing was in the name of FP Company and not directly to their IRAs, it was not a prohibited transaction.
- The Tax Court sided with IRS, determining that Fleck and Peek had clearly violated the Tax Code’s prohibition on indirect extensions of credit between disqualified persons (Fleck and Peek) and IRAs. The Court also upheld the 20% accuracy-related penalties assessed by IRS, finding that Fleck and Peek had not acted reasonably or in good faith.
Neither IRA owners nor Solo 401k owners should never guarantee a loan to or from their IRA or solo 401k, even if it’s done through a firm that is owned by the IRA or solo 401k plan.