Prohibited Transaction Disqualifies IRA

Prohibited

Transaction

Disqualifies IRA

We often discuss the pitfalls of self-directed IRAs and the increased risk of prohibited transactions. In a recent Tax Court case, Ellis v. C.I.R. (T.C. 2013) 106 T.C.M. (CCH) 468, Mr. Terry Ellis’ entire IRA was disqualified, subjecting him to not only accuracy related penalties imposed by the IRS but also a 10% early distribution tax on the entire IRA.

The Background: Mr. Ellis rolled over sizable distributions from his 401(k) to a newly opened, self-directed IRA. He then used his new IRA as start-up capital for a new business he established as an investment for this self-directed IRA. Mr. Ellis was designated as the general manager of the newly formed company and he received benefits and compensation from the company. He ran the business himself and it was his primary source of income. As a fiduciary of his IRA and 98% owner of the company, Mr. Ellis was clearly a “disqualified person.”

 The Facts: In this case, Mr. Ellis not only ran the company and earned income but the company also paid rent to another entity owned by Mr. Ellis, his wife and their children. The Court found that Mr. Ellis participated in prohibited transactions with his self-directed IRA by engaging in self-dealing. The Court also pointed out that although there were a few prohibited transactions involved, it only took one to disqualify the IRA. The Result: Approximately $320,000 converted from Mr. Ellis’ 401(k) to the IRA was deemed fully distributed and fully taxable. Not only was he liable for the income taxes, he was dinged with accuracy related penalties as well as a 10% early distribution penalty because he was under 59½.

The Moral: A single prohibited transaction can destroy your entire retirement plan that you worked your entire life to accumulate. Before you decided to go down the path of a self-directed IRA or use your IRA as business start-up capital, make sure you consult with your personal advisors.