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By John Hyre
The following guest post is a commentary by John Hyre about the recent Thiessen v. Commissioner case in United States Tax Court involving a prohibited transaction. The case centered on a prohibited transaction specific to IRC 4975(c)(1)(B), or any direct or indirect “lending of money or other extension of credit between an IRA and a disqualified person.” Another focus was the IRA holders being “fiduciaries” of the plans. Remember that a “disqualified person” includes a fiduciary as expressed in 4975(e)(2)(A). Because the Thiessens’ IRAs were Self-Directed IRAs (and, thus, they exercised discretionary authority and control over plan assets), the Tax Court concluded the Thiessens were fiduciaries of the plans.
While this area of tax law is grey, prohibited transactions, or anything that could be a prohibited transaction, must be avoided at all costs.
The Basic Lesson
Do not guarantee loans for your IRA, or for any entity owned by it. A corollary would be to not use IRA property to secure a personal loan. Get qualified, objective help when entering into IRA transactions–and keep them in the loop throughout the entire process. Watch out for “promotors” of various IRA/tax schemes.
Thiessen wanted to acquire a metal fabrication company. A broker who was selling such a company told Thiessen that he could use his IRA to acquire the company. Thiessen was referred to CPA Blees. The Thiessens used their IRA to purchase the company, partly on owner financing. A separate attorney was retained to structure the agreement and the owner financing. Blees was not included in that process. The specific structure involved the Thiessen’s IRA’s purchasing shares in a C-Corporation, funding that C-Corporation, and then using those funds along with owner financing to acquire the target’s assets. Importantly, the owner financing was guaranteed by the Thiessens.
Prohibited transactions kill IRAs, Roth IRAs, SEPs, HSAs and CESAs deader than chivalry. The size of the prohibited transaction does not matter. Nor does the fact that the prohibited transaction was completely unintentional or that it benefited the IRA. When an IRA dies, its assets are distributed to the owner and such a distribution is often taxable at very high rates. Further, an array of penalties often applies. We routinely advise clients that if they have a prohibited transaction in a large IRA ($250k +), they should expect to lose 50% to 60% of the IRA to the government in the form of taxes and penalties. Such harsh results, combined with the fact that prohibited transaction law is complex and murky, means that clients should be very conservative and exercise the utmost caution to avoid destroying their IRAs. Indeed, we prefer to advise a paranoid approach. This is not the time to be aggressive.
One prohibited transaction is “the extension of credit” by the IRA owner to the IRA, or by the IRA to the IRA owner. The term “extension of credit” is very broad, and encompasses much more than “making a loan to or from your IRA.” For example, using IRA property as collateral in a loan that involves the IRA owner is a prohibited transaction. Likewise, the use of the IRA owner’s property as collateral for a loan made to the IRA is an “extension of credit.” Also, personally guaranteeing a loan made to your IRA is a clear prohibited transaction.
As part of its asset acquisition, Thiessen’s IRA-owned corporation borrowed from the sellers in addition to making a large cash down payment. Such loans are common and, if properly structured, not a problem for the IRA. The problem occurred when the Thiessens personally guaranteed that loan. Such a guarantee on a corporate loan was theoretically distinct from guaranteeing a loan made directly to the IRA itself. The court ruled that a guarantee to a corporation 100% owned by IRAs is tantamount to a guarantee to the IRAs themselves. In other words, an indirect loan guaranty (to an IRA-owned corporation instead of to the IRA itself) was still a guarantee and therefore a forbidden “extension of credit.” This circumstance is often present with IRA law–things that cannot be directly done also cannot be indirectly done.
The amount distributed from the IRA as a result of the prohibited transaction was $432,076.41. The Thiessens owed a penalty of 10% of the distributed amount because they were under the “retirement” age of 59 ½ when the prohibited transaction caused the distribution. That penalty amounted to $43,208. The total tax liability was $180,129 or 42% of the amount of the IRA. This was lower than normal because certain other penalties (e.g. accuracy or “substantial understatement” penalty) were not applied in this case. See the closely-related case of Peek v. Commissioner for a similar scheme and ruling.
- Prohibited transactions–or anything that could be a prohibited transaction—must be avoided at all costs. This area of the law is grey and the cost of being wrong is massive.
- Get a qualified tax advisor (few CPAs or tax lawyers understand IRAs) who is not a “promotor.”
- If someone is selling you a specific structure, they are probably a promotor.
- Keep that qualified professional in the loop. Here, if CPA Blees had known about the loan guarantee, he may have been able to advise the Thiessens to avoid it.
- Anything that you cannot do directly in an IRA context is probably also forbidden if done indirectly.
The information provided in this guest post is for educational purposes only and should not be construed as advice of any kind.
 Because the broker had something to sell, he may not have been the best person from whom to take tax advice. The broker also recommended getting some owner financing as part of the sale of the business to the IRA.
 Blees had previously created an IRA structure that resulted in a massive loss in Tax Court. See Peek v. Commissioner.
 Your tax guy and your attorney should be in constant contact throughout a transaction. We shall see the consequences of failing to take that step. Perhaps if Blees had known of the subsequent loan guaranty, he could have kept his clients from entering into a prohibited transaction.
 401(k)s, including self-directed “Solo” 401(k)s, are penalized less harshly if they enter into a prohibited transaction. Instead of being destroyed, they normally pay an annual penalty of 15% of the prohibited transaction.