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Tax Court takes Broad View of IRA "Prohibited Transactions"

A recent decision by the U.S. Tax Court, Peek v. Commissioner, could have huge implications for some individuals with qualified retirement plans. In 2001, Lawrence Peek and Darrell Fleck decided to purchase a company called Abbott Fire & Safety. The partners structured the purchase, utilizing an aggressive tax strategy presented by a CPA.

Each of the partners established a self-directed IRA, to which they transferred funds from their existing IRA accounts. They set up a new corporation, FP Company, with 100% of the shares being purchased by the new IRA accounts that had been set up. The proceeds from this sale of stock were then used to purchase Abbott Fire & Safety, with the addition of promissory notes personally guaranteed by Fleck and Peek. All of this was done with the intention that Fleck and Peek would be named as sole corporate officers of FP Company (now dba "Abbott Fire & Safety).

The IRA accounts were converted to Roth IRAs, before selling the shares of FP Company for substantial capital gains, which neither Peek nor Fleck reported on their 2006 and 2007 tax returns. IRA accounts are subject to special rules, including the provision in IRC § 408(e)(2)(A), which says 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."

Transactions between a qualified plan and a disqualified person that are prohibited by Section 4975 include (A) sale or exchange, or leasing of any property; (B) lending of money or other extension of credit; (C) furnishing of good, service, or facilities; (D) transfer to, or use by or for the benefit of the disqualified person; (E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or (F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

The Internal Revenue Service argued that the accounts ceased to qualify as IRA accounts in 2001, when Peek and Fleck made personal loan guaranteed that were "prohibited transactions." Consequently, the IRS argued, the assets of the IRA are deemed to have been distributed to Peek and Fleck, who consequently owe income tax on the gain on sale in 2006 and 2007. Peek and Fleck denied that any prohibited transactions had occurred, since the loan guarantees were transactions the partners engaged in with FP Company, rather than directly with the IRA accounts that owned FP Company.

The Tax Court, pointing to the language in Section 4975, which prohibits any "direct or indirect" extension of credit between a qualified retirement plan and a disqualified person, ruled in favor of the Internal Revenue Service and held that the extensions of credit were indeed prohibited transactions. What resulted was a tax bill for each partner in excess of $250,000, including penalties and interest.

To learn more about IRS tax laws and regulations or about Brown, PC as a nationwide practice, please visit our firm's web site online or contact us at 888-870-0025. 

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