United States: Tax Court Decision Illustrates Potential Problems For Users Of Self-Directed IRAs

Self-directed IRAs, which allow the IRA owner to make direct investments in real estate or in non-publicly traded corporations, are increasingly popular. Proponents claim self-directed IRAs allow taxpayers to own rental properties or a business inside the IRA, enabling the owners to benefit from the anticipated higher rate of return from those types of investments. However, a recent court decision, Peek v. Commissioner, 140 T.C. No. 12, (May 9, 2013), illustrates the potential problems with using self-directed IRAs.

In Peek, the taxpayer, Lawrence Peek, wanted to join Darrell Fleck in 2001 to buy Abbot Fire and Safety Inc. (AFS). To assist them in structuring the purchase of AFS, the two hired a local CPA, who recommended a so-called IACC strategy whereby Peek and Fleck each rolled-over IRA or 401(k) assets into new, self-directed IRAs. The two IRAs then formed a new corporation, FP, by each contributing $309,000 to FP in exchange for 50% ownership interests. FP purchased AFS for $1.1 million. Part of the purchase price, $200,000, was in the form of a note from FP to the former owners of AFS. Peek and Fleck personally guaranteed the $200,000 debt.

In 2003 and 2004, Peek and Fleck converted their self-directed IRAs into self-directed Roth IRAs. In 2006, FP was sold. Each Roth IRA received $1,573,721 in 2006 and $94,471 in 2007, a substantial return on their initial investments.

Upon audit, the IRS determined that the 2001 loan guarantees constituted an extension of credit to the IRAs. Section 408(e) provides that an IRA that engages in a prohibited transaction, as defined in Section 4975, ceases to be an IRA as of the first day of the year in which the prohibited transaction occurs. Section 4975(c)(1)(B) prohibits any "direct or indirect . . . extension of credit" between an IRA and a disqualified person. (The IRA owners are "disqualified persons" for this purpose.) So, the IRS determined Fleck and Peek did not have IRAs, Roth or otherwise; they had investment accounts. Therefore, the amounts paid for FP in 2006 and 2007 were taxable to Fleck and Peek.

Fleck and Peek argued that they did not extend credit to the IRAs, but rather, they extended credit to FP, which was owned by the IRAs. The Tax Court said that they could not escape the reach of Section 4975 so easily. Creating an entity between them and the IRAs did not shield Fleck and Peek from being viewed as having indirectly providing credit to the IRAs.

The IRS assessed accuracy-related penalties. Fleck and Peek claimed the penalties should be waived because they had relied on the advice of a CPA. But because the CPA charged a value-based fee for his IACC strategy, the court treated him as a "promoter" of the structure. Consequently, Fleck and Peek were not able to rely on the CPA's opinion. Furthermore, the CPA's memorandum did not address the issue of personal loan guarantees, so Fleck and Peek could not be said to have relied on his advice for taking the position on their tax returns, the court said, sustaining the accuracy-related penalties.

Finally, the IRS asserted that Fleck and Peek had engaged in other acts of self-dealing with their IRAs. FP hired Fleck and Peek to perform services. FP rented real property from the families of Fleck and Peek. The IRS said that these were also acts of self-dealing prohibited by Section 4975. The court declined to rule on these questions because it had already determined the IRAs had ceased to be IRAs because of the personal loan guarantees.

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