The Thiessen Tax Court Case – Loan Guarantees Create Prohibited Transactions and Other Lessons
By Guest Contributor Attorney John Hyre
The Basic Lesson
Do not guarantee loans for your IRA, or for any entity owned by it. A corollary would be: Do 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.
The Facts
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.[1] Thiessen was referred to CPA Blees.[2] 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.[3] 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.
Discussion
Prohibited transactions kill IRA’s, Roth IRA’s, SEP’s, HAS’s and CESA’s deader than chivalry.[4] 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, it’s assets are distributed to the owner and such a distribution is often taxable at very high rates. Further, an array of penalties often apply. 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 IRA’s. Indeed, we prefer to advise a paranoid approach – prohibited transactions, or anything that could possibly be a prohibited transaction, should be avoided at all costs. 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 encompassed 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”. Another example: 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 IRA’s is tantamount to a guarantee to the IRA’s 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 59.5 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.
In the closely related case of Peek v. Commissioner, 140 T.C. 216 (same CPA, very similar scheme, same sort of loan guarantee that resulted in a prohibited transaction), negligence penalties (which would have increased the taxes above by $27,384) were applied because Peek knew “enough” about prohibited transactions, was heavily involved in the deal, and never received advise contradicting the idea that loan guarantees were an “extension of credit”. Peek was not entitled to rely on CPA Bleek’s opinion because Bleek was not a “disinterested professional”. Rather, he was a “promotor” of the structure that Peek ultimately bought into for his IRA. The Court defined a promotor as “an adviser who participated in structuring the transaction or is otherwise related to, has an interest in, or profits from the transaction.” Thus, for example, most companies that sell “check-book LLC’s” for a living are promotors of such LLC’s. As promotors, their advice cannot be relied upon to avoid IRS penalties in the event their structure does not function as advertised. The court also implied that Blees did not advise the taxpayer as to personal guarantees – in other words, he may not have known that the taxpayers entered into the personal guarantees in either the Thiessen case or in the Peek case. Keep your tax advisor in the loop until the end!
Summary:
- 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 CPA’s or tax lawyers understand IRA’s) 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
John Hyre is an attorney, accountant and real estate investor based out of Columbus, Ohio. He advises clients nationwide on to avoid tax trouble when structuring their self-directed IRA’s, 401(k)’s, HSA’s and CESA’s. John has also successfully defended SDIRA’s from IRS attack in audits and in Tax Court. He can be reached at johnhyre@realestatetaxlaw.com or at www.iralawyer.com
[1] The broker has something to sell. Perhaps he is not 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. <sigh>
[2] Blees had previously created an IRA structure that resulted in a massive loss in Tax Court, see the Peek case. Looks like the IRS is going after many of Blees’ clients. I hope he has good malpractice insurance. He seems to be doing fine: http://www.biggskofford.com/our-team/bios/christian-blees.
[3] 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.
[4] 401k’s (including self-directed “Solo” 401k’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.
