Checkbook Control IRA-Owned Entities Under Attack

By: H. Quincy Long

 A very popular idea in the self-directed IRA industry is to have what some have termed a “checkbook control” IRA.  Basically this involves the following steps:  1) an IRA is formed with a self-directed IRA provider; 2) a brand new LLC or other entity is formed with the IRA owner as the manager or a director and officer; and 3) the IRA custodian is directed to invest the IRA funds in the newly formed entity.  Voila! The IRA owner has checkbook control over his or her IRA funds and can do deals quickly without anyone looking over their shoulder to see that the rules are being followed.  Admittedly, this sounds like a wonderful idea from the IRA owner’s perspective, but it is fraught with danger and traps for the unwary, as some taxpayers are now discovering.  The IRS has been attacking this type of setup, especially when they involve Roth IRAs.

             The genesis for the idea is largely attributable to the case of Swanson v. Commissioner, a Tax Court case which was decided in 1996.  In that case, Mr. Swanson set up a self-directed IRA at a bank and formed a corporation of which he was appointed the director and president.  He then directed the bank to subscribe to the original issue shares of the corporation so that his IRA became the sole shareholder.  Subsequently Mr. Swanson transacted business between his IRA owned corporation and his privately owned corporation.  These transactions were prohibited transactions, but the IRS’ litigation position was limited to arguing that the purchase by the IRA of the original issue shares and the payment of dividends from the IRA owned corporation back to the IRA were prohibited.  Mr. Swanson had very good lawyers, and the IRS eventually conceded the case as it related to the alleged prohibited transactions.

The Swanson case certainly generated a lot of excitement, but a careful examination of the case reveals that the Tax Court ruling is limited.  Far from approving the entire concept of a “checkbook control” IRA owned entity, as some people allege, Swanson v. Commissioner can only be relied on for two concepts:  first, that the purchase of the original issue stock of the corporation was not a prohibited transaction because prior to the IRA purchasing the stock there were, by definition, no owners, which meant that there could not have been a transaction between the IRA and a disqualified person (the court ruled that the corporation did not become a disqualified person until it was funded, which raises other interesting issues); and second, that the payment of dividends from the IRA owned corporation back to the IRA was not a prohibited transaction as a direct or indirect benefit to Mr. Swanson, since the only benefit of the dividend payments accrued to his IRA and not to Mr. Swanson personally.  As the Tax Court noted in Repetto v. Commissioner, discussed below, in the Swanson case “the central issue was whether the IRS was substantially justified in its litigation position for the purpose of determining whether the taxpayer was entitled to an award of reasonable litigation costs.” Mr. Swanson recovered from the IRS litigation costs in the amount of $15,780.  Significantly, what was not at issue in the Swanson case was the fact that Mr. Swanson did benefit personally from the business transactions between his privately owned corporation and the corporation owned by his IRA, since these transactions were not addressed by the IRS in their litigation position.

On December 31, 2003, the IRS released IRS Notice 2004-8, entitled Abusive Roth IRA Transactions.  The notice generally covers a situation which is very similar to Mr. Swanson’s, in that it typically involves the following parties:  (1) an individual who owns a pre-existing business such as a corporation or a sole proprietorship, (2) a Roth IRA that is maintained for the taxpayer, and (3) a corporation or other entity, substantially all the shares of which are owned or acquired by the Roth IRA.  The privately owned business and the Roth IRA owned entity enter into transactions which are not fairly valued and thus have the effect of shifting value into the Roth IRA in an attempt to avoid the statutory limits on contributions to a Roth IRA.  Also covered by Notice 2004-8 is any transaction in which the Roth IRA corporation receives contributions of property, including intangible property, by a person other than the Roth IRA without a commensurate receipt of stock ownership, or any other arrangement between the Roth IRA corporation and the taxpayer or a related party that has the effect of transferring value to the Roth IRA corporation comparable to a contribution to the Roth IRA.  Under these circumstances the setup is deemed to be a listed transaction, which means that the taxpayers must disclose the transaction to the IRS or face significant penalties.  These transactions may be attacked in a number of ways, including as an excess contribution under Internal Revenue Code (IRC) Section 4973, or in appropriate cases a prohibited transaction under IRC Section 4975.

On April 24, 2009, the Office of Chief Counsel for the Internal Revenue Service released Chief Counsel Advice (CCA) #200917030.  Like Advisory Opinion Letters from the Department of Labor, a CCA does not set legal precedent, but nonetheless they are instructive on how the IRS views the topic and can be influential in the way a case is handled by the IRS and in Tax Court.  This CCA covered a situation in which the taxpayers, a husband and wife, set up a corporation owned by their Roth IRAs into which they would direct payments for consulting, accounting, and bookkeeping services they provided to other individuals and businesses.  The taxpayers provided services to various clients, including the company for which the husband worked but did not own, through the Roth IRA corporation, purportedly as employees of the corporation, but without compensation.  When the Roth corporation filed its corporate income tax return it properly disclosed the listed transaction.  However, the taxpayers did not disclose the listed transaction on their individual tax return.  Instead, they only disclosed an excess contribution to their Roth IRAs on IRS Form 5329, which they said had been removed so as to avoid the 6% excess contribution penalty.  The CCA indicated that in this case, like the transaction described in IRS Notice 2004-8, the structure of the transaction purportedly allowed the taxpayers to create a Roth IRA investment that avoids the contribution limit by transferring value to the Roth IRA corporation comparable to a contribution to the Roth IRA, thereby yielding tax benefits that are not contemplated by a reasonable interpretation of the language and purpose of Section 408A (the Internal Revenue Code section pertaining to Roth IRAs).  Effectively, the taxpayers in this case were transferring the value of their services to the Roth IRA corporation, which in turn paid dividends back to their Roth IRAs.

In the recently released Tax Court Memo 2012-168, Repetto v. Commissioner, the IRS argued and the Tax Court agreed that the Repettos had entered into a listed transaction as contemplated by IRS Notice 2004-8, but had failed to report it properly.  The Repettos formed a partnership called Ozark Future LLC with a builder, Porschen Construction, Inc., to build spec homes.  Eventually the Repettos formed a Subchapter S corporation called SGR and transferred their ownership in Ozark Future to the newly formed corporation.  In 2003 the Repettos met with the CPA for Mr. Porschen and another person who was both an attorney and CPA.  The attorney suggested that the Repettos form 2 corporations, each of which would be owned 98% by their respective Roth IRAs.  The new Roth IRA corporations would provide services to SGR, and the relationship with between SGR and Ozark Future would remain the same.  Although the Repettos did not have a good understanding of the structure, they agreed to have the attorney set it up.  In order to set this up with Roth IRAs, the Repettos made an excess contribution to their Roth IRAs.  After the Roth IRAs and the corporations were set up, SGR entered into 10 year agreements for the Roth IRA corporations to provide services to SGR at SGR’s place of business, which was the Repettos’ home, including bookkeeping, marketing and other administrative functions.  The Roth IRA corporation owned by Mrs. Repetto’s IRA paid her a small salary in 2004-2006, and also had a medical and dental care expense reimbursement plan beginning in 2004.  The total dividends declared to Mr. Repetto’s Roth IRA were $117,600 and the amount declared to Mrs. Repetto’s Roth IRA was $127,400.  The Tax Court relied on the substance-over-form and sham transaction doctrines to find that the service agreements were nothing more than a mechanism for transferring value to the Roth IRAs.  The service agreements did not change who provided the services to SGR, since the Repettos continued to do all the work as they had done prior to when the purported service agreements were entered into. In the end, among other penalties the Repettos had to pay excise tax penalties under IRC Section 4973 based on the value of their Roth IRAs at the end of each year, plus additional penalties for failure to timely file a return since they failed to attach Form 5329 to their tax return to report their excess contributions, plus more penalties for having failed to properly report their participation in a listed transaction.  The Repettos’ reliance on the CPA and attorney who set up the plan did not save them from the penalties, since the advice was from the promoters of the investment or advisers who had a conflict of interest.

As of the writing of this article, there is another case pending before the Tax Court (Peek and Fleck v. Commissioner) involving a Roth IRA owned corporation which was formed by the Roth IRAs of two otherwise unrelated parties.  The corporation was originally owned by traditional IRAs which were later converted into Roth IRAs.  The IRA owned corporation purchased an operating business which was sold some years later for a significant capital gain.  The IRS is alleging that the taxpayers, who were employed by the corporation, violated the prohibited transaction rules by 1) guaranteeing personally a note signed by the corporation owned by their IRAs, and 2) having their IRAs invest in the corporation pursuant to an understanding or arrangement that the corporation would thereafter provide benefits to them as individuals, including the payment of wages to them and lease payments for facilities from the corporation to an LLC owned by their wives individually.  I will update this article when the final decision comes out, but it looks bad for the taxpayers at this time, in my opinion.

It is noteworthy that in each of these cases the IRA owners were actively involved in business activities which allowed them to shift value to their Roth IRAs from their personal services.  Two other issues could arise from checkbook control IRA owned entities, but these issues have not been litigated as far as I know.  First, the direct or indirect provision of goods, services, or facilities between a plan (including an IRA) and a disqualified person (including the IRA owner), is a prohibited transaction under IRC Section 4975(c)(1)(C).  At some point the IRS may allege a prohibited transaction under this section for someone who is a manager or director and officer of a company owned by their IRA.  Second, IRC Section 408(a)(2) requires the trustee of IRA funds to be a bank or non-bank custodian.  It is possible that attempting to avoid the proscription against IRA owners handling their own IRA funds with the simple imposition of an entity might be some day be attacked as invalid by the IRS.

Perhaps the only good news is that none of the attacks on IRA owned entities mentioned in this article have dealt with a situation where the entity only made investments as opposed to running a business and where no prohibited transactions were otherwise involved.  Even in this “perfect” scenario there is danger, as the prohibited transaction rules are somewhat complex and the IRA owner may inadvertently cause the IRA owned entity to enter into a prohibited transaction with complete innocence.  Yet, as stated in the case of Leib v. Commissioner, “good intentions and a pure heart are no defense” when it comes to the prohibited transaction rules.

One thing which is patently obvious to me about this area – if you are going to have your IRA own a checkbook control entity, you and/or your advisor had better have a very good understanding of 1) the prohibited transaction rules under IRC Section 4975, 2) the Plan Asset Regulations contained in 29 C.F.R. §2510.3-101, 3) Interpretive Bulletin 75-2, which is contained in 29 C.F.R. §2509.75-2, and 4) at least when it comes to a business or debt financed property owned by an IRA or an IRA owned entity, how Unrelated Business Income Tax (UBIT) contained in IRC Sections 511-514 comes into play.  If you are being advised by someone to set up a checkbook control IRA owned entity and they cannot explain how these rules apply to your entity clearly and how they interact with each other, then run the other way.  To fail to understand completely the rules is like jumping out of an airplane without a parachute – it may be incredibly fun on the way down, but eventually you’re going to go SPLAT!

© Copyright 2012 H. Quincy Long.  All rights reserved.