Personal guarantees by IRA owners of note for corporation owned by IRAs were prohibited transactions

Personal guarantees made by IRA owners of a promissory note from a corporation owned by the IRAs constituted prohibited transactions and disqualified the IRAs, which caused the gain from the sale of the corporation by the IRAs to be personally taxable to the IRA owners, according to the U.S. Tax Court.

Two individuals formed two self-directed IRAs funded with rolled-over cash from their other retirement accounts. They also formed a corporation. The IRAs each purchased a half-interest in the corporation, which then bought a business using cash and promissory notes. One note was personally guaranteed by the taxpayers. A couple of years later, the corporation’s stock was transferred from the IRAs to Roth IRAs, which later sold the corporation and received payment over the two tax years at issue.

Code Sec. 4975(c)(1)(B) prohibits loans or the extension of credit (direct or indirect) between a qualified plan and a disqualified person. The IRA owners acknowledged that a loan guaranty is an indirect extension of credit. However, the IRA owners argued that the credit extension was between them, as disqualified persons, and the corporation owned by the plans (i.e., the IRAs), not the IRAs themselves. The court ruled that the statute prohibited the IRA owners from making loans or loan guarantees either directly to their IRAs or indirectly to the IRAs by way of the entity owned by the IRAs. The court noted that Congress employed broad language in the statute with the intention of preventing an obvious evasion, such as the IRA owners’ assertion. Their interpretation would rob the statute of its intended breadth.

The prohibited transaction triggered the disqualification of the IRAs, with the result that the assets were deemed to be distributed and, thus, the IRA owners personally owned the corporate stock. Gain from the sale of the stock was, therefore, taxable to them personally under Code Sec. 408(e)(2)(B). The taxpayers’ plans ceased to be IRAs at the time of the guarantees, which constituted a continuing prohibited transaction until the later stock sale, thus precluding any possible statute-of-limitations argument. Since the original IRAs ceased to qualify as IRAs at the time of prohibited transaction, the Roth IRAs ceased to be Roth IRAs when they were funded with the corporate stock. Thus, the gains from the sale of the stock were not exempt from tax. The court ruled that the IRA owners were liable for the taxes as the creators and beneficiaries of the accounts that sold the stock.

Source: Peek v. Commissioner (TC).