Using Your IRA to Invest in Businesses

Presented by: Bill Smith, Esq. Managing Director, CBIZ MHM, LLC

December 15th and 16th, January 13th, February 3rd

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Before We Get Started…

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Today’s Presenter

William M. Smith, Esq. Managing Director, CBIZ National Tax Office 301.951.3636 | billsmith@cbiz.com Bill Smith is a managing director in the CBIZ National Tax Office. Bill monitors federal tax legislation and consults nationally on a broad range of foreign and domestic tax services for businesses and individuals, including mergers and acquisitions, domestic and international investments or divestitures, and the review, negotiation and drafting of tax aspects of business agreements.

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Agenda

Where We Stand Big Money IRAs ROBS IRA Job Machine IRS Looks at ROBS

History of Using IRAs for Alternative Investments Swanson Tool Tax Shelter Use IRS Hits Back Hard: Notice 2004-8 Vindication: Hellweg The Election GAO Report

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Agenda

Recent Cases Taproot v. Commissioner Peek and Fleck v. Commissioner Ellis v. Commissioner Dabney v. Commissioner

WHERE WE STAND

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“Individual Retirement Accounts: Preliminary Information on IRA Balances Accumulated as of 2011,” the GAO said someone who contributed the maximum amount each year to an IRA from 1975 to 2011 and invested it in the Standard & Poor's 500 Index would have about $350,000. The maximum contribution this year is $5,500, plus an extra $1,000 for people age 50 and older.

9,000 IRAs with assets over $5 million

1,100 IRAs with assets over $10 million

314 IRAs with assets over $25 million

GAO Report Sept. 2014

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CEO of Yelp 2.7 million shares Class B Common in Roth IRA (convertible

to Class A Common) Yelp traded at $76.54 on Sept. 16 Value: $206 million

GAO Example 2008 contribution of 4 million shares valued at

$0.00125/share Obtained venture capital, went public, share price rose to

$60/share Value: $196 million

Big IRA Examples

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Rollovers as Business Startups New C corporation formed (“Newco”) Newco sets up 401(k) that allows investment in company

stock and the rollover of assets from other qualified plans or IRAs

Entrepreneur is the only employee Rolls over qualified plan assets to Newco 401(k) Newco 401(k) buys Newco stock at par value or low value Newco buys franchise or starts other business

ROBS

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Guidant Financial Website ROBS Explanation

Is it legal? Absolutely. The Employee Retirement Income Security Act of 1974 (ERISA) passed the responsibility of retirement saving from the employer to the employee.

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BeneTrends 100 transactions per month in 2009 Estimates tens of thousands have been completed

IRS estimated 9 major “players” in 2009 IRS set up a pre-approved opinion letter program in

2008

ROBS

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IRS Switches Course – October 2008 Memorandum Describes typical ROBS Coordinated efforts with DOL Plans are prototypes, so determination letters have been

issued Opened specific examination project Found significant disqualifying operational defects

No employee notices No employee participation Employees don’t receive allocable shares of employer stock Valuation issues No annual reports

ROBS

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Found significant disqualifying operational defects Asset transfers exceed the 5500EZ amounts Violations of anti-discrimination rules as plan only benefits principal Compensation issues with principal Prohibited transactions Poor appraisal Value of company is less that what is being paid by 401(k) (since

company typically has no assets) Promoter fees (paid by plan) – promoter may be plan fiduciary

due to investment advice, and the promoter fee is then prohibited “Permanency” of retirement program

ROBS

HISTORY OF USING IRAS FOR ALTERNATIVE INVESTMENTS

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Started all of the activity

Procedure position: Motion for attorneys fees because IRS was not “substantially justified” in claiming transaction violated prohibited transaction rules

Facts TP owned Swansons’ Tool (“Tool”), an S Corporation In business since 1983, builds components some of which

are exported Formed a DISC, Swansons’ Worldwide (“WW”) for exports TP’s self-directed IRA purchased all of the initial shares of

WW

Swanson v. Commissioner (1996)

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Facts Operated as DISC, receiving commissions from Tool and

declaring dividends to the IRA from 1985-1988 Repeated procedure for an FSC in 1989 (Swansons’ Trading

Company – “Trading”) IRS Position TP is disqualified person (“DP”) under Code § 4975

As a fiduciary because he controls investments of the IRA As an officer and director

Payments of dividends is a prohibited transaction as it benefits TP so is self-dealing

Sale of WW stock to IRA is a prohibited transaction because he was sole director of WW

Swanson v. Commissioner (1996)

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General Rule Section 4975(c)(1)(A) defines a prohibited transaction

as including any “sale or exchange, or leasing, of any property between a plan and a disqualified person”. Section 4975(c)(1)(E) further defines a prohibited transaction as including any “act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account”.

Swanson v. Commissioner (1996)

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Ruling No prohibited transactions

When IRA bought WW stock, because WW was not a disqualified person at that time as no shares of stock had been issued (initial offering)

When WW paid dividends to IRA, because TP’s only benefit, despite being a fiduciary, was as a participant/beneficiary of the IRA

IRS positions substantially unjustified

Swanson v. Commissioner (1996)

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In early 2000s, some firms started marketing transactions involving the use of traditional and Roth IRAs

Some advisors who started with Grant Thornton in Kansas City were found to be particularly aggressive (Grant Thornton cooperated with IRS investigations when it became aware of what these advisors were doing)

Various transactions used Management company Merger to convert Traditional IRA to Roth IRA

And Then Came the Tax Shelters

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Dr. Poof Allen R. Davison was one of the Grant Thornton advisors Known “Dr. Poof” for his ability to make taxes seemingly

disappear Enjoined by the court from engaging in tax shelter activity:

“Davison also promoted a Roth IRA-C arrangement, [where] the shares of the management company, which is also a C corporation, are owned by a Roth IRA, and the management company receives actual funds (as opposed to only journal entries), which then pass to the Roth IRA as purported dividends.”

Upheld by 8th Circuit Court of Appeals in 2011 (2011-2 USTC ¶ 50,188)

And Then Came the Tax Shelters

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Notice 2004-8 (December 31, 2003) Made Roth IRA management companies listed transactions Included any transaction where Individual owns pre-existing business Individual has Roth IRA The Roth IRA owns all of the shares of a new

corporation, and “any arrangement between the Roth IRA corporation and

the TP … that has the effect of transferring value to the Roth IRA corporation”

Disclose or face § 6707A penalties

And Then Came the IRS Response

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Hellweg v. Commissioner, T.C. Memo 2011-58 Validation of Swanson v. Commissioner Roth IRA formed DISC similar to Swanson DISC received commissions from S corporation Court relied on Swanson:

“Similarly, the acquisitions of ADF International stock by petitioners' Roth IRAs were also not prohibited transactions under section 4975(c)(1)(A), (B), or (C) because ADF International was not a disqualified person at the time of the stock acquisitions. The C corporations' payment of dividends to the Roth IRAs was not a prohibited transaction under section 4975(c)(1)(D), (E), or (F) because the dividends were not income of the Roth IRAs until they were received by the Roth IRAs.”

And Then Came the Taxpayer Response

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Mitt Romney reveals he has an IRA worth more than $100 million in 2012 Bain Capital allowed service partners to invest in deals via

their IRAs Congress Democratic Representatives concerned that valuation

discrepancies may “create an end run around contribution limits” – ask IRS to answer questions about abuse

Obama’s 2013 Budget $3 million cap on IRAs for certain high wealth individuals

And Then Came the Election

RECENT CASES

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TP set up corporation in Nevada Issued all shares to his Roth IRA Elected to be an S Corporation Earned net income, but passed through to Roth IRA which

doesn’t pay tax IRS said Roth IRA not an eligible shareholder of S

Corporation, so it is a C Corporation and must pay taxes Court rejected TP’s grantor trust argument and that IRA

should be disregarded for eligible taxpayer rules. Court disagreed, held for IRS.

No discussion of IRA-owned business issues

Taproot Admin. Svcs. v. Commissioner 2012-1 USTC ¶ 50,256 (9th Cir. 2012)

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TP set up LLC (taxed as corporation)

Rolled over 401(k) to self-directed IRA

Issued 98% of interests to his IRA for $319K capital contribution

Company sold used cars; TP was general manager

Company paid TP compensation of $10K in 2005, $30K in 2006

Company leased its operating premises from another LLC owned by TP and his family

Ellis v. Commissioner TC Memo 2013-245

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TP was a fiduciary and disqualified person A DQ is “any person who: (1) exercises any discretionary authority or

discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets; (2) renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so; or (3) has any discretionary authority or discretionary responsibility in the administration of such plan. Sec. 4975(e)(3). Further, a fiduciary with respect to a qualified retirement plan is also a disqualified person for the purposes of section 4975.”

Set up of Company was not a prohibited transaction (relying on Swanson)

Ellis v. Commissioner TC Memo 2013-245

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Compensation TP engaged in a transfer of plan income of assets for his own

benefit (self-dealing), and to a DQ when he paid himself a salary because The assets of the IRA consisted exclusively of Company stock Company funded exclusively by IRA

No exemption for services rendered to the plan (IRA) because amounts were paid for services rendered to the company

Result Plan assets treated as distributed and taxable Excise tax Penalties

Ellis v. Commissioner TC Memo 2013-245

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ROBS type transaction to create self-directed IRA by rolling over funds from prior 401(k)

IRAs for TPs used to fund FP Company FP Company acquired the assets of AFS, an unreleated fire

alarm and protection company on the following terms: Price $1.1 million $850K cash $450K bank loan $400K from IRAs cash

$50K promissory note from FP Company to broker; and $200K promissory note from FP Company to AFS owner,

secured by personal guarantees of Peek and Fleck

Peek and Fleck v. Commissioner TC Memo 2013-245

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IRS: loan guarantees were prohibited transactions “Any direct or indirect loaning of money or other extension of credit

between a plan and a disqualified person.” TPs: guarantee was extension of credit between DQ and FP

Company, not DQ and plan Court: TPs reading would allow anyone to circumvent the

rules by interposing a shell company. Held that the guarantee was a prohibited transaction

Result: IRA terminated, assets treated as distributed on day of guarantee Income and excise tax; penalties (could not rely on advice of CPA

promoter for reasonable cause and good faith)

Peek and Fleck v. Commissioner TC Memo 2013-245

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T.C. Memo. 2014-108

A taxpayer attempted to purchase real property through his self-directed IRA

Custodian (Schwab) informed Dabney that Schwab did not allow IRAs to hold alternative investments, including real property

Schwab wired money to escrow instructing title company to put title in name of IRA, but title company mistakenly titled in Dabney’s name.

Tax Court held that because Schwab did not allow real property, even if correct name had been used it would not have been held in his IRA

Further, although he could have transferred IRA to a custodian who allowed alternative investments and completed the transaction, he did not. Instead, he checked the box stating he was taking an early distribution with no know exception to taxation

Taxpayer liable for income tax and early withdrawal penalty on full amount.

Dabney v. Commissioner – Blown attempt to have IRA Invest in Real Property

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The Tax Court ruled that a $100,000 penalty under IRC §6707A (failure to disclose reportable transaction – IRA owned and managed company) should be based on the taxes reported on the original return.

Yari v. Comm’r, 142 T.C. 7

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Questions?

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