Co-Mingling Personal Funds within a Self Directed IRA is a Sure Way to IRS Disallowance
In a recent court decision, Peek vs. Commissioner, prohibited transaction rules under IRC § 4975 for self-directed IRAs, will be fully enforced by the IRS. IRC § 4975 clearly outlines prohibited transactions, and defines who are disqualified parties to an IRA. In this particular case, their troubles could have been avoided if the parties to the IRA had followed the rules and received better advice from their CPA.
Now some may ask if there is a problem with self-directed IRAs in general, or that problems will arise from failure to simply follow the rules?
To summarize this case, Mr. Peek, the main individual involved, had his IRA disallowed by the IRS because of an investment that was deemed to be a prohibited transaction.
Mr. Peek and another gentlemen wanted to purchase a business with their self directed IRA funds. Both visited with a CPA who talked them into setting up self-directed IRAs to purchase a business. In 2003 and 2004, based upon that advice they then proceeded to convert their IRAs into self-directed IRAs and used their IRAs to finance their purchase. There’s absolutely nothing wrong with any of this, and so far so good, as it’s perfectly legal to invest into a business with funds from a self directed IRA. According to the rules, IRA owners are allowed to partner in a business investment with other people’s IRAs, so long as the individuals are not disqualified. The good news is that they ended up selling it in 2006 for a substantial profit.
So why did this transaction fail the IRA prohibited transaction rules?
Well, it back in 2001, prior to setting up their self-directed IRAs, they had received loan proceeds guaranteed by them personally. They then used these funds to establish their self-directed IRAs in 2003-2004. So at that time the guarantees were to them personally, and not to their IRAs, which actually constitutes a prohibited transaction.
Section 408(e) states, “An IRA that engages in a prohibited transaction as defined in Section 4975 ceases to be an IRA on 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. Unfortunately for them, their CPA should have known the rules or at least researched the question for them and informed them before they made their investment. The lesson to be learned here is that anytime you commingle personal funds or personal loans with your IRA funds, you are committing a prohibited transaction.
Moreover, the case facts don’t end here, as there were additional acts that were deemed prohibited and illegal. Mr. Peek and his business partner were hired by the acquired company to perform services, from which they were paid. In addition, they also rented property from a family member to house the business, which is also a prohibited transaction; hence the parties are now disqualified to participate.
Section 4975 of the IRS Code, strictly states that you as an individual are a disqualified person to your IRA when you commit your personal funds to your IRA, which they clearly did.
Let’s be clear here, a self directed IRA is not a bad idea, but you must follow the rules to avoid IRS disallowance. The CPA should have known that the extension of credit from a disqualified party would be a prohibited transaction, as well as performing services owned by your IRA that include renting property from a lineal family member. All of these parties are considered disqualified to participate within your own self directed IRA.
So, yes, let’s reiterate that their CPA should have been aware of these rules and advised them appropriately. Even with this court case demonstrating some of the pitfalls of a self directed IRA, they still remain necessary for everyone who is interested in a tool for retirement planning. Not withstanding caveat emptor, be advised that everyone must do their own due diligence, and perform their own research, including discussing the matter with a CPA or a tax professional, especially with any kind of government regulated investment schemes.
Whether this is a case where they either purposely broke prohibited transaction rules, thinking that they’d get away with it, or just not being educated about them, all of this could have been avoided had they done a little bit of research.
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