Why Not Use Your IRA for a Business Investment?
You are presented a business opportunity. Maybe it is a rental real estate investment or a franchise operation. You also have most of your spare cash sitting in a rollover IRA. Is there a good way to use those IRA funds for your business investment?
That is a frequently asked question, and if you look for an on-line answer, you will find a number of web sites that tell you how to do exactly that. These web sites are likely sponsored by self-directed IRA service providers that are enticing potential customers who would like to tap their IRA funds without taking a current tax hit.
However, the IRS is not bullish on taxpayer investments of their IRA funds in their own business ventures. As an example, take the case of a taxpayer who rolled his sizable 401(k) retirement plan account into an IRA and then used the IRA account to purchase control of a limited liability company (LLC) set up to operate a used car business. The taxpayer subsequently formed a second LLC owned through his IRA in order to acquire and lease commercial real estate.
The LLCs then went on to make payments of compensation to the taxpayer for services rendered to their respective businesses, and cash flow distributions to the taxpayer and his spouse as LLC members with partial ownership interests. These payments did not flow through the IRA but were made directly from the LLCs.
The IRS was displeased. It pursued the taxpayer on the basis that the transactions involving the IRA’s business investments constituted “prohibited transactions” that destroyed the IRA’s tax exempt status and triggered a deemed taxable distribution of all IRA assets to the taxpayer.
The offending transactions included payment of compensation to the taxpayer for services rendered to the IRA controlled LLCs. This was deemed an indirect transfer from the IRA to the taxpayer as a fiduciary to the IRA, which is prohibited by statute. The taxpayer’s argument that the payment was made by the LLCs, not the taxpayer’s IRA, was rejected by the Tax Court in Ellis v. Commissioner of Internal Revenue on the grounds that the LLCs and the taxpayer’s IRA “were substantially the same entity.” A statutory exception for payment of “reasonable compensation” to IRA service providers was held not to apply to the taxpayer’s management of the business operations of the LLCs. The Tax Court also rejected the general idea of using IRA assets to fund personal business operations as a “plan to…use retirement savings as startup capital” so that the taxpayer “would operate this business and use it as his primary source of income by paying himself compensation for his role in its day-to-day operation.”
Also note that the IRS has attacked similar arrangements involving business start-ups funded through qualified profit sharing plans, which it refers to as ROBS (“rollovers as business start-ups”) transactions.
Recommendations: Is it possible to thread the needle and set-up a complaint arrangement to fund a private business through a retirement plan? It is possible, but you have to be very, very careful not only with the initial set up but also with the continued operation of the business. Also bear in mind that the tax advantage of operating a business through a tax-exempt retirement plan goes away if the UBTI (unrelated business taxable income) rules apply. Further, you lose a significant tax advantage of building and selling a business - taxation at capital gains rates - if the business is owned by your retirement plan.
Golan & Christie LLP
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Chicago, Illinois 60602