Take-Away: A recent Tax Court decision was won by the taxpayer who surprisingly argued that she did not own an IRA, consequently she could neither be taxed on distributions nor assessed a 10% penalty.

Facts: The owner used her IRA to make a $40,000 loan to her father in 2005, in exchange for a promissory note from him. She later loaned another $60,000 to a friend in 2012, using a second promissory note. In 2013 the IRA owner changed  custodians for her IRA,  which also held cash of $96,508 in addition to the $100,000 represented by the two promissory notes.  In 2013 the cash was moved to a new IRA custodian but the two notes were not ‘rolled’ into the owner’s new IRA. The owner did not report any taxable distributions in 2013 from her IRA. The IRS finally caught up with the owner and brought a deficiency action against her in which it claimed that the owner received a total distribution in 2013 of $196,508. But she only rolled  $96,508 cash into the new IRA, and therefore she received a $100,000 distribution (the two promissory notes) along with a 10% penalty because she received a distribution from her IRA prior to age 59 1/2. The IRS thus sought $42,427 in back taxes and penalties.  Marks v. Commissioner, TC Memo, 2018-49.

Successful Argument: Why did the IRA owner win her case? She argued that there was no taxable distribution in 2013 because she did not even own an IRA at that time. That’s right, she claimed that there was no IRA. Her loan to her father was a prohibited transaction under IRC 4975; the implication of the prohibited transaction with an IRA is that the IRA is disqualified retroactive to January 1 of the year in which the prohibited transaction occurred- 2005. IRC 408(e)(2)(A). Therefore, the IRA ceased to be an IRA back in 2005 when the loan from the IRA was made to the owner’s father. The result was that in 2013 it was not an IRA but simply an ordinary taxable investment account; therefore, taking the money from the former IRA had no taxable significance in 2013. The IRS actually conceded to this argument that the distribution was not taxable in 2014.  Nor did the 10% penalty for an early distribution apply since the account was not an IRA.

Pyrrhic Victory?: A nice bit of lawyering by the attorney who represented the IRA owner. However, since the owner admitted that it was not an IRA going back to 2005, some interesting tax consequences, either  good,   bad, and ugly, might be the result.

  • Good: The failure to report the distribution in 2005  under-reported the owner’s income for that year. If the under-reported income was in excess of 25%, that would extend the statute of limitations to assess the deficiency to 6 years, not 3 years. But even that 6 year period had passed, thus making it ‘too late’ for the IRS to assess back taxes and interest. In short, because the statute of limitations had run, the IRA owner essentially received an income tax-free distribution of her entire IRA going back to 2005.
  • Bad: If it was no longer an IRA going back to 2005, then any interest, dividends, or capital gains experienced in the account over the following years were not reported by the owner on her income tax returns. While the IRS can go back to collect taxes on that unreported income from the owner’s ‘investment’ account, it can only do so for ‘open years’, more likely three years, before the statute of limitations applies, but not back all the way to 2005. Consequently, some back taxes, penalties and interest will accrue on that unreported income generated by that ‘investment’ for those ‘open years.’
  • Ugly: If the account was not an IRA going back to 2005, then the attempted ‘rollover’ of $96,508 in 2013 was not a rollover. The $96,508 was not transferred from an IRA account to another IRA account, so the transfer of those funds will be treated as a new contribution to a new IRA. The $96,508 is far in excess of what an IRA owner can contribute to a traditional IRA in a single calendar year, the result of which is that the owner has made an excess contribution to the ‘new’ IRA. Excess contributions attract a 6% excise tax each year until the excess  funds are either withdrawn from the IRA, or they are ‘absorbed’ by being treated as a permitted annual contribution  for each calendar year after the ‘new’ IRA was opened. 5 years of an imposed  6% excise tax on the $96,508 [assuming the owner continued to actually make annual contributions to her IRA after 2013 from her earned income] would result in $28,952 in excise taxes [which is still better than the $42,427 the IRS originally sought from the owner.]

Prohibited Transactions: It is important to note that not all prohibited transactions associated with an IRA will lead to the IRA being disqualified. Some prohibited transactions may lead instead to an excise tax imposed, but not to  an outright disqualification of the IRA. The usual punishment for a prohibited transaction is the imposition of an excise tax. [IRC 4875(a) and (b)- lending of money or other extension of credit between a plan and a disqualified person.] But then there is an overriding rule imposed in the Tax Code which provides that ‘if during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by IRC 4975 with respect to such account…” which leads to disqualification of the entire IRA. To make this distinction, if the IRA owner had made a loan from her IRA to herself, she would have ‘engaged in’ a prohibited transaction, leading to the IRAs disqualification. But her loan was to her father, who is a disqualified person (being related to the IRA owner) but he is ‘not the individual for whose benefit the account was established.’ [IRC 408(e)(2).] Which then leads to the question if the IRS was wrong when it stipulated that the IRA was disqualified going back to 2005.

Lingering Questions: Thus the question is should the IRA have been disqualified in 2005, or only subject to an excise tax due to the prohibited transaction- a loan to a related party? Restated, does IRC 408(e)(2) mean that the normal excise tax applies unless the IRA owner is on ‘both sides’ of the prohibited transaction, i.e. she loan the money to herself and not to a third person? That is one possible interpretation of the words ‘engages in.’

Neither the Tax Code nor the implementing Regulations provides any certainty as to the when an excise tax applies to a prohibited transaction as opposed to the disqualification of the entire IRA. There are prior Tax Court cases where a loan to the IRA owner was clearly found to be a prohibited transaction that caused the IRA to be disqualified in the year of the loan. See Peek et ux., et. al. v Commissioner, 140 T.C. 12 (2013), which dealt with a  loan guaranty made by the IRA owners for a bank loan made to a corporation owned by their IRAs. But in Marks, the loan was not to the IRA owner, but instead to her father, so she arguably did not personally benefit from the loan.

Which leads to one last question: if there was a mild infraction of the prohibited transaction rules years ago,  does that mild infraction cause the disqualification of the entire IRA from that date forward, e.g. a loan that was made to a family member that was repaid within 90 days? Wouldn’t the imposition of an excise tax for that infraction be more appropriate than a multi-year disqualification of the entire IRA?

Conclusion: Unfortunately the IRS’s prohibited transaction rules are not easily understood. Added to that confusion are the multitude of financial advisors who have great ideas for how an IRA can be used as capital to start a business or to purchase investment property, advice that usually triggers the prohibited transaction rules. But still unclear is if the result of that prohibited transaction is merely the imposition of an excise tax, or a disqualification of the entire IRA. A few examples of each type of prohibited transaction from the IRS would be a helpful starting point.