Usually an IRA is invested in stocks, bonds, mutual funds, and perhaps certificates of deposit. Sometimes a retiree may see this nest egg as a resource for a more unconventional investment. In that case, one needs to beware of the rules against self-dealing. Some transactions are prohibited under the tax code and may lead to a disqualification of the IRA’s tax-deferred status. Here are two examples.
A Loan to the IRA Owner
In December 1993, Ocean One North, Inc., was delinquent on its mortgage on certain improved real estate. Ernest Willis, a 50% owner of Ocean One, resolved the problem by purchasing the mortgage. To fund this transaction, Willis withdrew $700,000 from his IRA. The loan was for the short term, as Willis returned the money to the IRA 64 days later. If only he’d repaid the money in 60 days!
Then, in 1997, Willis engaged in a check-swapping process between his brokerage account and his IRA. Eight times he simultaneously moved money between the two accounts, making total deposits of $2,022,000 into the brokerage account and $1,835,000 into the IRA. The net result of transactions was an increase of $186,500 in the brokerage account, done in such a way that the IRA appeared to make no taxable distributions, as all funds were restored to it within 60 days.
Fast forward to 2007, when Willis declares bankruptcy. Normally, an IRA is a protected asset in bankruptcy, but not in this case. The bankruptcy court found that Willis engaged in prohibited transactions with his IRA, and so at that moment it lost its status as a qualified retirement plan. From a tax perspective, that would mean the $700,000 loan in 1993 was a taxable distribution, and the repayment of it was an excess IRA contribution. That’s an academic point, however. From a bankruptcy perspective, the IRA fully was subject to the claims of Willis’ creditors, the Court held.
A Loan to a Parent
In 2005 Stacey arranged a $40,000 loan from her IRA to her father. Another IRA loan was made in 2012, this time $60,000 to Stacey’s friend. In 2013, Stacey arranged for a rollover of her IRA to a new custodian. For some reason, the promissory notes for the loans were not rolled into the new account.
The IRS spotted the transaction and charged that the failure to roll the notes into the new account created a taxable distribution to Stacey of $98,000. Why the distribution was less than $100,000 was not explained; perhaps $2,000 of principal had been repaid? Taxes on the distribution, coupled with the penalty for failing to report it plus a 10% penalty because Stacey was not yet 59½, brought the total assessment to some $42,000.
At trial, Stacey initially argued that the notes were rolled into the new account. The Court then ordered both sides to prepare additional memoranda on whether the loan to Stacey’s father was a prohibited transaction under the tax code provisions of ERISA, and what the tax consequence of that would be.
Both parties concluded that the loan was a prohibited transaction, with the result that the IRA ceased being an IRA the year that the loan was made. Accordingly, the distribution of the notes, even if it occurred, would not result in additional taxable income to Stacey in 2013.
Because the IRA terminated so long ago, the statute of limitations for collecting additional taxes that should have been paid in 2005 had expired.
However, Stacey may not be entirely off the hook. Presumably she needs to refile her returns for all open years to report the investment income from the account that became an ordinary investment account in 2005. What’s more, the attempted rollover in 2013 was not proper, and the entire amount may be an excess IRA contribution, subject to a 6% excise tax until it is withdrawn.
At The Trust Company of Kansas, we help people. We promise to minimize the burden of wealth management, and bestow the freedom to enjoy everything else. The officers at The Trust Company of Kansas are always willing to discuss your goals for your estate and help you to create a plan that is well-aligned with your wishes. Investment management is one of our core competencies. If you have a specific question about IRAs, wealth management, or trusts, please contact us at (800) 530-5254 or visit tckansas.com/contactus, and one of our Certified Trust and Financial Advisors will be happy to assist you.