Source: https://ascpa.wordpress.com/2013/10/31/payment-of-salary-by-robs-formed-corporation-to-ira-beneficiary-found-to-be-prohibited-transaction/
Timestamp: 2016-05-02 08:14:43
Document Index: 362046055

Matched Legal Cases: ['§6201', '§4975', '§4975', '§4975', '§4975', '§7701', '§4975']

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Payment of Salary by ROBS Formed Corporation to IRA Beneficiary Found to Be Prohibited Transaction
October 31, 2013 by Ed Zollars, CPA A ROBS (rollover as a business startup transaction) produced disastrous consequences for the individual whose rollover was involved in the case of Ellis v. Commissioner, TC Memo 2013-245, TC Memo 2013-245, http:// http://www.ustaxcourt.gov/InOpHistoric/EllisMemo.Paris.TCM.WPD.pdf.
The issues in the case was whether the taxpayer had engaged in a prohibited transaction under IRC §4975 as part of his use of funds received from his previous employer’s 401(k) plan to have his IRA start a used car business. If an IRA engages in a prohibited transaction, the entire balance of the account is deemed distributed to the IRA beneficiary and tax is triggered.
The IRS saw four separate point at which a prohibited transaction under §4975 had occurred:
When Mr. Ellis had his IRA purchase an initial interest in the newly formed LLC (which elected to be taxed as a corporation) that previously had no ownership interests issued
When Mr. Ellis received compensation from the entity as an officer of that entity after formation in 2005
When Mr. Ellis received compensation from the entity as an officer in 2006 and
When Mr. Ellis had the corporation enter into a lease with an entity owned by Mr. Ellis, his spouse and their children in 2006.
The Court found Mr. Ellis dodged the first bullet. The IRS argued that, as the corporation was constructively owned by Mr. Ellis, the original purchase of interests was a transaction with a disqualified person (the corporation controlled by Mr. Ellis). However, the Tax Court agreed with Mr. Ellis’ reliance on its decision in the case of Swanson v. Commissioner, 106 TC 76, which held that a corporation with no shareholders was not a disqualified person. Only after the shares were issued (following the transaction) would the new entity become a disqualified person.
However, Mr. Ellis did not fare as well on the second issue. There, the Court Mr. Ellis controlled the corporation and the payments it would make to him. The court noted that:
The direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan is a prohibited transaction under section 4975(c)(1)(D). Similarly, an act by a disqualified person who is a fiduciary whereby he directly or indirectly deals with the income or assets of a plan in his own interest or for his own account is a prohibited transaction under section 4975(c)(1)(E).
The Court found that the payment of salary to Mr. Ellis violated this provision. While it paid Mr. Ellis from its own bank account and not that of the IRA, the IRA had virtually exclusively funded the entity. The Court noted:
To say that CST was merely a company in which Mr. Ellis’ IRA invested is a complete mischaracterization when in reality CST and Mr. Ellis’ IRA were substantially the same entity. In causing CST to pay him compensation, Mr. Ellis engaged in the transfer of plan income or assets for his own benefit in violation of section 4975(c)(1)(D). Furthermore, in authorizing and effecting this transfer, Mr. Ellis dealt with the income or assets of his IRA for his own interest or for his own account in violation of section 4975(c)(1)(E).
The Court also rejected the claim that §4975(d)(10) exempted the transaction. That provisions provides an exemption for reasonable compensation paid to a fiduciary for performance of duties of the plan. The Court found the payments were not for his duties of managing the investments of his IRA, but rather being the general manager of the car dealership.
In essence, Mr. Ellis formulated a plan in which he would use his retirement savings as startup capital for a used car business. Mr. Ellis 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. Mr. Ellis effected this plan by establishing the used car business as an investment of his IRA, attempting to preserve the integrity of the IRA as a qualified retirement plan. However, this is precisely the kind of self-dealing that section 4975 was enacted to prevent.
That language does not bode well for other ROBS transactions, especially where the individual maintains any sort of connection to the entity and is compensated as part of that connection.
Posted in Tax | Tagged Prohibited Transaction, ROBS | 4 Comments	4 Responses
on November 7, 2013 at 12:57 pm | Reply planwiz
It would have been worthwhile for the author to point out that this was not a classic ROBS transaction. In a classic ROBS transaction, the retirement entity purchasing the equity interest in the new business is a traditional 401(k) profit sharing plan and not an IRA. It could be argued that this makes a difference primarily because of the rather broad exemption for such purchase/ownership afforded by ERISA 408(e) and IRC 4975(d)(13)
on January 21, 2014 at 11:17 am | Reply Mike Hawthorne
I am an attorney specializing in the creation of ROBS-compliant structures and IRA-LLC structures. This article completely confuses the mentioned Tax Court case with a ROBS structure, which requires a C corporation (not LLC) and a profit-sharing plan (not IRA). In a ROBS, the individual would be permitted to draw a salary based on company profits. The tax court case actually refers to the idea of an IRA utilizing an LLC for “checkbook control” (permitting the IRA owner to manage the IRAs investments without going through the custodian for every detail). This is also legal provided the owner does not receive compensation and does not participate in the labor. The owner’s only mistake was allowing the LLC to pay him a salary; otherwise, everything he did was fine.
on January 27, 2014 at 2:59 pm | Reply Ed Zollars, CPA
To follow-up on the issues here. Whether a “ROBS” must involve a qualified plan is a marketing question primarily, since there’s not a vehicle described in the IRC as a “ROBS” transaction. Certainly some entities marketing “acquire a business” structures with retirement funds have used the term with regard to IRA structures. But, in any event, the article and even the headline clearly identifies the underlying plan as an IRA.
There is some more leeway in the area of qualified plans, but the court’s opinion doesn’t suggest that the Court was overly concerned with those issues, rather concentrating on the issue that the entity was essentially 100% for the benefit of the recipient. Given the court’s view on that one, it seems likely a “solo-401(k)” (another marketing term) would be viewed in the same light–with a somewhat different, but still rather disadvantageous, result.
The Court did not appear to find the fact this was a state law LLC structure significant in some way as opposed to being formed a state law corporation. Once the entity elected corporate status under “check the box”, it was a corporation as far as the Tax Court was concerned when applying §4975. Note that the Court more than once simply refers to the entity as a corporation, something you wouldn’t expect the Court to do if the underlying LLC structure was the crucial fact.
That makes sense, since the check the box regulations are under IRC §7701 and, per the provision’s, apply for all purposes under Title 26 (including dealing with §4975 which resides in the same section). As well, the Peek case (noted below) involved a pure state-law corporation held by two IRAs (of the two owners).
I do not argue (and neither, as far as I know, does the IRS) argue that it is utterly impossible to use retirement funds in a nontraditional manner, nor to use it to acquire a closely held business. In fact, as I note, the Tax Court did not find the acquisition of the interests in this case to be prohibited. Rather, the problems occurred when the entity tried to do something–such as pay a salary to an employee who was also the IRA beneficiary or, in the case of Peek v. Commissioner, 140 TC No. 12, guaranteed the debt of the business when it got a bank loan.
Like any court case, this simply describes the results of a trial court case on a particular set of facts and the intended readers of this blog (CPAs specializing in tax matters) are expected to understand that point.
on December 15, 2014 at 1:49 pm | Reply stratumplans
Ed – late to the discussion here but I am curious about your interpretations. While I completely agree with your qualifications as a CPA making interpretations of tax court decisions, Your classification of the Ellis case as case law pertaining to the ROBS structure seems to me a stretch. Rather, the case seems to more directly speak to the validity of a “Checkbook IRA” and the fact that the IRA owner/manager of such an entity must not receive improper benefit from the entity.
I am curious to learn your view, however, regarding the idea that properly structured ROBS are valid by exemption from ERISA Section 408(e) combined with the provisions of ERISA Section 406 – 407 and are particularly exempt from prohibited transaction rules under IRC Section 4975(d)(13),
My understanding is that a properly structured ROBS uses a C-Corp owned wholly by the Individual 401(k) plan sponsored by the C-Corp. The capital raised by the stock offering therein may be used to further the operations of the C-Corp. The most common conflict that arises, then, becomes that of “owner’s compensation”. The flow being: C-Corp offers shares of C-Corp to DC plan sponsored by C-Corp whereby C-Corp becomes wholly owned by the DC plan but controlled by the DC plan’s trustee and single participant – then proceeds of this capital raise are used to pay a salary to the DC plan’s trustee/single participant/C-Corp executive. Clearly this smells of a PT. In fact, the DOL has intoned alert about their perceived ROBS abuses including that of salary paid to the trustee/single participant/C-Corp executive out of the ROBS proceeds. Yet, to my knowledge there is no direct case law finding the presence of a PT when such a flow occurs.
Ultimately, a more sensible approach to the consultation discouraging ROBS “owner compensation” may be found in a more logical tax analysis comparing the “double taxation” of C-Corp salary to the combination of income tax and penalty for early distribution from a qualified plan/IRA.
Regardless, best practices would indicate that “owner compensation” from ROBS proceeds is not prudent. If any salary is paid to the DC plan’s trustee/single participant/C-Corp executive, it should come from the C-Corp’s income from operations in the spirit of IRC exemptions that allow the structure to exist in the first place.
Perhaps the Ellis case will ultimately serve useful to any future challenge as it applies to the ROBS structure. But at present, that case is purely an IRA thing.
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