Court Opinion

ID: 2805895
Source: CourtListenerOpinion
Date Created: 2015-06-05 15:01:36.925293+00
Date Added: 2024-06-11T12:05:30.083295
License: Public Domain

United States Court of Appeals
                                  For the Eighth Circuit
                              ___________________________

                                      No. 14-1310
                              ___________________________

                                Terry L. Ellis; Sheila K. Ellis

                      l                      Petitioners - Appellants

                                              v.

                              Commissioner of Internal Revenue

                          l                Respondent - Appellee
                                       ____________

                          Appeal from the United States Tax Court
                                      ____________

                                  Submitted: April 14, 2015
                                     Filed: June 5, 2015
                                       ____________

Before WOLLMAN and GRUENDER, Circuit Judges, and DOTY,1 District Judge.
                        ____________

DOTY, District Judge

       Terry and Sheila Ellis appeal from the decision of the tax court2 finding a
deficiency in their 2005 income tax and imposing related penalties. Because we

      1
      The Honorable David S. Doty, United States District Judge for the District of
Minnesota, sitting by designation.
      2
          The Honorable Elizabeth C. Paris, United States Tax Court Judge.
conclude that Mr. Ellis engaged in a prohibited transaction with respect to his
individual retirement account (IRA), we affirm.

                                          I.

      On May 25, 2005, an attorney for Mr. Ellis formed CST Investments, LLC
(CST), to engage in the business of used automobile sales in Harrisonville, Missouri.
The operating agreement for CST listed two members: (1) a self-directed IRA
belonging to Mr. Ellis, and (2) Richard Brown, an unrelated person who worked full-
time for CST. The operating agreement contemplated that Mr. Ellis’s IRA would
provide an initial capital contribution of $319,500 in exchange for a 98 percent
ownership in CST, and that Brown would purchase the remaining 2 percent interest
for $20. Mr. Ellis was designated as the general manager for CST and given “full
authority to act on behalf of” the company. The operating agreement also stated that
“the General Manager shall be entitled to such Guaranteed Payment as is Approved
by the Members.”

       Mr. Ellis’s IRA did not exist at the time CST was formed. Rather, he
established the IRA with First Trust Company of Onaga (First Trust) in June 2005.
On June 22, 2005, he received $254,206.44 from a 401(k) that he had established with
his previous employer, and he deposited the amount in his IRA. He then directed First
Trust as the custodian of the IRA to acquire 779,141 shares of CST at a cost of
$254,000. On August 19, 2005, Mr. Ellis received an additional $67,138.81 from his
401(k), which he again deposited into the IRA. He directed First Trust to acquire an
additional 200,859 shares of CST at a cost of $65,500. Mr. Ellis reported the transfers
from his 401(k) to the IRA as non-taxable rollover contributions. By the end of 2005,
the IRA had a fair market value of $321,253, consisting of its membership interest in
CST and $1,773 in cash.

                                         -2-
       To compensate him for his services as general manager, CST paid Mr. Ellis a
salary of $9,754 in 2005 and $29,263 in 2006. The wages were drawn from CST’s
corporate checking account and were reported as income on the Ellises’ joint tax
returns for both years. It is unclear whether CST paid the salary pursuant to the
guaranteed payment provision in its operating agreement or under Mr. Ellis’s
authority as general manager. Under either scenario, however, Mr. Ellis had the
ability to effectively direct the payments to himself.

       On March 28, 2011, the Commissioner of the Internal Revenue Service sent the
Ellises a notice of deficiency, identifying a $135,936 income-tax deficiency for 2005
or, in the alternative, a $133,067 deficiency for 2006. The notice also imposed a
$27,187 accuracy-related penalty for 2005 or, in the alternative, a $26,613 accuracy-
related penalty and $19,731 late-filing penalty for 2006. The Commissioner
determined, in relevant part, that Mr. Ellis engaged in prohibited transactions under
26 U.S.C. § 4975(c) by (1) directing his IRA to acquire a membership interest in CST
with the expectation that the company would employ him, and (2) receiving wages
from CST. The notice explained that, as a result of these transactions, the IRA lost its
status as an individual retirement account and its entire fair market value was treated
as taxable income. See 26 U.S.C. § 408(e)(2).

       The Ellises filed a timely petition in tax court to contest the notice of
deficiency. The parties jointly stipulated to all material facts and moved for a decision
under Tax Court Rule 122. On October 30, 2005, the tax court upheld the
Commissioner’s determination that Mr. Ellis engaged in a prohibited transaction by
causing CST to pay him wages in 2005.3 The tax court determined that Mr. Ellis
“formulated a plan in which he would use his retirement savings as startup capital for
a used car business” and use the business as his primary source of income. Because

      3
       The tax court found no deficiency in income tax for 2006 and did not impose
any penalties for that year. The Commissioner does not appeal this determination.
                                          -3-
Mr. Ellis could direct his compensation from CST, the tax court found that he engaged
in the transfer of plan income or assets for his own benefit in violation of
§ 4975(c)(1)(D) and dealt with the income or assets of his IRA for his own interest or
account in violation of § 4975(c)(1)(E).4 The Ellises now appeal.

                                           II.

      The Ellises argue that the tax court erred in upholding the Commissioner’s
determination that Mr. Ellis engaged in a prohibited transaction by causing CST to
pay him wages in 2005.5 We review the tax court’s legal conclusions and application
of law to the facts de novo. Blodgett v. Comm’r, 394 F.3d 1030, 1035 (8th Cir.
2005); Musco Sports Lighting v. Comm’r, 943 F.2d 906, 907 (8th Cir. 1991).

         Section 4975 limits the allowable transactions for certain retirement plans,
including individual retirement accounts under § 408(a). It does so by imposing an
excise tax on enumerated “prohibited transactions” between a plan and a “disqualified
person.” 26 U.S.C. § 4975(a). Prohibited transactions include any “direct or indirect
. . . transfer to, or use by or for the benefit of, a disqualified person of the income or
assets of a plan;” or “act by a disqualified person who is a fiduciary whereby he deals

      4
        The tax court also found that the IRA’s purchase of an interest in CST was not
a prohibited transaction because the company did not have any membership interests
when the investment was made. See Swanson v. Comm’r, 106 T.C. 76, 88 (1996)
(explaining that a “corporation without shares or shareholders does not fit within the
definition of a disqualified person”). It declined to address the Commissioner’s
argument that the investment was prohibited because it was made as part of an
arrangement through which Mr. Ellis would derive a personal benefit in the form of
wages. Because we determine that the payment of wages was prohibited under
§ 4975(c), we need not consider whether the investment was prohibited as well.
      5
        The Ellises do not dispute that, if a prohibited transaction did occur in 2005,
they are liable for the associated accuracy-related penalty and 10 percent tax for an
early distribution from a qualified retirement plan. See 26 U.S.C. §§ 72(t), 6662.
                                           -4-
with the income or assets of a plan in his own interest or for his own account.” Id. §
4975(c)(1)(D), (E). Such transactions are prohibited even if they are made in good
faith or are beneficial to the plan. See Westoak Realty & Inv. Co., Inc. v. Comm’r,
999 F.2d 308, 311 (8th Cir. 1993); Leib v. Comm’r, 88 T.C. 1474, 1481 (1981).

         If a disqualified person engages in a prohibited transaction with an IRA, the
plan loses its status as an individual retirement account under § 408(a), and its fair
market value as of the first day of the taxable year is deemed distributed and included
in the disqualified person’s gross income. 26 U.S.C. § 408(e)(2). It is undisputed that
Mr. Ellis was a disqualified person under § 4975(e)(2)(A) because he was a fiduciary
of his IRA. See id. § 4975(e)(3) (defining a fiduciary as one who “exercises any
discretionary authority or discretionary control respecting management of such plan
or . . . management or disposition of its assets”). The parties also agree that CST was
a disqualified person because Mr. Ellis was a beneficial owner of the IRA’s
membership in the company. See id. § 4975(e)(2)(G)(i) (including as a disqualified
person a corporation in which 50 percent or more of “the combined voting power of
all classes of stock entitled to vote or the total value of shares of all classes of stock
of such corporation” is owned by a fiduciary); id. § 4975(e)(4) (stating that ownership
includes indirect ownership). Therefore, the only issue on appeal is whether the
payment of wages in 2005 was a prohibited transaction.

      The tax court properly found that Mr. Ellis engaged in a prohibited transaction
by directing CST to pay him a salary in 2005. The record establishes that Mr. Ellis
caused his IRA to invest a substantial majority of its value in CST with the
understanding that he would receive compensation for his services as general
manager. By directing CST to pay him wages from funds that the company received
almost exclusively from his IRA, Mr. Ellis engaged in the indirect transfer of the
income and assets of the IRA for his own benefit and indirectly dealt with such
income and assets for his own interest or his own account. See 26 U.S.C.

                                           -5-
§ 4975(c)(1)(D), (E); 29 C.F.R. § 2509.75-2(c) (“[I]f a transaction between a party in
interest6 and a plan would be a prohibited transaction, then such a transaction between
a party in interest and such corporation . . . will ordinarily be a prohibited transaction
if the plan may, by itself, require the corporation . . . to engage in such transaction.”);
Dep’t of Labor Op. No. 2006-01A, 2006 WL 149107, at *2 (Jan. 6, 2006) (finding
that a particular lease agreement between a disqualified person and a corporation in
which an IRA invested was a prohibited transaction).

       The Ellises rely on the Plan Asset Regulation, 29 C.F.R. § 2510.3-101, to argue
that a prohibited transaction did not occur because Mr. Ellis’s salary was drawn from
CST’s corporate account and not from the income or assets of the IRA. See 29 C.F.R.
§ 2510.3-101(c) (providing that the underlying assets of an “operating company”7 in
which a plan invests are not considered plan assets for determining whether a
prohibited transaction occurred). The plain language of § 4975(c), however, prohibits
both “direct and indirect” self-dealing of the income or assets of a plan. See Comm’r
v. Keystone Consol. Indus., Inc., 508 U.S. 152, 159 (1993) (reading “indirect”
broadly); Peek v. Comm’r, 140 T.C. 216, 225 (2013) (finding taxpayers’ personal
guaranties on a promissory note issued by a corporation that was owned by their IRAs
were prohibited under § 4975(c) as indirect extensions of credit to the IRAs). The

       6
       The Department of Labor has interpretive authority over § 4975 and 29 U.S.C.
§ 1106, a parallel ERISA provision pertaining to prohibited transactions between a
plan and a “party in interest.” See Dep’t of Labor Op. No. 2006-01A, 2006 WL
149107, at *1 n.1 (Jan. 6, 2006). The terms “party in interest” and “disqualified
person” are analogous for purposes of this appeal. See Rutland v. Comm’r, 89 T.C.
1137, 1143 n.5 (1987). Interpretations of § 1106 are instructive in determining
whether a prohibited transaction has occurred under § 4975. See Leib, 88 T.C. at
1480-81.
       7
        An operating company is “an entity that is primarily engaged . . . in the
production or sale of a product or service other than the investment of capital.” 29
C.F.R. § 2510.3-101(c). The parties agree that CST is an operating company.

                                           -6-
Plan Asset Regulation cannot be read to nullify this general rule against indirect self-
dealing. See 29 C.F.R. § 2509.75-2 (stating that the fiduciary responsibility rules
regarding prohibited transactions are outside the scope of the Plan Asset Regulation);
Dep’t of Labor Op. No. 2006-01A, 2006 WL 149107, at *2 n.3 (Jan. 6, 2006)
(explaining that certain transactions between a disqualified person and a corporation
in which a plan invests are prohibited regardless of whether they meet the plan asset
regulation).

       The Ellises also argue that the payment of wages, under the circumstances
presented here, is exempt under § 4975(d)(10). That provision excludes from the list
of prohibited transactions the “receipt by a disqualified person of any reasonable
compensation for services rendered, or for the reimbursement of expenses properly
and actually incurred, in the performance of his duties with the plan.” As noted by the
tax court, however, this exemption applies only to compensation for services rendered
in the performance of plan duties. See Lowen v. Tower Asset Mgmt., Inc., 829 F.2d
1209, 1216 n.4 (2d Cir. 1987). CST compensated Mr. Ellis for his services as general
manager of the company, not for any services related to his IRA. Section 4975(d)(10)
is therefore inapplicable to this dispute.

      Accordingly, we affirm the decision of the tax court.

                        ______________________________

                                          -7-