Those
who do not take note of rulings by the United States Tax Court may have missed a
recent decision that has caused many in the retirement plans community to sit
up and take notice.
The
case, Ellis v Commissioner, involved
a taxpayer who funded a business start-up with assets rolled over to an IRA
from a former employer’s qualified plan, a transaction referred to as a rollover-as-business startup (ROBS).
Unfortunately, in the process of establishing a used car business with
the rolled-over funds, causing the business to enter into a real estate rental
agreement with related parties, and paying himself for services to the business,
the IRS determined that the defendant ran afoul of the prohibited transaction rules. As a result, the IRA that had funded the used
car business start-up was disqualified, deemed distributed, and the defendant became
subject to substantial tax and penalty consequences.
We have
known for some time that the IRS has been “making a list, and checking it
twice,” when it comes to ROBS to inject a little seasonal flavor.
The Service is deeply concerned about transactions that abuse the tax
rules in order to avoid legitimate taxation.
Some feel
this U.S. Tax Court ruling is a “shot across the bow,” bearing in mind
that it was the Service that first disqualified the defendant’s IRA,
which—following appeal—led to the involvement of the Tax Court. It certainly should serve as a caution to anyone
who might consider using accumulated retirement assets to start a business. The real scrutiny began roughly five years
ago with an IRS compliance initiative targeting ROBS arrangements.
More typical
than the IRA rollover example in this Tax Court case, in the ROBS process a
taxpayer sets up a corporation, which establishes a qualified plan. The plan first accepts the rollover, then
uses it to purchase stock issued by the founding corporation. The stock is in the plan, and the rollover cash
used to purchase it is used by the corporation (the owner) to fund a business
start-up, or perhaps purchase a business franchise.
Not all such
transactions are considered abusive or illegal.
Some of these ROBS arrangements have been approved in the past. But some, as in Ellis v
Commissioner, either cross the line as prohibited transactions, or break
ERISA rules for plan operation. One example
of a post-ROBS operational failure is allowing the owner’s account to purchase
the corporate stock, an investment that is denied to others who—now or later—may
participate in the plan. Besides the
potential discrimination in such a situation, there may also be issues with
establishing the value of the corporate stock purchased with the rollover
assets. Often, the amount of the rollover
and the value of the stock purchased by the plan are—too coincidentally—
virtually the same, even when the corporate entity has yet to do a dime’s worth
of business. That can be seen as a red
flag to a reviewer.
The IRS is
also interested in IRA and employer plan asset valuation in more general
terms. Valuation is a special concern
when an investment is not traded on a public exchange, and is therefore hard to
value. Such investments may include real
property, securities options, debt obligations, partnership interests, and
others. Valuation is of particular
importance when potentially taxable distributions are taken from retirement
arrangements, or when a taxpayer executes a Roth IRA conversion, or an in-plan
Roth rollover (IRR) within a 401(k), 403(b) or 457(b) governmental plan. Like a distribution of pre-tax assets, a Roth
conversion or IRR is a taxable event. If
investments are unintentionally or intentionally undervalued, the asset owner
may gain, while the U.S. Treasury—and American taxpayers—lose.
One clear
manifestation of this asset valuation concern is the DRAFT 2014 Instructions to Forms 1099-R and 5498, released in June.
In these draft instructions the IRS specified
that both fair market values reported on Form 5498, IRA Contribution Information, and distributions reported on Form
1099-R, Distributions From Pensions,
Annuities, Retirement or Profit Sharing Plans, IRAs, Insurance Contracts, etc.,
were to identify hard-to-value assets.
The IRS has
since made this significantly more detailed reporting an option for 2014, due
possibly to challenges involved in information gathering and systems
programming for custodians, trustees, and plan administrators. But, make no mistake; the IRS intends to
collect more detailed information on the presence of such assets in
tax-advantaged retirement savings arrangements.
The objective can only be to ensure that such assets are not mis-valued
in an attempt to avoid proper taxation.
Like it or
not, such initiatives serve notice that the Service intends to close some of
the cracks through which they believe questionable transactions may have been falling and serves as a warning that anyone entering into one of these arrangements do so with an eye towards the prohibited transaction rules and IRS concerns.