IRA Owner Taxed on Attempted Loan Transaction

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In another decision, the Tax Court concluded that a multi-step transaction intended to result in a loan from the taxpayer’s IRA to a third party — to be held by the IRA as an investment — resulted in a taxable distribution to the taxpayer instead.

Facts of the Case

A doctor with a self-directed simplified employee pension IRA (SEP-IRA) entered into an agreement for the IRA to lend money to a private corporation.

However, the loan document stated that the money was to be repaid to the IRA owner rather than to the IRA. The taxpayer then signed a form titled “Retirement Distribution or Internal Transfer” and provided it to the IRA custodian.

The taxpayer requested that the IRA distribute $125,000 to a taxable brokerage account he held jointly with his wife. The taxpayer then wired $125,000 from that joint account to his personal account with another institution. Finally, the taxpayer wired $125,000 from that account to the borrower to complete the loan transaction.

The taxpayer didn’t report as income on his personal return the $125,000 received from his IRA and then lent to the corporation. After an audit, the IRS took the position that he had received a taxable $125,000 distribution from the IRA. The IRS said that it was a taxable distribution, mainly because the taxpayer signed the loan document in his personal capacity rather than on behalf of his IRA and because the loan hadn’t been paid back.

This taxpayer also took his case to court. At the time the case arrived in court, the loan was still outstanding and there had been no attempt to collect it.

Taxpayer’s Argument

The taxpayer maintained that he didn’t receive a taxable distribution because the various transactions beginning with the signing of the loan document and ending with the funds being transferred to the borrower should be collapsed and treated as an interest-earning investment by the IRA in the loan. Specifically, the taxpayer argued that he didn’t have any legal right — a so-called claim of right — to the funds withdrawn from the IRA, because he had a prior obligation to lend the money to the borrower. In short, the taxpayer claimed that he merely acted as a conduit or agent of the IRA in transmitting the funds to the borrower.

Unfortunately for the taxpayer, the court agreed with the IRS that the he had received a taxable distribution, because the facts showed that the taxpayer had unfettered control over the funds. Therefore, he effectively owned the funds for tax purposes, which meant he had received a taxable distribution.

The court distinguished the taxpayer’s situation from the facts underlying two other cases where IRA owners had arranged for funds to be withdrawn from their self-directed IRAs and then used the funds to acquire non-traditional investments to be held by their IRAs. In those cases, the withdrawn funds weren’t payable to the IRA owners. Instead, they were payable to the parties from whom the investments were being acquired. So the IRA owners never had any personal access to the withdrawn funds.

In contrast, the IRA owner in this case did have personal access to the funds, because they were transferred into accounts that were under his control before being transferred to the borrower. As a result, the IRA withdrawal was treated as a taxable distribution to the owner. (Vandenbosch, TC Memo 2016-29)

The Lesson

There are a couple lessons from these cases. First, owners of self-directed IRAs must be careful in structuring the acquisition of non-traditional investments for their accounts. The other lesson is more general: You may think you understand the applicable tax rules, but that notion may be a recipe for bad tax results. Be smart: Talk with your advisor before pushing the button.

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