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Playing with fire: Using an IRA to finance your business

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Joe Kristan is a CPA at Roth & Company P.C. 

When that great opportunity to start or buy a new business comes along, you probably need some cash to jump on it.  For many of us, our IRAs are the biggest financial asset. Yet unless it's a Roth IRA, you generally have to pay tax to get at the money, and if you are under 59, you also owe a 10% penalty. You may be able to get most or all of the cash in your Roth IRA tax-free, but then future earnings on those funds are taxable.

That's why it's tempting to try to have the IRA itself own a business. A recent Tax Court case shows that IRA ownership of a small business is playing with fire.

The biggest danger of owning your business in an IRA has been the risk of having a “prohibited transaction.” The tax law has hair-trigger rules for pension funds and other exempt organizations to prevent abuse of the funds by related parties or trustees. If you have one, you have a penalty tax of at least 15%, and maybe 100%. Worse, you terminate your IRA.

The Tax Court case involved a C corporation owned by IRAs. As is typical in a closely-held business, the lenders wanted a loan guarantee from the entreprenuers. Disaster ensued:

The Tax Court said this constituted an “indirect extension of credit” to the IRA (my emphasis):

 As the Commissioner points out, if the statute prohibited only a loan or  loan guaranty between a disqualified person and the IRA itself, then the prohibition could be easily and abusively avoided simply by having the IRA create a shell subsidiary to whom the disqualified person could then make a loan. That, however, is an obvious evasion that Congress intended to prevent by using the word “indirect”. The language of section 4975(c)(1)(B), when given its obvious and intended meaning, prohibited Mr. Fleck and Mr. Peek from making loans or loan guaranties either directly to their IRAs or indirectly to their IRAs by way of the entity owned by the IRAs.

This was a prohibited transaction, blowing the IRA. That meant when the corporation was sold in 2006, instead of a tax-free sale inside an IRA, it was a taxable sale by the owners. The result was over $400,000 in additional taxes, plus another $90,000 in penalties.

I suspect there are a lot of similar taxpayers out there.  They will be following this case if it is appealed with intense interest. If this ruling holds, this will be a catastrophe to such folks, in the same league as the ruin caused by Incentive Stock Options (ISOs) exercised just prior to the dot-com collapse. The ISO disaster was bad enough to get Congress to enact legislative relief. 

-Joe Kristan

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