MLR

Guaranties ended IRAs and tax-exempt status

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The Tax Court decided in a recent case that Lawrence Peek and Darrel Fleck engaged in prohibited transactions when they guaranteed loans to a company.

Because their individual retirement accounts held the company stock, the prohibited transactions caused their IRA accounts to lose tax-exempt status. As a result, Peek and Fleck were liable for tax on the capital gains realized on the later sale of the stock.

As background, Peek and Fleck established traditional IRAs in 2001. They also formed FP Company, Inc., and directed their new IRAs to purchase 100 percent of FP’s newly issued stock. When FP purchased the assets of Abbott Fire & Safety, Inc. (AFS), Peek and Fleck personally guaranteed a $200,000 promissory note from FP to the sellers of AFS.

In 2003 and 2004, Peek and Fleck rolled over the FP stock from their traditional IRAs to Roth IRAs, including in their income the value of the stock rolled over. In 2006, the Roth IRAs sold all of the FP stock.

The IRS contended that Peek’s and Fleck’s personal guaranties of the FP loan were prohibited transactions, and as a result, the gains realized from the 2006 sale of FP stock should have been included in their income. Fleck and Peek argued that their personal guaranties were not prohibited transactions because the loan guaranties were between them and FP, an entity owned by the IRAs, rather than the IRAs themselves.

The court concluded that Peek’s and Fleck’s personal guaranties of the FP loan were an indirect extension of credit to the IRAs, which is a prohibited transaction. The court said that a prohibited transaction can result from any direct or indirect extension of credit between a plan and a disqualified person (Peek and Fleck v. Commissioner, 140 TC No. 12, May 9, 2013).

The court further held that the gains realized on the sale of the FP stock were included in Peek’s and Fleck’s incomes. Specifically, the court found that the accounts that held the FP stock were not IRAs in 2006 when the stock was sold, the accounts ceased to be IRAs exempt from income tax in 2001, and Fleck and Peek were liable for tax on the capital gains realized from the sale of the stock.

As a result of the guaranties, each original account holding the FP stock ceased to qualify as an IRA in 2001. In 2003 and 2004, when Fleck and Peek established the Roth IRAs, those accounts ceased to be Roth IRAs when they funded the accounts with FP stock because the prohibited transactions continued as to those accounts.

In the end, the court found that both Peek and Fleck were liable for the 20 percent “substantial understatement of tax” accuracy-related penalty under Internal Revenue Code Section 6662.