This time the party challenging a taxpayer’s claim that he had not engaged in a prohibited transaction with his IRA was not the IRS. Rather the trustee and one creditor in the taxpayer’s bankruptcy case argued that the IRA was no longer a tax exempt IRA due to a violation of the prohibited transaction rules that took place in 2007, rendering the funds in the IRA available to be used to pay creditor’s claims.

In the case of In re: Kellerman the United States Bankruptcy Court for Arkansas, Docket No. 4:09-bk-13935, the Court agreed with the creditor’s that the taxpayer’s IRA had engaged in prohibited transactions, rendering the funds available to pay creditor’s claims.

The issue involved a joint investment between the IRA an entity controlled by the taxpayers. As the Court described the matter:

The alleged prohibited transactions involve the 2007 acquisition of approximately four acres of real property located near Maumelle, Arkansas. Panther Mountain Land Development, LLC ("Panther Mountain") played a precipitating and integral role in the purchase. Barry Kellerman and his wife each own a 50 percent interest in Panther Mountain. (Arvest Ex. 5, at 28.) The address for Panther Mountain is the same as Barry Kellerman Construction, Inc. and is the debtors' home address. (Arvest Ex. 1, at 32.) Barry Kellerman is also a co-debtor on a number of debts with Panther Mountain. (Arvest Ex. 1, at 23.)

The “self-directed” IRA chose to participate in a partnership effectively with Panther Mountain.

The basic outline of the agreement, as described by the Court, was as follows:

Although the IRA and Panther Mountain each possessed a 50 percent interest, the Partnership Agreement called for the IRA to deliver the real property as a "Noncash Contribution[ ]" valued at $122,830.56. (Debtors' Ex. 2.) The IRA was also called upon to make a "Cash Contribution[ ]" of $40,523.93 by November 30, 2007. (Debtors' Ex. 2.) Panther Mountain's sole obligation was a cash contribution of $163,354.49 -- an amount equal to the IRA's cash and non-cash contribution values -- at an unspecified "construction completion" date. (Debtors' Ex. 2.) Neither party introduced testimony or evidence that Panther Mountain ever partially or fully made its cash contribution. (Arvest Ex. 5, at 17.)

The day after the partnership was formed Mr. Kellerman directed the IRA to sell off $123,000 of assets. The purchase of the four acre tract took place at the same time.

Later in the year the partnership paid Business expenses on behalf of the partnership of $40,523.92, with additional expenses being paid in later years.

Shortly after Mr. Kellerman filed for bankruptcy Panther Mountain did as well. On its schedules Panther Mountain showed both Mr. Kellerman and his IRA (rather than the partnership) as unsecured creditors.

The Court noted that, pursuant to IRC §408(e)(2) an IRA will lose its tax-exempt status as of the first day of a tax year if, at any time during that year the IRA has engaged in a prohibited transaction as defined by IRC §4975. In such a case the IRA is treated as making a full distribution of the assets it holds as of the first day of the tax year.

A prohibited transaction involves a transaction with a disqualified person as defined at IRC §4975(e). The taxpayers admitted that they were disqualified persons. As the Court describes:

Specifically, Barry Kellerman is the beneficiary of the IRA and a fiduciary under subsection 4975(e)(2)(A) because he exercises "discretionary authority" and "discretionary control" over the IRA as the owner. Dana Kellerman qualifies as a "member of the family" pursuant to subsection 4975(e)(2)(F) as the wife of Barry Kellerman. Panther Mountain constitutes a "disqualified person" under subsection 4975(e)(2)(G) because Barry Kellerman asserts a 50 percent membership interest. Likewise, the Entrust Partnership is a disqualified person pursuant to subsection 4975(e)(2)(G). Based on the debtors' concessions and the court's findings on disqualified persons, all that remains is a determination of whether a prohibited transaction occurred that terminated the tax exempt status of the IRA.

And, unfortunately for the taxpayers, the Court found multiple prohibited transactions in this case.

Merely having the IRA invest in real estate does not create a prohibited transaction by itself. As the Bankruptcy Court noted:

In Cherwenka, the court considered whether a debtor could exempt a self-directed IRA utilized "to invest in distressed real properties and have the IRA realize profit from the later sale of these properties." 508 B.R. at 232. There, the debtor located potential real estate investments, a representative of the IRA executed the purchase documents, and the debtor reviewed the closing statements. Id. After flipping and selling a property, the IRA realized all the profits from the sale. Id. In contrast to the case before this court, the debtor in Cherwenka asserted that he "never jointly owned a property with [the IRA]." Id. Although the debtor was a disqualified person based on his ownership of the IRA, the court found that the debtor's involvement in selecting property and participating in other actions taken by the IRA did not constitute a prohibited transaction because the evidence failed to demonstrate that the "IRA-owned properties resulted in any benefit to [the] [d]ebtor outside of the plan." Id. at 237.

The Court also found that, based on a Department of Labor ruling, the fact that the taxpayer indirectly owned a minor interest in the same property as the IRA also wasn’t a problem.

The Court noted:

Similar to the benefit analysis set forth in Cherwenka, a United States Department of Labor opinion is equally instructive; wherein, it considered "whether allowing the owner of an IRA to direct the IRA to invest in a limited partnership, in which relatives and the IRA owner in his individual capacity are partners, [ ] violate[d] section 4975 of the [Internal Revenue] Code." Office of Pension and Welfare Benefit Programs, Opinion No. 2000-10A (E.R.I.S.A.), 2000 WL 1094031, at *1 (Dept. of Labor July 27, 2000). Analyzing the facts, the Department of Labor noted that the owner of the IRA was a fiduciary and a disqualified person based on his "investment discretion over the assets of his IRA." Id. at *2. Further, the owner of the IRA was a disqualified person based on "his capacity as the general partner of the [p]artnership to the extent he exercise[d] discretionary authority over the administration or management of the IRA assets invested in the [p]artnership" as were his children, who were members of the partnership. Id. However, the opinion states that the partnership was "not a disqualified person under section 4975(e)(2)(G) of the [Internal Revenue] Code" because the owner of the IRA only owned 6.5 percent of the partnership. Id. Thus, the Department of Labor found that the "IRA's purchase of an interest in the [p]artnership would not constitute a transaction described in section 4975(c)(1)(A) of the [Internal Revenue] Code" because the owner of the IRA would receive no "compensation by virtue of the IRA's investment in the [p]artnership." Id. at 3.1 The Department of Labor additionally stated:

that if an IRA fiduciary causes the IRA to enter into a transaction where, by the terms or nature of that transaction, a conflict of interest between the IRA and the fiduciary (or persons in which the fiduciary has an interest) exists or will arise in the future, that transaction would violate either 4975(c)(1)(D) or (E) of the [Internal Revenue] Code. Moreover, the fiduciary must not rely upon and cannot be otherwise dependent upon the participation of the IRA in order for the fiduciary (or persons in which the fiduciary has an interest) to undertake or to continue his or her share of the investment.

Id. Thus, the Department of Labor held that "an IRA may invest in a partnership," and a "violation of [sub]section 4975(c)(1)(D) or (E) w[ould] not occur merely because the fiduciary derives some incidental benefit from the transaction involving IRA assets." Cherwenka, 508 B.R. at 239.

However, the Court noted there comes a point where the shared benefits outside the IRA become too significant. The Court turns to a 2004 Tax Court decision noting:

In Rollins, the United States Tax Court also looked to the benefit derived in holding that a plan owner was a disqualified person who engaged in prohibited transactions pursuant to subsection 4975(c)(1)(D) by directing his plan to make loans to various entities in which he held a membership interest. Rollins v. Comm'r, T.C.M 2004-260, 2004 WL 2580602, at *9 (U.S. Tax Ct. Nov. 15, 2004). The court noted that "[t]he transactions were uses by petitioner or for petitioner's benefit[ ] of assets of the [p]lan." Id. Thus, the "petitioner derived a benefit (as significant part owner of each the [b]orrowers) from the [b]orrowers' securing financing without having to deal with independent lenders" and engaged in a prohibited transaction each time a loan was made. Id. at *10.

In this case the Court found:

In 2007, Barry Kellerman engaged the IRA in transactions including: (1) the purchase of the real property with IRA funds and subsequent conveyance of the real property to the IRA and Panther Mountain (the "non-cash contribution" under the Partnership Agreement), and (2) the cash contribution of $40,523.93 made by the IRA to the Entrust Partnership (the "cash contribution" under the Partnership Agreement). Collectively, individually, and with some redundancy, both the non-cash contribution and the cash contribution constitute "prohibited transactions" with disqualified persons pursuant to subsections 4975(c)(1)(B), (D), and (E), which renders the IRA non-exempt.

The Court first found that the transactions, in substance and, at least to some extent, in form, represented a loan between the IRA and a party in interest. The Court noted:

At trial, the debtors argued that this was not a loan transaction but rather an investment in real estate through the Entrust Partnership. Despite a lack of traditional loan documentation, the facts suggest otherwise. Panther Mountain, jointly owned by the debtors, filed its own Chapter 11 bankruptcy on September 20, 2009. (Arvest Ex. 5.) On its schedules, Panther Mountain listed the IRA, not the Entrust Partnership, as an unsecured creditor for $163,000.00; the claim is described as "50% Interest in new entity." (Arvest Ex. 5, at 4, 11, 17-18.) This figure approximates Panther Mountain's $163,354.49 cash contribution to the Entrust Partnership that was ambiguously due "[a]t construction completion" and equals the IRA's immediate obligation to make a non-cash contribution of $122,830.56, representing the purchase price of the property, and a cash contribution of $40,523.93 to develop the property. (Debtor Ex. 2 at 1.) The aggregate of the non-cash and cash contributions is $163,354.49. This treatment, as listed on the Panther Mountain schedules, is more consistent with Panther Mountain using the IRA as a lending source for the purchase price and development of the four-acre tract without any real commensurate obligation by Panther Mountain to do anything other than perhaps contribute an equal amount at an unspecified and ambiguous date.

The Court found, as well, that Mr. Kellerman had used the assets of the IRA for the benefit of the various disqualified persons.

Barry Kellerman, as the owner and fiduciary of the IRA, (1) orchestrated the IRA's membership in the Entrust Partnership with Panther Mountain, (2) signed the Buy Direction Letter and the Sale Letter that facilitated the purchase of the four acres solely by the IRA but held with Panther Mountain as tenants in common, and (3) directed the payment of "Business Expense[s]" by the IRA to develop the four-acre tract. The real purpose for these transactions was to directly benefit Panther Mountain and the Kellermans in developing both the four acres and the contiguous properties owned by Panther Mountain. The Kellermans each own a 50 percent interest in Panther Mountain and stood to benefit substantially if the four-acre tract and the adjoining land were developed into a residential subdivision. Similar to the petitioner in Rollins, the Kellermans utilized the IRA to indirectly "secur[e] [additional] financing" for their existing Panther Mountain development "without having to deal with independent lenders." Rollins, 2004 WL 2580602, at *10. Thus, the Kellermans utilized the income and assets of the IRA for their benefit, as disqualified persons, in violation of subsection 4975(c)(1)(D).

The court found, as well, that the transactions were ones where Mr. Kellerman had dealt with the funds in the IRA for his own interest.

Therefore, the Court found:

The first transaction -- the non-cash contribution -- occurred on or about August 8, 2007, and the second transaction -- the cash contribution -- occurred on or about December 5, 2007. Therefore, based on the prohibited transactions engaged in by disqualified persons, the IRA ceased being tax exempt as of January 1, 2007, pursuant to 26 U.S.C. § 408(e). Thus, the debtors may not claim any interest in the IRA as exempt under 11 U.S.C. § 522(d)(12) of the United States Bankruptcy Code.

This case illustrates that while it is possible to have a “self-directed” IRA that invests in items such as real estate, there are a number of tax law “land mines” that await taxpayers in this area. Unfortunately taxpayers too often reason that “it’s their money” and that “it’s also a good investment” therefore what they propose to do can’t run afoul of the law.

The problem, of course, is that as one attorney I know once stated—it’s called a prohibited transaction, not a “bad” transaction. As a practical matter, properly handling a “self-directed” IRA is just not a good “do-it-yourself” project for most taxpayers and should only be undertaken after the specific transactions are approved by an attorney versed in the area of prohibited transactions. As well, the taxpayer must be aware that a consultation with the attorney will be needed any time any transaction, no matter how small, is contemplated that wasn’t explicitly discussed with counsel before.

As a practical matter, for the vast majority of taxpayers the “cost/benefit” analysis of using a self-directed IRA simply won’t turn out favorably. And, as should be clear from the Court’s analysis in this case, it will be virtually (if not completely) impossible to structure a transaction where the taxpayer tries to use a mix of their IRA and non-IRA assets (including assets or entities controlled by the taxpayer).