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Fiduciary Links: Self-Dealing Takes on New Meaning with Novel IRA Investment

Posted by Duane Thompson on November 18, 2013

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>>>>Self-dealing is often associated with a fiduciary who benefits personally from a transaction with a qualified plan while entrusted to act solely in the interest of others.

However, a recent U.S. Tax Court opinion in Ellis v. Commissioner offers an illustration of the penalties involved in self-dealing with, well, one’s own IRA under section 4975 of the tax code. In this instance, Terry Ellis was deemed to be a fiduciary engaged in a prohibited transaction when he withdrew assets from his IRA account to set up a used car dealership that paid him a salary as well as rent to a related business entity owned by his family.

According to the Oct. 29th decision, in 2005 Terry Ellis rolled over a “sizeable” 401(k) account held by his employer, Aventis Pharmaceuticals, Inc., into a new IRA. Within a few days Ellis established a used car dealership in Harrisonville, Mo., under CST Investments, a limited liability company, and invested nearly all of the IRA assets in the dealership. Ellis owned 98 percent of the business.

During the next two years CST paid him a salary and entered into a lease agreement with CDJ LLC, another legal entity set up by Ellis to acquire the property for the used car lot. CDJ was owned by Ellis, his wife and three children and leased back to the used car business. Ellis also reported a pension distribution of $321,266 in 2005 from the IRA, but did not report any portion of it as taxable.

According to the Tax Court, Ellis failed to report using the IRA to purchase membership interests in CST, the $9,754 he received in compensation during 2005 or $29,236 the following year, or the $21,800 in rental payments in 2006 to CDJ, of which he was a 50 percent owner. The IRS issued a notice of deficiency for one of the two tax years of $135,936 for 2005, or alternatively, $133,067 for 2006. In addition, the IRS added accuracy-related penalties of $27,187 for 2005, or alternatively, $26,613 for 2006.  On top of that the IRS issued notice for failure to file a timely tax return in 2006 for an additional penalty of $19,731.

Tax Court Judge Elizabeth Crewson Paris determined that initially the car dealership was not a disqualified person under tax code section 4975(e)(2)(G) until Ellis actually funded the company. Judge Paris also determined that Ellis was a fiduciary of his IRA because he exercised control over the assets and was therefore a disqualified person to the IRA account. CST, in turn, became a disqualified person in connection with the IRA because Ellis owned 98 percent of the company, or more than a 50 percent controlling interest.

Section 4975 lists a number of prohibited transactions involving an IRA, including transfer to, or use of plan assets for the benefit of a disqualified person, or by a fiduciary who deals with the income or assets of the plan for his own account. As a consequence, Judge Paris held that Ellis exercised control over the disposition of the IRA assets and met the definition of a fiduciary within the meaning of section 4975. Moreover, Judge Paris noted that the term “disqualified person” under Section 4975(e)(2) includes a corporation or partnership in which 50 percent or more of the total value of shares or capital interest is owned directly or indirectly by a fiduciary.

“To say that CST was merely a company in which Mr. Ellis’ IRA invested is a complete mischaracterization when in reality CST and Mr. Ellis’ IRA were substantially the same entity,” Judge Paris wrote in her opinion. 

Ellis’s attorney argued unsuccessfully that CST was not a disqualified entity at the time of the distribution, and that the payments made by the company to his client were not from the IRA, but merely the income or assets of the company  in which Ellis’ IRA had invested.

Another argument made in defense of Ellis was that section 4975(d)(10) provides a safe harbor from prohibited transactions by a disqualified person for receipt of reasonable compensation for services rendered, or for reimbursement of expenses incurred in performance of duties to the plan. However, Judge Paris disagreed, stating the compensation paid by CST to Ellis had nothing to do with administration of a qualified retirement plan, but rather for his management role at the used car business.

“In essence, Mr. Ellis formulated a plan in which he would use his retirement savings as startup capital for a used car business,” Judge Paris stated. “Mr. Ellis effected this plan by establishing the used car business as an investment of his IRA, attempting to preserve the integrity of the IRA as a qualified retirement plan. However, this is precisely the kind of self-dealing that section 4975 was enacted to prevent.”

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