Thiessen, (2016) 146 TC No. 7
The Tax Court has held that a taxpayer’s personal guarantees of loans made to a corporation that he formed and that was owned by his individual retirement account (IRA) were prohibited under Code Sec. 4975 and resulted in a deemed distribution of all of the IRA assets. It also found that taxpayer’s disclosures regarding the relevant transactions weren’t sufficient to prevent the 6-year statute of limitations on assessment from applying. Click here for the Opinion of the Court.
Background. Under Code Sec. 408(e)(1), an IRA is exempt from income tax. However, Code Sec. 408(e)(2)(A) provides that if, during any tax year, an individual or his beneficiary engages in any transaction prohibited by Code Sec. 4975 with respect to his IRA, the IRA will cease to be an IRA as of the first day of the tax year. Code Sec. 408(e)(2)(B) provides that in any case in which an IRA ceases to be an IRA because of this rule, Code Sec. 408(d)(1) applies as if there were a distribution on the first day of the tax year in an amount equal to the fair market value (on that day) of all assets in the account.
Code Sec. 4975(c)(1) lists transactions that constitute prohibited transactions. Specifically, Code Sec. 4975(c)(1)(B) prohibits “any direct or indirect lending of money or other extension of credit between a retirement plan and a disqualified person.”
Under Code Sec. 4975(e)(2)(A), a “disqualified person” is defined as a fiduciary, i.e., any person who exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets. (Code Sec. 4975(e)(3)(A)) A spouse of a disqualified person is also a “disqualified person.” (Code Sec. 4975(e)(2)(F))
Code Sec. 4975(d)(23) generally provides that the prohibitions set forth in Code Sec. 4975(c)(1)(B) do not apply to the lending of money or other extension of credit between a plan and a disqualified person “in connection with the acquisition, holding, or disposition of any security or commodity, if the transaction is corrected before the end of the correction period.”
Congress has defined the terms “security” and “commodity” by incorporating (with slight modifications) the definitions of those terms found in Code Sec. 475(c)(2) and Code Sec. 475(e)(2), respectively. (Code Sec. 4975(f)(11)(D)(i); Code Sec. 4975(f)(11)(D)(ii)) A “security” for purposes of Code Sec. 4975(d)(23) includes: (1) a share of stock in a corporation; (2) a partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; (3) a note, bond, debenture, or other evidence of indebtedness; (4) an interest rate, currency, or equity notional principal contract; (5) an evidence of an interest in, or a derivative financial instrument in, any security described in (1) through (4), or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency; and (6) a position that is not a security described in (1) through (5) and is a hedge with respect to such a security. (Code Sec. 475(c)(2); Code Sec. 4975(f)(11)(D)(i)) A “commodity” for purposes of Code Sec. 4975(d)(23) includes: (1) a commodity that is actively traded; (2) a notional principal contract with respect to an actively traded commodity; (3) an evidence of an interest in, or a derivative instrument in, any commodity described in (1) or (2), including an option, forward contract, futures contract, short position, and similar instrument in such a commodity; and (4) a position that is not a commodity described in (1) through (3) and is a hedge with respect to such a commodity. (Code Sec. 475(e)(2))
Code Sec. 6501(a) generally provides that a valid assessment of income tax liability may not be made more than three years after the later of the date the tax return was filed or the due date of the tax return. However, Code Sec. 6501(e)(1) extends the general 3-year period to a 6-year period where the taxpayer fails to report gross income in excess of 25% of the amount of gross income reported on the return. In computing the amount of gross income omitted for this purpose, any amount “disclosed in the return, or in a statement attached to the return, in a manner adequate to apprise the Secretary of the nature and amount of such item” is not taken into account. (Code Sec. 6501(e)(1)(A)(ii))
Facts. In June 2003, the taxpayers, Mr. and Mrs. Thiessen, rolled over their tax-deferred retirement funds into newly formed IRAs, caused the IRAs to acquire the initial stock of a newly formed C corporation (Elsara), and caused Elsara to acquire the assets of an existing business, Ancona.
The Thiessens were named as Elsara’s officers and directors, and they (and no one else) have served in those positions ever since. Elsara has never been characterized as a company with publicly offered securities or with securities issued by an investment company registered under the Investment Company Act of 1940.
The Thiessens guaranteed the repayment of a loan that Elsara received from the seller of the assets as part of the acquisition price. The Thiessens’ 2003 joint Federal income tax return reported that the rollover of the retirement funds into the IRAs was nontaxable. The 2003 joint return did not disclose the Thiessens’ guarantees of the loan or any other fact that would have put IRS on notice of the nature and the amount of any deemed distribution resulting from the guarantees. The 2003 joint return also did not disclose or even mention Elsara or its 2003 corporate return.
IRS determined that the Thiessens failed to report for 2003 a taxable distribution from their IRAs.
The loan guarantees were prohibited transactions. The Tax Court determined that the Thiessens received taxable distributions from their IRAs during 2003. The Thiessens’ guarantees of the loan were prohibited transactions under Code Sec. 4975(c)(1)(B) because the guarantees were the Thiessens’ indirect extensions of credit to the Thiessens’ IRAs. The Court further found that the Thiessens’ participation in the prohibited transactions caused the IRAs to lose their status as IRAs and be deemed to have distributed their assets to the Thiessens in a taxable transaction.
The Court said its holding was compelled by its opinion in Peek, (2013) 140 TC 216, which held, on similar facts, that an individual who guarantees repayment of a loan extended by a third party to a debtor is, although indirectly, extending credit to the debtor. Likewise, it held that the Thiessens’ IRAs are “plans” within the meaning of Code Sec. 4975(e)(1)(B) (the Thiessens’ IRAs are described in Code Sec. 408(a)), and the Thiessens are “disqualified persons” within the meaning of Code Sec. 4975(e)(2)(A) and Code Sec. 4975(e)(3)(A) (the Thiessens exercised discretionary authority or discretionary control over the management of their IRAs, as well as over the management and disposition of the assets of their IRAs).
The Thiessens made several arguments that Peek should be disregarded or distinguished. For example, they asserted that the Department of Labor has the primary authority to interpret the prohibited transaction rules and that the Court in Peek interpreted those rules inconsistently with the interpretation of the Department of Labor.
In disagreeing with this argument, the Court noted that Congress included provisions on prohibited transactions in both title 26 and title 29, and President Carter gave the Department of Labor primary authority to interpret both sets of those provisions. (See Reorganization Plan No. 4 of 1978, sec. 102.) That does not mean, however, that the Department of Labor has the final word as to the interpretation of those provisions. “It is emphatically the province and duty of the judicial department to say what the law is.” The Court then said that it read the opinion in Peek to be consistent with the statute. And, as a secondary matter, it said Peek was not inconsistent with the interpretation of the Department of Labor. (See, e.g., DOL Advisory Op. 90-23A, 1990 WL 263443 (July 3, 1990), which concluded in a setting similar to that in Peek (and here) that a personal guaranty would be a prohibited transaction under Code Sec. 4975(c)(1)(B).)
The Court also said that the Thiessens’ guarantees were not given in connection with the acquisition, holding, or disposition of a security or commodity within the meaning of Code Sec. 4975(d)(23). Instead, they were given in connection with Elsara’s acquisition of assets. Those assets failed to meet the relevant definition of “security” or “commodity.” While the Thiessens gave the guarantees incident to an overall plan that included their IRAs’ acquisition or holding of Elsara stock, the aim of the transaction was to acquire Ancona’s assets rather than to acquire Elsara’s stock. The Court concluded that the more appropriate characterization of the guarantees, therefore, was that they were given in connection with the asset acquisition rather than in connection with the Thiessens’ IRAs’ acquisition or holding of the Elsara stock.
Six-year statute of limitations applies. The Court also ruled that the 6-year statute of limitations on assessment applied because the Thiessens’ disclosures were insufficient.
The Thiessens argued that the 3-year limitations period applied because they disclosed on the face of their 2003 joint return that they rolled over their retirement fund distributions into the IRAs. The Court said that this argument was flawed. The prohibited transactions were the Thiessens’ guaranteeing of the loan, and the unreported income arose from the resulting taxable deemed distribution to the Thiessens of the assets in their IRAs (and not from the Thiessens’ rollover of the retirement funds into their IRAs). Indeed, the deficiency notice stated specifically that the unreported income stems from IRA distributions and made no mention of the rollovers or the taxability thereof. A reasonable person would not discern from the 2003 joint return that the Thiessens had omitted any gross income for 2003.