Self-Directed IRA Prohibited Transaction Costs Taxpayers Over $250K
Mat Sorensen


May 28, 2013

The latest IRA prohibited transaction case is called Peek & Fleck v. Commissioner, U.S. Tax Court 140 T.C. No. 12 (March 8, 2013) and concerns two tax payers who used self directed IRAs to establish and fund a newly formed corporation which corporation purchased a fire and safety company that was for sale by third parties and was known as ASF Company.

Both Mr. Peek and Mr. Fleck funded the newly formed company with funds from their self directed IRAs and the company used those combined funds in the approximate amount of $400,000, as well as a bank loan for $450,000, and a loan from the sellers of the business of $200,000 to acquire all of the stock of ASF Company.  In entering into the $200,000 loan with the sellers, however, Mr. Peek and Mr. Fleck (who were not personally invested or owners in the transaction) signed personal guarantees and offered their personal residences as collateral as part of the terms of the loan with the sellers. This critical mistake, the personal extension of credit for their IRAs investment, resulted in the IRS alleging a prohibited transaction under IRC § 4975 (c)(1)(B).

The Tax Court agreed with the position of the IRS and disqualified the IRAs investment all the way back to when the prohibited transaction and the personal extension of credit for the IRAs occurred. This was extremely problematic for the self directed IRA owners as they were later able to turn their IRAs $200,000 investment into a return of over $1,500,000. However, the consequence of the prohibited transaction negated the IRAs tax favored status and resulted in the self directed IRA owners incurring taxes of over $250,000 per account owner. Using self directed IRAs in the investment was an excellent idea, however, the actions of using personal credit to solely benefit the IRAs clearly violated the prohibited transaction rules and literally cost the self directed IRA owners hundreds of thousands of dollars.

An alternative way to approach this issue would have been to avoid the personal guarantees and use of the IRA owner’s personal assets as collateral and to instead structure the loans used to purchase the business as non-recourse loans perhaps being secured in favor of the seller’s by the stock being sold. An additional alternative may have been to include other non-disqualified persons whose IRAs were not invested and to include them as partners and as possible personal guarantors to the loans. As a general rule of thumb, always avoid signing personal guarantees or offering personal assets as collateral when obtaining loans to fund self directed IRA investments. Seek out what are known as non-recourse loans where you do not have to offer your personal name or assets as collateral and you’ll keep your IRAs tax preferred status outside of scrutiny by the IRS.

Author, Mathew Sorensen is a partner at KKOS Lawyers and routinely advises clients on the prohibited transaction rules, on self directed IRA investment structures such as IRA/LLCs, and represents self directed IRA owners before the IRS and the U.S. Tax Court.

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