A Series Of Landmark Prohibited Transaction Cases: Peek & Fleck Vs The IRS
This article is part 2 of a series with the goal of educating you, the Self-Directed IRA LLC investor, on how to successfully invest & avoid triggering prohibited transactions.
At this point in your life you know two things in life are certain, those things being death & taxes. It almost feels like a no win situation doesn’t it? Funny enough, according to Greek mythology, you even have to pay to book passage on the boat that takes you to the afterlife!
Try to think of prohibited transactions as the sharks circling you and your state of the art Self-Directed IRA LLC investment vehicle (or should I say boat?)
The prohibited transaction rules are extensive, and the penalties even more so. Penalties for triggering a prohibited transaction range from excise taxes to instant dismantlement of your IRA plus fines. (Can you say “ouch” ?)
As you can see, anyone investing with a Self-Directed IRA LLC should be careful to avoid engaging in prohibited transactions, for to do so is doom. Not to mention, the IRS will always have an eye on you from then on out. (But then again, they already did, didn’t they?)
Peek & Fleck Vs The IRS
In 2001, two taxpayers, Mr. Lawrence Peek and Darrel Fleck decided to use Self-Directed IRA’s to acquire a business. They established Self-Directed IRAs using 401k rollovers, created a new company named FP Company, and then directed the IRAs to purchase the stock of FP Company with the cash in their IRA’s.
To finalize their purchase, in addition to the cash and other credit lines, FP Company provided a promissory note to the sellers. This promissory note was backed by the personal guarantee of Peek & Fleck, and the guarantees were then backed by the deeds to the Peek & Fleck’s homes.
In 2003 and 2004, Peek & Fleck converted their traditional IRAs to Roth IRAs. In 2006 and 2007, the IRAs sold FP Companies stock, which had increased in value, for a gain. Peek & Fleck utilized their Roth IRA to ensure there would be no tax on the gain from the sale of the stock.
The IRS, believing a prohibited transaction had occurred, audited the income tax return for both Peek & Fleck for the tax years of 2006 and 2007.
After reviewing the individuals’ tax returns, the IRS adjusted their tax returns to include the capital gains income from the sale of the stock as well as imposed excise tax for excess IRA contributions.
Both Peek and Fleck contested the IRS’s adjustment and went to the Tax Court with a petition.
The IRS argued that Mr. Fleck’s and Mr. Peek’s personal guarantee of a promissory note from FP Company to the sellers of the business in 2001 as part of FP Company’s purchase of the business assets were prohibited transactions.
Unfortunately for Peek & Fleck, The Tax Court agreed with the IRS. The Tax Court found that Peek & Fleck had committed prohibited transactions, that their IRA’s had ceased to be IRA’s as of the beginning of 2001, and that their capital gain from the sale of FP Company by the IRA’s should’ve been taxed.
The Tax Court pointed to Internal Revenue Code Section 4975, which prohibits direct and indirect lending of money or extensions of credit between an IRA and its owner.
The Tax Court found that it did not matter if the loan guaranteed by Peek & Fleck was to FP Company and not the IRAs directly. Why? Because IRC Code 4975 clearly prohibits the lending of money or extension of credit between a retirement plan and a disqualified person.
Then Peek & Fleck countered this, claiming that the IRS’s notices issued in 2006 and 2007 were too late because the loan was made in 2001. The IRS disagreed and so did the Tax Court.
The court cited that since the non-recourse loan was ongoing, the prohibited transaction continued and on January 1, 2006 it remained true that both Mr. Peek and Mr. Fleck personally guaranteed the company loan.
Case Outcomes & Summary
The Tax Court found that Mr. Peek, his attorney, and his business colleague’s (Mr. Fleck) personal guaranties of a loan/note from their newly-formed corporation stock of which was owned by Peek & Fleck’s Self-Directed IRA’s, to third party incident to asset purchase transaction was an IRC Section 4975 prohibited transaction.
The Court set a precedent, finding that whether or not their IRA’s were involved directly was irrelevant since IRC Section 4975 was broadly worded to include both direct and indirect loans and guaranties to IRAs.
What Happened to Peek & Fleck?
The Tax Court found Peek and Fleck liable for a 20% tax penalty because their underpayments of tax were a “substantial understatement of income tax”. But unfortunately for them, that wasn’t the worst part.
Most prohibited transactions are resolved with the owner paying a tax, such as UBTI or UBIT. But in this case, because a prohibited transaction occurred between an IRA and its owner, which results in the tax disqualification of the IRA, Peek & Flecks IRA’s were disqualified and totally distributed.
Here’s a link to the case for your reference.
What You Can From This Case + My Thoughts
The Peek case affirmed that, in the eyes of the Tax Court and the IRS, an IRA holder can legally use retirement funds to invest in a wholly owned entity which is controlled by him or her without triggering the IRA prohibited transaction rules.
What was not mentioned above is that Peek & Fleck relied on the advice of a certain CPA, who was also advocating for the transaction, no doubt for personal gain. (Conflict of interest, anyone?)
When it comes to investing with a Self-Directed IRA, you should always seek the help of a professional who knows the ins and outs of the IRS rules so you don’t find yourself in a situation like Peek & Fleck.
If you want to learn more about investing with a Self-Directed IRA LLC and how to avoid triggering prohibited transactions, call Royal Legal Solutions now at (512) 757–3994 to schedule your free consultation!