Some entrepreneurs are tempted to use their IRA retirement funds to invest in their small business. Instead of cashing out their retirement accounts and using that money to fund their venture, they use something often referred to as a “checkbook IRA,” where they invest in a business “inside” the IRA.
In my book “Finance Your Own Business,” I described these programs in detail and warned that they are risky because you may run afoul of IRS rules against prohibited transactions. The IRS expects your IRA investments to be “hands-off” investments. If you violate the rules, the IRS may consider your use of retirement funds to fund your business as a withdrawal from your IRA, which can result in steep taxes and penalties.
A new legal case illustrates just how expensive missteps can be. Together with new Department of Labor regulations that may place additional burdens on the promoters of the plans, it might mean that self-directed IRAs used to invest in the owner’s business could become a thing of the past.
The $180,000 Tax Penalty
James and Judith Thiessen had money in their Kroger retirement plan and wanted to buy a metal fabrication shop, according to court documents. They were told by a CPA that they could roll their Kroger retirement accounts into self-directed IRAs. The CPA formed a Colorado C corporation.
In 2003, the CPA then advised the Thiessens to use their self-directed IRAs to invest in the new C corporation. James transferred $384,000 of his retirement money, and Judith transferred $47,000 of hers, to buy shares in the new C corporation.
They also took $60,000 from their personal account to put a down payment into escrow to begin the purchase of the business, and completed the financing with a personally guaranteed $200,000 promissory note to the seller.
In 2010, the facts of the transaction came to the attention of the IRS. The IRS considered it a prohibited transaction because the Thiessens put non-retirement funds into the deal and personally guaranteed the note.
Because the IRS considered it a prohibited transaction, the use of retirement funds were treated as an early withdrawal and a $180,000 penalty was assessed. The Thiessens fought the penalty unsuccessfully.
In the case, Thiessen vs. Commissioner (of the IRS), decided March 29, 2016, the U.S. Tax Court agreed with the IRS, stating that the Thiessens exercised discretionary control over their IRA monies. The investment into a C corporation was not acceptable when the corporation was acquiring assets for the Thiessens’ use. The metal shop the Thiessens operated was not a passive, public stock investment.
Ironically, the decision cited the 2013 Tax Court case of Peek vs. Commissioner, which involved two unrelated taxpayers in a similar type of transaction. The same CPA who handled the Theissen’s case also handled the Peek transaction.
As a result of these cases, there may be other business owners who have reason to worry about whether their self-directed IRA used to invest in their business – including real estate – runs afoul of IRS rules. After all, an article in the Journal of Accountancy estimated over half of all self-directed IRA accounts are not in legal compliance.
If you are in this situation, you may want to consult a tax attorney for an independent opinion. And if you are thinking of using retirement funds in a self-directed IRA to invest in a business, I urge you to get advice from an independent qualified professional first.
Advisors Could Be on the Hook, Too
Here’s another possible nail in the coffin of these programs. New regulations announced by the Department of Labor require all who provide retirement investment advice to plans and IRAs to abide by a “fiduciary” standard — putting their clients’ best interest before their own profits.
Many who sell these plans do not give advice or warn of all the complexities and challenges complying with these plans. However, if they are accepting fees for setting up these plans, they will likely be held to the fiduciary standard. If their advice were truly impartial, they would have to warn entrepreneurs that these plans are extremely risky and most likely not in the business owner’s best interest.
For more information on the good and bad ways to fund your business and investments please see my new book, co-authored with credit expert Gerri Detweiler, entitled “Finance Your Own Business.”