There are ways to structure transactions to avoid income taxes.
Creative taxpayers and tax attorneys have used qualified retirement accounts for this purpose (the tax savings from ESOPs is an example). One has to be careful when structuring transactions involving these qualified plans.
Given the flexibility in the rules and the absence of financial advisors, hose with self-directed IRAs can have a higher risk of inadvertently run afoul of these rules. The recent PLR 202105005 provide an example of this.
The ruling does not address the self-directed IRA rules. It addresses an S corporation election. But the fact pattern described in the ruling provides an opportunity to consider a few of the rules that apply to self-directed IRAs. It shows how easy it is to run afoul of these rules.
Facts & Procedural History
This is a private letter ruling request. It was submitted by a corporation that had tried to qualify as a Subchapter S corporation.
The corporation was owned by more than one shareholder who lived in a community property state. The shareholders signed the Form 2553, Election by a Small Business Corporation, to convert the entity to an S corporation. The shareholder’s spouses did not sign the form.
The corporation also issued shares to a trust. The trust was not a a “grantor” trust, a “QSST” (or qualified subchapter S trust), or an “ESBT” (or electing small business trust).
The corporation also issued shares to one of the shareholder’s IRAs. The corporation realized that an IRA cannot own S corporation stock, so it repurchased the shares from the IRA and reissued them to the IRA account owner. The PLR does not say whether this repurchase happened within the same year as the shares were transferred to the IRA.
During the years at issue, the legal entity filed Forms 1120S, U.S. Income Tax Return for an S Corporation, to report the income and loss from the corporation. The shareholders reported the income and loss from the corporation as they would if it was an S corporation.
The corporation sought a ruling that the termination of its S corporation was inadvertent. If granted, this would allow the corporation to be an S corporation and avoid having to file income tax returns as if the corporation was a C corporation.
The IRS granted the request. This means that the corporation is eligible to be an S corporation retroactive back to the date in its Form 2553.
As noted above, we aren’t focusing on the ruling the corporation requested. We’re focusing on the transaction with the IRA. The transaction with the IRA raises questions about the prohibited transaction rules and the excess contribution rules.
Prohibited Transaction Rules
We have covered the prohibited transaction rules on this website before. You can find links to these articles on our Self-Directed IRA page.
The prohibited transaction rules are found in Section 4975. Generally, the rules prohibit transactions between the IRA and the IRA owner. Subsection (c) includes a list of transactions that are prohibited. One such transaction is the “transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan.”
The facts in this ruling request suggest that this language may have been triggered. If so, it would impose an 100% penalty on the IRA account owner equal to the amount transferred. This penalty only applies if the transfer is not corrected in the same tax year. So presumably the transfer was corrected in the same tax year in this case. Let’s work with that assumption.
The ruling suggests that the corporation “repurchased” the shares from the IRA. A repurchase of shares would seem to trigger a prohibited transaction. This type of “sale” is different than returning the shares using the “rescission doctrine” under Rev. Rule 80-58 to void the transfer.
What about distributions from the corporation to the shareholders during the time the IRA owned shares? While not addressed in the ruling, as an S corporation retroactive back to the earlier date, the net profit or loss would flow through to the shareholders. This is true whether distributions were made to the shareholders or not. If the shares were held even for a day the income or loss would have to be reported to the IRA (there are two options for reporting it, either on a day-to-day basis or on an overall year basis). It would seem that this deemed income would trigger a prohibited transaction.
If distributions were actually made during the time the IRA owned shares, it would seem that the distributions would also trigger a prohibited transaction.
The private letter ruling does not address these issues.
Excess Contribution Rules
There are also excess contribution rules for IRAs. These rules generally limit the amount that can be contributed to an IRA account each year. Contributions in excess of this amount incur a six percent tax.
The facts in this ruling suggest that the corporation paid the IRA to repurchase the shares from the IRA. This raises questions as to whether the repurchase was an excess contribution.
The private letter ruling does not address these issues.
Transactions with qualified plans require careful planning. An IRA tax attorney should be hired to evaluate the deal. This can help ensure that the transaction does not trigger additional tax or penalties.
If the transaction is already completed, the tax attorney can also advise on how to unwind or reform the transaction or how to enlist the IRS’s help in remedying any deficiency. This can go a long way to avoiding tax and penalties if the IRS was to audit the taxpayers tax returns and discover the transaction.
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