A ROBS (rollover as a business startup transaction) produced disastrous consequences for the individual whose rollover was involved in the case of Ellis v. Commissioner, TC Memo 2013-245, TC Memo 2013-245, http:// http://www.ustaxcourt.gov/InOpHistoric/EllisMemo.Paris.TCM.WPD.pdf.
The issues in the case was whether the taxpayer had engaged in a prohibited transaction under IRC §4975 as part of his use of funds received from his previous employer’s 401(k) plan to have his IRA start a used car business. If an IRA engages in a prohibited transaction, the entire balance of the account is deemed distributed to the IRA beneficiary and tax is triggered.
The IRS saw four separate point at which a prohibited transaction under §4975 had occurred:
- When Mr. Ellis had his IRA purchase an initial interest in the newly formed LLC (which elected to be taxed as a corporation) that previously had no ownership interests issued
- When Mr. Ellis received compensation from the entity as an officer of that entity after formation in 2005
- When Mr. Ellis received compensation from the entity as an officer in 2006 and
- When Mr. Ellis had the corporation enter into a lease with an entity owned by Mr. Ellis, his spouse and their children in 2006.
The Court found Mr. Ellis dodged the first bullet. The IRS argued that, as the corporation was constructively owned by Mr. Ellis, the original purchase of interests was a transaction with a disqualified person (the corporation controlled by Mr. Ellis). However, the Tax Court agreed with Mr. Ellis’ reliance on its decision in the case of Swanson v. Commissioner, 106 TC 76, which held that a corporation with no shareholders was not a disqualified person. Only after the shares were issued (following the transaction) would the new entity become a disqualified person.
However, Mr. Ellis did not fare as well on the second issue. There, the Court Mr. Ellis controlled the corporation and the payments it would make to him. The court noted that:
The direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan is a prohibited transaction under section 4975(c)(1)(D). Similarly, an act by a disqualified person who is a fiduciary whereby he directly or indirectly deals with the income or assets of a plan in his own interest or for his own account is a prohibited transaction under section 4975(c)(1)(E).
The Court found that the payment of salary to Mr. Ellis violated this provision. While it paid Mr. Ellis from its own bank account and not that of the IRA, the IRA had virtually exclusively funded the entity. The Court noted:
To say that CST was merely a company in which Mr. Ellis’ IRA invested is a complete mischaracterization when in reality CST and Mr. Ellis’ IRA were substantially the same entity. In causing CST to pay him compensation, Mr. Ellis engaged in the transfer of plan income or assets for his own benefit in violation of section 4975(c)(1)(D). Furthermore, in authorizing and effecting this transfer, Mr. Ellis dealt with the income or assets of his IRA for his own interest or for his own account in violation of section 4975(c)(1)(E).
The Court also rejected the claim that §4975(d)(10) exempted the transaction. That provisions provides an exemption for reasonable compensation paid to a fiduciary for performance of duties of the plan. The Court found the payments were not for his duties of managing the investments of his IRA, but rather being the general manager of the car dealership.
The Court concluded:
In essence, Mr. Ellis formulated a plan in which he would use his retirement savings as startup capital for a used car business. Mr. Ellis would operate this business and use it as his primary source of income by paying himself compensation for his role in its day-to-day operation. Mr. Ellis effected this plan by establishing the used car business as an investment of his IRA, attempting to preserve the integrity of the IRA as a qualified retirement plan. However, this is precisely the kind of self-dealing that section 4975 was enacted to prevent.
That language does not bode well for other ROBS transactions, especially where the individual maintains any sort of connection to the entity and is compensated as part of that connection.