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Prohibited Transactions Can Come Back to Haunt You

By Beverly DeVeny, Chief IRA Analyst
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Two individuals wanted to purchase a business together. They set up self-directed IRAs and a corporation to hold the business. The self-directed IRAs purchased the shares of the new company, which then purchased an ongoing business. The purchase of the business was partly funded with loans that were personally guaranteed by the two individuals.

The IRAs were later converted to Roth IRAs. Eventually the Roth IRAs sold the stock held in the business at a profit. IRS got wind of all of this and sent the individuals tax notices for tax on the gains realized from the sale of the stock and for accuracy related penalties. The individuals took the case to tax court.

The ultimate decision of the tax court was not good for the IRA owners. The judge found that the tax code prohibits a direct or indirect extension of credit between IRA assets and a disqualified person. He found that the loan guarantees were an indirect extension of credit by the individuals to the IRAs through the business the IRA owned.

The court found that once the prohibited transaction occurred, the IRA was no longer qualified and that the prohibited transaction continues to exist until the loan is paid. When the IRAs were converted to Roth IRAs, the Roth IRAs were not qualified because the IRAs were not qualified. Therefore, the gain on the sale of the stock was taxable in the year it occurred.

When prohibited transactions occur in an IRA, the repercussions may not be felt until many years later. If the consequences from the prohibited transaction are not properly reported to IRS, there is no statute of limitations. IRS can come back at any time and assess penalties due to the prohibited transaction. In this case, the individuals were also hit with accuracy related penalties.

Any time you want to do something out of the box with an IRA, you have to be very sure that you know what you are doing in order to stay out of trouble. The prohibited transaction rules are nothing to laugh at.

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