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Tax Court Warns Owners in Using IRA ROBS

WASHINGTON – Brokers and financial consultants have been promoting for the past 15 years to prospective franchise buyers the use of Individual Retirement Accounts and 401(k) plans in purchasing a startup business to avoid tax burdens. The Internal Revenue Service explains the process this way:

ROBS plans [Rollover as Business Startups), while not considered an abusive tax avoidance transaction, are questionable because they may solely benefit one individual—the individual who rolls over his or her existing retirement funds to the ROBS plan in a tax-free transaction. The ROBS plan then uses the rollover assets to purchase the stock of the new business.

Last week the U.S. Tax Court made a decision in Peek v Commissioner asserting that two Colorado taxpayers, Lawrence Peek and Darrell Fleck, engaged in a prohibited transaction when using their self-directed IRA assets to purchase a new business. The judge stressed the importance of meeting the legal obligations set out by the IRS, which these two individuals failed to do. 

Circumstances of the case

The tax court opinion outlines the case beginning when Peek showed an interest in acquiring Abbot Fire & Safety, Inc. (AFS), a business specializing in alarms and fire protection products and systems. When Peek’s partner, a family member, could not participate in the transaction, he asked his attorney Fleck to join him in the venture.

The men contacted the company’s brokerage firm, A.J. Hoyal & Co., who in turn introduced them to Christian Blees, a certified public accountant in charge of structuring the acquisition. Blees presented the interested buyers with a package identified as the “IACC” plan, which called for the participants to establish a self-directed individual retirement account (IRA), transfer funds into those accounts from their existing IRAs or 401(k) plans, and set up a new corporation. From there they would sell shares in the new company to their self-directed IRA accounts, and use the funds from the sale of shares to purchase a business interest.

In addition to describing the plan, the documents they received included an extensive discussion of the IACC strategy and an opinion letter from certified public accountant Blees. The materials warned that it would be detrimental to IACC plan’s tax objectives for taxpayers to engage in any “prohibited transactions” dealing with the self-directed IRAs under Internal Revenue Service code 4975.

After submitting the IACC application for purchasing Abbot Fire & Safety, Inc., Peek and Fleck received a document that outlined the plan in order to buy the company’s assets. They subsequently implemented the plan and compensated CPA Blees for his firm’s services in structuring the purchase and conducting due diligence. 

The cash in the IRA was not sufficient to finance the transaction in purchasing the Abbot company, so they borrowed from other sources, one being a note to the seller, personally guaranteed by the individuals who owned the IRAs. Those IRAs owned 100% of the stock of an employer who now ran the business. Abbot then owed money to the seller of the assets used in the business and the individual IRA owners had personally guaranteed that debt.

The men later converted those IRAs to Roth IRAs. Several years later Peek and Fleck sold the Abbot Fire & Safety business. They assumed that the gain on the sale would be tax free when received by the Roth IRAs and when distributed to them as the owners of the Roth IRAs.

Judge Gustafson challenged that business transaction. He asserted that their personal guarantees—whose IRAs owned the stock in the company—of the notes they used to pay the seller were the problem. The business they acquired owed money to the seller of the assets used in the business and the individual IRA owners personally guaranteed that debt. The IRS claimed that the personal guarantees by the IRA owners of the note to the seller constituted an indirect loan to the IRA itself. According to code, that would be a “prohibitive transaction.”

The judge listed deficiencies for 2006 and 2007 to be $225,049 for Lawrence Peek, with penalties totaling $45,000. For Darrell Fleck deficiencies were $248,177, with penalties of $496346.

Industry reacts to court decision

Benetrends founder and chairman Len Fischer, who has been in the business 30 years, said the critical difference in their registered Rainmaker Plan and the one outlined in the tax court case is that theirs is a qualified retirement plan and not a self-directed IRA, allowing the plan to invest in common stock. Fisher states, “The rules are very different for self-directed IRAs. The ROBS community is not affected by this court decision.”

Steven Cooper, president of SDCooper Company, a 35-plus year veteran in the business, explained there are three rules under ERISA law, Employees Retirement Income Security Act passed in 1974, which was the original law. “You must receive adequate consideration, or fair market value.  No commissions can be charged with respect to or from a disqualified person. And you have to be an “eligible individual account plan”. IRAs are excluded from that definition in ERISA 407 (d)(3). That third rule is what was violated in the tax case decision.” 

Cooper said the tax court basically found that the granting of a guarantee is a direct or indirect extension of credit, and the court didn’t even have to look at the rest of the prohibitive transactions, but he wishes they had. He said he has been taking the IRS to task on those other issues since 2006. 

New York tax attorney Bruce Schaeffer has been a strong opponent of IRA rollover plans. “Benetrends’ structured transactions are almost identical to those here, in that you roll the money over to an IRA which buys, in most cases, the franchise you want. My issue with these IRA plans is right there in that first step when you roll over the IRA and invest the money in any normal circumstance.” He explained, “You are taking money out of the plan and it’s taxable and you have to invest after tax money. They hold it in the plan and say it’s exempt and that issue is not addressed at all in this case. So, Benetrends’ mechanism is either still bad or still good, but this tax court case doesn’t address it.”

Schaeffer said what the tax court decision does address is if someone takes it one step further and buys that business and also lends money to that business or guarantees the business loans. “That’s what blew up the whole structure,” he states. “That was a prohibited transaction.”


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