Use of Self-directed IRA With Guaranteed Note Resulted in Prohibited Transaction

Use of an IRA or qualified plan to help finance the purchase of a business may have just gotten a little riskier. A recent Tax Court case highlights the dangers of this approach and the devastating tax consequences that may result.

In Peek v. Commissioner, two individuals rolled over assets from a retirement plan of a previous employer into new IRAs. The two then used the IRAs to purchase most of the stock in a new business and signed a promissory note personally guaranteeing payment for the remaining assets. The taxpayers eventually sold the business for a significant gain.

The U.S. Tax Court ruled that a prohibited transaction occurred when the two personally guaranteed the promissory note. The prohibited transaction resulted in the IRAs losing their tax deferred status beginning in the year of the guarantee. The individuals were required to pay capital gains taxes on the sale of the business and were assessed penalties and interest on the tax deficiency.

Individuals should be cautious when using an IRA or qualified plan to finance a purchase of a business. It is unclear what effect, if any, the Peek case will have on a structure labeled by the IRS as a rollover as a business startup (ROBS), however, the Court reserved judgment on whether payment of a salary by the business to the two individuals was itself a prohibited transaction. Individuals that have utilized a ROBS to finance a business purchase should review the purchase structure to assess whether a prohibited transaction has taken place and whether remedial measures should be taken.

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