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IRA Investment Question


Guest schamb

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Does the law allow you to use IRA funds to buy stock in a private company that you control?

If so, would it be difficult to find a custodian that would be flexible enough to allow you to do this?

If so, does the law allow you to use ROTH IRA funds to buy stock in a business structured as a Sub S corp or partnership (pass through entity for tax purposes).

Thanks.

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Prohibited transaction rules of IRC 4975©(1)(A) prevent the owner of 50% or more of a company's stock from having his IRA purchase the stock. IRAs cannot invest in Sub S corp stock. rev. rule 92-73 IRA can invest in limited partnership which is not controlled by IRA owner.

mjb

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I would think that these kind of self-dealing transactions are prohibited because you could, if allowed, artificially boost the tax sheltered assets by manipulating the corporate circumstances. For example, if the IRA can buy stock in a closely held Sub S corp then the door is open for the corporation owners to boost the stock price by not taking payroll and increasing cash assets of the firm. Let's see, this reduces the double hit of SSN taxes and boosts tax sheltered values. You can see why some tax payers might love this option. The easiest way to reduce the shenanigans is to eliminate any of these transactions.

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Not all self dealing transactions are prohibited. For example, under the Swanson case, the owner of an unincorporaated business with a steady net profit could act as the incorporator/director of the business as a C corp which will issue 100 shares of stock as its initial subscription. The owner could direct the IRA custodian to purchase the 100 shares for $3000 when the stock is issued after incorporation. The IRA, as owner of 100% of the corporation would receive the net profit tax free as dividends. If the owner is eligible for a Roth IRA there would never be any income tax due on the distributions.

mjb

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A lot of custodians would have a problem with that approach because at the end of the year they must attach a valuation to the holdings. The situation you proposed would not allow any normal kind of market valuation.

I see the situation you proposed as ripe for abuse. Suppose the corporation sold the stock for $1 per share and then turned around an issued a $100 per share dividend? Or, perhaps the company would subsequently announce a buyback program and offer $100 for each original $1 share. If I understand your answer above, Mbozek, would you not leave open a huge door for abusive self-dealing?

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John: The custodians only care about someone providing them with the year end valuation-- Usually it is the accountant for the business. The custodians do not want to perform the valuation of the investments. I also do not undertand your self dealing claim in the context of IRC 4975© since the payment of dividends is a perfectly permissible use of corporate assets. Corporations frequently pay an extraordinary dividend. Also in a corporation which is an asset of IRA does it matter whether there is retained earnings of $100 or the corp pays a dividend of $100 from the retained earnings. In either case the Corp has the same designated value. In other words if a share of the stock held in the IRA has a FMV of 101 and the corp pays out a dividend of 100 then the IRA now has the same value- $1 in stock and $100 in cash.

mjb

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Ok, perhaps I was not clear.

If I could buy stock in my own company from an IRA and was in the position to set dividend policy and set stock buyback policy of that company.... then I could easily define a scenario where I had just $10,000 in the IRA at the year begining and at year end have artificially pumped up the IRA assets to say $100,000 if there was enough money in the corporation.

I don't think the IRS wanted to leave a Mack truck loophole. That is why I am surprised that anything less than an arms length transaction is allowed. There is a difference between a corporation having retained earnings of $100 and issuing a dividend of $100. You may be assuming that retained earnings may be the driving force that would establish a stock price. That is not true in the stock market as a whole and is certainly not the relationship in most narrowly held and infrequently traded stocks. If it was, then all price/book ratios would be the same. They are not, not even if you restrict your analysis to a single industry like software or banking.

My point if you allow anything remotely like self dealing involving stock prices and dividend policies, in the absence of an active marketplace for setting valuation, you leave the door open to some very questionable practices to artificially boost the assets in the tax sheltered account.

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John: The IRS is no longer permitted to administer the tax law Rambo style to close loopholes unless it has express authority under a specific tax law provision to do so. (Maybe you should read the 1998 IRS Reform Act and its legislative history to understand the limits of IRS authority). As I asked in my previous post what provision of the IRC 4975© pt rules prevents a corporation from paying a dividend to a shareholder which is an IRA. The PT rules prohibit a fiduciary from using the plan assets to benefit the fids personal account but nothing prevents an IRA from benefiting from the action of the IRA owner to declare a dividend which benefits shares owned by the IRA. In the Swanson case the IRS was ordered to pay 50k to a taxpayer for legal fees incurred when the IRS incorrectly applied the PT rules to the subscription to purchase stock by an IRA in which the IRA owner was a director of the newly formed company. If you have a point based upon substantial authority in the tax law please state it.

mjb

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I am raising the question of potential "abuse" opened by the absence of regulations in this area. I use the term "abuse" in a common lay persons sense. What you have specified constitutes in my mind a loophole that may allow a tax payer to artificially boost a tax sheltered account. I can't conceive that Congress by choice created this option but rather it is an overlooked circumstance. They certainly did not want folks to convert regular IRAs to Roth's without paying taxes and only if they met income tests. They limited the maximum annual contribution to a Roth. They restricted married filing separately... etc. My point is not based upon the details of IRS code. From a public policy perspective, I don't see it in the best interest of country to allow self-dealing. It is outside of the normal marketplace and invites abuse.

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It is not a question of what Congress intended to create, it is what the law says. The IRS cannot interpert the IRC based upon vague policy grounds -- when it does so it gets in trouble with the courts for lack of statutory authority. The IRS has opposed Crummey trusts for 30 years as a loophole which violates tax policy-- and lost in every court. The Clinton administraton proposed legislation to eliminate Crummey trusts which was defeated by Congress. Until the PT rules are amended by Congress the PT rules do not cover the subscription by an IRA to purchase an initial offering of a company owned by the IRA owner. By the way the company in the Swanson case was a DISC which as I understand it was designed to generate millions of $ in tax free dividends to the IRA shareholder.

mjb

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MBozek:

If the individual directed that his IRA purchase the stock from himself (directly, instead of buying the stock from the corporation), couldn't that argued to be a prohibited transaction because of his investment control over the IRA? I've always thought so, but I've never resarched the issue.

Kirk Maldonado

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Yes- a sale of the stock between the IRA owner and his IRA is a PT under IRC 4975© even if it is at arms length for FMV. But under the precedents an IRA owner can direct the IRA custodian to subscribe to an initial offering of stock from the issuing corporation without a sale occurring under the PT rules.

mjb

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See FSA 1999-524 for IRS ruling that subscription by IRA custodian to purchase stock of company in which IRA owner was the director and president and board resoultion to pay dividends to shareholders including the IRA is not a PT. Swanson case is at 106 TC 76 (1996).

mjb

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