ROTH IRAs and Prohibited Transactions

[Guest weston]

Do the prohibited transaction rules in 4975 apply to Roth IRAs? 4975 does not specifically include Roth IRAs in the definition of a "plan." But 408A(a) states that Roth IRAs will be generally be treated like IRAs (except as described in 408A) which suggests that 4975 still applies.

Here is the situation: officers and directors of a new limited liability company issue ownership units of that company to their Roth IRAs. Gains and losses are reported to the Roth IRA-owners via Form K-1. The company issues significant cash distributions to the IRA-owners. Upon retirement of the officer/director, the Roth-IRA ownership units are purchased by the company. Distributions are then taken from the Roth IRAs at a future date, according to the Roth IRA rules.

Hoped for result? Earnings from the company pass to the Roth IRA and then to the beneficiaries tax free (other than corporate income taxes).

Thanks all.

[mbozek]

Roth IRAs are subject to the same investment rules as regular IRAs. Why not read the custodial agreement issued by the custodian which should tell you what a permissible investment is. Most custodians restrict IRA investments in non publicaly traded securities or privately held interests and prior approval is required before the custodian will take title to the asset.

[Ron Snyder]

The answer is not exactly. IRC Section 408(e)(2)(A) provides:

"If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year."

IRC Section 4975©(3) also contains special language that applies to IRAs: "An individual for whose benefit an individual retirement account is established and his beneficiaries shall be exempt from the tax imposed by this section with respect to any transaction concerning such account (which would otherwise be taxable under this section) if, with respect to such transaction, the account ceases to be an individual retirement account by reason of the application of section 408(e)(2)(A) or if section 408(e)(4) applies to such account."

[mbozek]

Not Exactly? If the Roth owner engages in a PT then wouldnt the earnings be taxed as ordinary income and subject to the 10% penalty tax. If the roth includes amounts which were received after a rollover, the 10% penalty tax will apply if the distribution is made within 5 years of the contribution The Roth would be treated as after tax income and would lose the ability to increase tax free without any minimum distribution during the life of the owner and spouse.

If someone else engages in a PT involving the Roth then the 15% PT tax applies

[John G]

Questions like this have come up about 5 times in the past year. I hope the tax pros will rise to the challenge and clearly define what is allowed, what is clearly not allowed, and the gray areas.

As a non-accountant, I have a problem with the proposal. The owners of the company could artificially pump up the value of the stock or distributions in a way that would not be normal. Let me exagerate: define a business with one penny per share stock, allow execs to buy stock from IRA/Roths, subsequently goose the dividends to thousands of dollars and elevate stock valuation in non-market transactions. As an investor, I would like a piece of this action but it sounds like I wouldn't even be likely to hear about it much less participate!

It seems to me that this is an end run around the annual limitations Congress expected for Roths. One could argue that eligibility to have a Roth might be bogus under such an arrangement. For example, why not reduce you salary by 50k and then boost the dividends by that amount. So someone who might make 140k can qualify, and get a huge tax free bonus in their Roth. If they took full salary, they would not qualify for a Roth and would be paying taxes. Sounds like a too obvious scheme for dodging taxes to this citizen.

I know some custodians have major heartburn over non-market transactions. One reason is that they are obligated to set a market valuation at year end. Under the above arrangement, there would be no meaningful market valuation to use.

[mbozek]

The PT rules of IRC 4975 are extremely complex and subject to many exceptions. The owner of an IRA is a fiduciary if he has discretion to choose the investments. Generally under the PT rules a disqualified person (fiduciary) cannot enter into the sale, exchange or leasing of any property with the IRA. Thus a fiduciary cannot buy or sell an IRA asset to his personal account even if the purchase or sales price is the FMV of the asset. There are a number of exceptions to the above rule. For example, the PT rules do not apply if the IRA owner directs the IRA custodian to purchase a subscription of an initial offering of a company in which the owner is the initial director. There are also many regulatory and statutory PT exceptions. Any analysis of the PT rules is intensely fact driven and requires expert counsel who should be retained before entering into the transaction. Also counsel must review the transaction under the rules for permissible assets prescribed by the IRA custodian. Some custodians do not accept odd assets such as privately held stock, offshore corporations or limited partnerships. IRA custodians require the issuer of the security to provide a year end valuation by January 15 as a condition to allowing the asset to be held in the IRA.

Although it may be hard to believe there are some exceptions that allow taxpayers to convert taxable income into a non taxable income by establishing a Roth IRA which owns an interest in a corporation in which the taxpayer is a director or employee under applicable precedents. This is why expert counsel must be retained. I would be glad to review any proposals by a client who retains me. Otherwise you can read IRS Pub 590 for a brief summary of the PT rules.

[John G]

Thanks Mbozek,

I am aware that some federal regualtions (perhaps the PT rules) effect the participation by an IRA accountholder (non-employee) of a bank that issues stock in an initial or secondary offering. In this case, it is dealings of the custodian that are at issue. There are all sorts of hoops that the taxpayer must jump through to allow an account (originally at the bank in question) to be used to buy shares. It is not at all a problem if the IRA assets are held by an outside custodian.

[mbozek]

In conversions of mutual savings banks to stock corporations the bank may limit the the subscription of initial shares to individuals and not allow the bank as custodian to purchase shares for a IRA or HR-10 plan. An individual cannot purchase the shares and make a contribution to an IRA because all IRA contributions must be made in cash. I think the case is Lemishow v. CIR 110 TC 110 & 110 TC 346 ( 1998)