In Ellis v. Commissioner of Internal Revenue, No. 14-1310 (8th Cir. 2015), the taxpayers were appealing from the decision of the tax court finding a deficiency in their income taxes and imposing related penalties. Upon reviewing the case, the Eighth Circuit Court of Appeals (the “Court”) concluded that taxpayer Mr. Ellis engaged in a prohibited transaction with respect to his individual retirement account (the “IRA”), and affirmed the tax court’s ruling.
In this case, an attorney for Mr. Ellis formed CST Investments, LLC (“CST”), to engage in the business of used automobile sales in Harrisonville, Missouri. The operating agreement for CST listed two members: (1) a self-directed IRA belonging to Mr. Ellis (owing 98% of the company,), and (2) Richard Brown, an unrelated person who worked fulltime for CST (owning the remainder of the company). Mr. Ellis was designated as the general manager for CST and given “full authority to act on behalf of” the company. The operating agreement also stated that “the General Manager shall be entitled to such Guaranteed Payment as is Approved by the Members.”
Mr. Ellis’s IRA did not exist at the time CST was formed. Rather, he established the IRA with First Trust Company of Onaga (“First Trust”) in June 2005. On June 22, 2005, he received $254,206.44 from a 401(k) that he had established with his previous employer, and he deposited the amount in his IRA. He then directed First Trust as the custodian of the IRA to acquire 779,141 shares of CST at a cost of $254,000. On August 19, 2005, Mr. Ellis received an additional $67,138.81 from his 401(k), which he again deposited into the IRA. He directed First Trust to acquire an additional 200,859 shares of CST at a cost of $65,500. Mr. Ellis reported the transfers from his 401(k) to the IRA as non-taxable rollover contributions. To compensate him for his services as general manager, CST paid Mr. Ellis a salary of $9,754 in 2005 and $29,263 in 2006. While not clear if these were guaranteed payments per the operating agreement, Mr. Ellis had, at all times, the power to have CST make payments to him.
On March 28, 2011, the Commissioner of the Internal Revenue Service sent the taxpayers, the Ellises, a notice of deficiency and related penalties, based on a determination that Mr. Ellis engaged in prohibited transactions under 26 U.S.C. § 4975(c) by (1) directing his IRA to acquire a membership interest in CST with the expectation that the company would employ him, and (2) receiving wages from CST. The notice explained that, as a result of these transactions, the IRA lost its status as an individual retirement account and its entire fair market value was treated as taxable income. See 26 U.S.C. § 408(e)(2). The Ellises filed a timely petition in tax court to contest the notice of deficiency. The tax court upheld the Commissioner’s determination, and the Ellises appealed.
In analyzing the case, the Court said that Code section 4975 limits the allowable transactions for certain retirement plans, including individual retirement accounts under § 408(a). It does so by imposing an excise tax on enumerated “prohibited transactions” between a plan and a “disqualified person.” 26 U.S.C. § 4975(a). Prohibited transactions include any “direct or indirect . . . transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;” or “act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account.” § 4975(c)(1)(D), (E). If a disqualified person engages in a prohibited transaction with an IRA, the plan loses its status as an individual retirement account under § 408(a), and its fair market value as of the first day of the taxable year is deemed distributed and included in the disqualified person’s gross income. 26 U.S.C. § 408(e)(2).
The Court continued by noting that, here, it is undisputed that Mr. Ellis was a disqualified person under § 4975(e)(2)(A) because he was a fiduciary of his IRA (as he can direct asset investment). The parties also agree that CST was a disqualified person because Mr. Ellis was a beneficial owner of the IRA’s membership in the company. See id. § 4975(e)(2)(G)(i) (including as a disqualified person a corporation in which 50 percent or more of the stock is owned by a fiduciary); id. § 4975(e)(4) (stating that ownership includes indirect ownership). Therefore, said the Court, the only issue on appeal is whether the payment of wages to Mr. Ellis was a prohibited transaction. The record establishes that Mr. Ellis caused his IRA to invest a substantial majority of its value in CST with the understanding that he would receive compensation for his services as general manager. By directing CST to pay him wages from funds that the company received almost exclusively from his IRA, Mr. Ellis engaged in the indirect transfer of the income and assets of the IRA for his own benefit and indirectly dealt with such income and assets for his own interest or his own account. This results in a prohibited transaction by Mr. Ellis with respect to his IRA, and the IRA’s loss of its status as such with the corresponding deemed distribution to the Ellises in an amount equal to the former IRA’s fair market value.