“Can IRAs Be Used to Fund New Businesses?” Moses & Singer LLP Tax Attorney Steven Glaser Comments on the Uses and Limits of IRAs as a Source of Business Capital

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In a recent case, the Tax Court considered the circumstances affecting the use of individual retirement accounts to finance a business, raising new questions about IRA-based investments.

Steven J. Glaser, Partner, Moses & Singer LLP

Investors can use funds from IRAs for business investments but it is important to proceed with caution

“Individuals have long looked to tax-qualified individual retirement accounts (which includes both traditional and Roth IRAs) as a source of capital for establishing or purchasing businesses,” observes Steven Glaser, a senior tax attorney at Moses & Singer LLP. “But funds from IRA accounts cannot be used with the same degree of freedom as other funds when it comes to business investment.” A Tax Court's decision last month in Lawrence and Sara Peek, 140 T.C. No. 12 (2013) ("Peek"), sheds light on the limitations peculiar to that source of capital as well as raising unanswered questions as to how far the Internal Revenue Service (the "Service") may go to circumscribe such transactions.

IRAs are subject to prohibited transaction rules under the tax code. If such a transaction occurs, the IRA is disqualified. If amounts are subsequently placed in the disqualified IRA, they may be subject to an annual excise tax as excess contributions.

These restrictions may give pause to an IRA owner who seeks to tap his IRA for funds to establish a new business or purchase an existing one. However, both the courts and the IRS have ruled that an IRA may subscribe to the stock of a new corporation without violating the prohibited transaction rules, so long as the transaction takes the form of a direct investment by the IRA in the venture.

According to court documents, the Peek case involved a business opportunity taken with IRA funds. Mr. Fleck identified a fire alarm and fire protection company as an attractive investment. He formed a corporation as an acquisition vehicle together with his co-investor, Mr. Peek. Their IRAs purchased its shares with each becoming a 50 percent shareholder. The IRAs did not provide the acquisition vehicle with sufficient money to buy the target for cash. Consequently the sellers took back a note from the corporate purchaser, requiring the personal guarantees of the two IRA owners.

Ultimately, the business was sold for a substantial profit to the IRAs. Would the gains be taxed?

In the court documents for this case, the Tax Court ruled in favor of the IRS stating that the guarantee by the business associates of the corporate acquiror’s indebtedness constituted a prohibited indirect extension of credit to the IRA. It did not matter that the guarantee benefited the corporation, not the IRAs.

“Taxpayers who invest in businesses through their IRAs may avoid the prohibited transaction at issue in Peek by not making loans to the business or guaranteeing its debt,” advises Glaser. More troubling, however, is the Service's contention in Peek that the payment of wages by the corporation to the IRA owners as employees also constituted a prohibited transaction. Because the Tax Court decided Peek on the basis of the guarantee issue, it declined to rule on the wage issue.

Since an investor in a business will often work in the business and will reasonably expect to receive a salary for his efforts, the wage issue appears to be a critical one for IRA owners who seek to invest in operating business through their IRAs. It remains unclear whether an investor who purchases a business using his IRA and works in that business may pay himself compensation without adverse tax consequences.

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Steven Glaser is a partner at Moses & Singer LLP. As a member of the Firm's Tax Practice, he focuses on tax, pension, corporate and banking law. He has significant experience advising on and litigating a wide variety of benefits and tax issues.    Please see Steve's biography for articles on this and related subjects. Moses & Singer LLP, a law firm founded in 1919, serves the legal needs of prominent businesses and successful individuals in New York City and worldwide.

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