IRA as Startup? IRS Says No

Case documents from Ellis v. Commissioner of Internal Revenue show used car dealership owners Terry and Sheila Ellis were found liable for substantial tax payments and penalties resulting from the loss of tax-deferred status for Terry Ellis’ IRA.

The two face income tax deficiency payments of about $260,000, as well as nearly $54,000 in accuracy-related penalties, following the decision from the United States Tax Court to revoke the IRA’s tax-deferred status.

The issue was the couple’s decision to launch an LLC, dubbed CST Investments, to assist in the management of their existing used car business, in an arrangement in which Terry Ellis would be compensated as the general manager of the company.

Here’s how the process went: In June 2005, Terry Ellis received a distribution of about $254,000 from a 401(k) account he accumulated with a former employer. He deposited the entire amount of the distribution check into a newly opened IRA, which was then used to purchase membership units of CST in exchange for cash payment from the IRA.

Several more rounds of distributions and payments occurred in the following months, totaling $319,500.

Rolling 401(k) assets into a business startup is not necessarily considered a prohibited transaction under the Employee Retirement Income Security Act (ERISA), but the Internal Revenue Service (IRS) took issue with the fact that Terry Ellis subsequently drew a little less than $10,000 in compensation from the company in tax year 2005. The following year, he drew more than $29,000 in compensation.

Case documents also show the IRS took issue with Terry Ellis’ decision that CST Investments would pay rent to CDJ LLC, another entity owned by the Ellis family.

All this amounted to concerns that the business startup strategy violated self-dealing prohibitions under ERISA, especially those in section 4975. These prohibitions hold even in a case where the transaction would qualify as a prudent investment when judged under the highest fiduciary standards.

In other words, the court found that Terry Ellis had engaged in the transfer of plan assets for his own benefit—a per se violation of ERISA—as the salary he received was not an expense related to the management of the IRA but was in fact payment for managing the used car business.

Specifically, the IRS argued Terry Ellis engaged in the following prohibited transactions:

• Selling and exchanging of membership interests in CST using IRA assets;
• Ordering CST, an entity owned by his IRA, to pay him compensation; and
• Having CST enter a lease agreement with CDJ, an entity that he also owns.

The IRS’s claims of deficient tax payments also reflect a determination that, for the years in which the prohibited transactions occurred, the Ellis family is liable for an additional 10% tax mandated under Internal Revenue Code Section 72(t) covering early distributions from qualified retirement plans.

The full text of the decision (docket number 12960-11), including substantial background on the case and applicable regulations, is available here.