James Theissen and his wife worked for Kroger or its subsidiaries for 30 years. They lived in Colorado, and in 2002 Kroger informed Mr. Theissen that his job would be moved to Ohio. As the Theissens did not wish to move, they retired and rolled their 401(k) money into “his and hers” IRAs, totaling some $432,076.41.
Because Mr. Theissen was interested in metal fabrication, he began shopping for a company to buy. He planned to use the IRA money to fund the purchase and let the IRA own the new company. A corporation was formed, Elsara, and the couple’s IRAs purchased all the Elsara stock. A suitable metal-fabricating firm was found. The price was $601,000. The couple contributed $60,000 from their savings; Elsara paid $341,000; and Elsara also provided a promissory note for $200,000, to be paid over five years at 7% interest.
Unfortunately, the Theissens also personally guaranteed repayment of the note.
Apparently, the note was properly repaid according to its terms. However, in 2010, six years after the transaction, the IRS challenged the financial structure used for the acquisition of the business. According to the IRS, the personal guarantee of the note was a prohibited transaction. It amounted to an extension of credit to the IRAs by the beneficiaries of the accounts.
Federal law has some very strict rules concerning transactions between qualified retirement plans, which includes IRAs, and those who are the beneficiaries of such plans. The public policy being served is the preservation of the money in the plan for retirement.
Before adopting this structure for their business purchase, the Theissens consulted with a CPA firm and an attorney. They didn’t come up with this idea on their own. Nevertheless, the Tax Court ruled that they had, in fact, committed a prohibited transaction when they personally guaranteed the loan. That caused two unfortunate consequences. First, the IRAs stopped being tax qualified in 2003. That meant the entire amount in them was deemed distributed to the Theissens in that year and subject to ordinary income tax, which came to nearly $190,000. Second, because neither was yet 59½ at the time of the distribution, they owed an additional 10% penalty tax! Plus interest since 2003.
It’s not entirely clear how this will enhance the Theissens’ retirement income security, but perhaps that was not the point.
Dr. Mark Vandenbosch decided to loan $125,000 to a radiology technician whom he had befriended, John Carver. Carver needed the money for an investment opportunity. The source of funds was Dr. Vandenbosch’s Simplified Employee Pension (SEP). However, the SEP did not distribute funds to Carver, nor did it execute a promissory note for the loan. Rather, the money went into Vandenbosch’s personal checking account, and the loan document showed the doctor and his wife as the lenders.
The couple argued that they were acting as conduit, and that the loan to Carver was essentially a tax-free IRA rollover. The Tax Court held that it was not. The $125,000 was a taxable early distribution to the doctor, subject to income taxes and the 10% penalty for early distribution. Fortunately, the balance in the doctor’s SEP was not tainted by the transaction, so it continued to be tax deferred.