IRA Can Own 100% of a Newly Established Entity and be Managed by the IRA Holder and Not Trigger a Prohibited Transaction
Swanson V. Commissioner 106 T.C. 76 (1996).
The idea of using an entity owned by an IRA to make investments was first reviewed by the Tax Court in Swanson V. Commissioner 106 T.C. 76 (1996).
The underlying facts involved James Swanson (the taxpayer’s) combined use of two entities owned exclusively by his IRAs to defer income recognition.
James Swanson was the sole shareholder of H & S Swansons’ Tool Company, an S corporation that builds and paints component parts for domestic and foreign equipment manufacturers. Following the advice of tax counsel, Swanson arranged in 1985 for the establishment of Swansons’ Worldwide, Inc. (“Worldwide”), a Domestic International Sales Company (“DISC”). A DISC is a domestic corporation, usually a subsidiary, that is typically used to defer tax on income generated by the entity.
Mr. Swanson appointed Florida National Bank as trustee and custodian of IRA #1, who retained the power to direct its investments. Mr. Swanson then directed Florida National to execute a subscription agreement to purchase 2,500 shares of Worldwide original issue stock. The shares were issued and IRA #1 became the sole shareholder of Worldwide. Mr. Swanson then engineered a similar transaction with a second IRA at another bank.
The IRS Attack
The IRS issued a notice of deficiency to Mr. Swanson in June 1992. The IRS stated that prohibited transactions had occurred causing IRAs #1 and #2 to be terminated. The IRS made the following arguments:
- Mr. Swanson is a disqualified person within the meaning of section 4975(e)(2)(A) of the Code as a fiduciary because he has the express authority to control the investments of IRA#1.
- Mr. Swanson is also an Officer and Director of Swansons’ Worldwide. Therefore, direct or indirect transactions described by section 4975(c)(1) between Swansons’ Worldwide and IRA #1 constitute prohibited transactions.
- Mr. Swanson, as an Officer and Director of Worldwide directed the payment of dividends from Worldwide to IRA #1.
- At the time of the purchase of the Swanson Worldwide stock, Mr. Swanson was a fiduciary of his IRA and the sole director of Swansons’ Worldwide.
- The sale of stock by Swanson Worldwide to Mr. Swanson IRA constituted a prohibited transaction within the meaning of Section 4975(c)(1)(A) of the Code.
Mr. Swanson’s Position in Response to the IRS
Mr. Swanson took the position in their Tax Court petition that no prohibited transaction had occurred. Their position was that since the Worldwide shares issued to IRA #1 were original issue, no sale or exchange occurred. Also, they stated that as director and president of Worldwide, Swanson engaged in no activities on behalf of Worldwide that benefited him other than as beneficiary of IRA #1. Mr. Swanson made similar points with respect to IRA #2.
The IRS Concedes the Prohibited Transaction Issue.
The IRS conceded the prohibited transaction issue in the Swanson case on July 12, ’93 when it filed a notice of no objection to an earlier motion by the Swansons’ for partial summary judgment on that issue.
Mr. Swanson sought litigation costs against the IRS on the Prohibited Transaction Issue
The Tax Court Rebuffs IRS Arguments on IRA Prohibited Transaction Issue and Imposes Litigation Costs.
The IRS argued that its litigation position with respect to the IRA prohibited transaction issue was substantially justified. The Tax Court disagreed with the IRS’ position, finding that it was unreasonable for the IRS to claim that a prohibited transaction occurred when Worldwide’s stock was acquired by IRA #1 for the following reasons:
- The stock acquired was newly issued. Before that time, Worldwide had no shares or shareholders. A corporation without shares doesn’t fit within the definition of a disqualified person under the prohibited transaction rules. As a result, Mr. Swanson only became a disqualified person with respect to IRA #1 investment into Worldwide only after the Worldwide stock was issued to IRA #1.
- It was only after Worldwide issued its stock to IRA #1 that Mr. Swanson held a beneficial interest in Worldwide’s stock. Mr. Swanson was not a “disqualified person” as president and director of Worldwide until after the stock was issued to IRA #1
- The payment of dividends by Worldwide to IRA #1 was not a self-dealing prohibited transaction under Internal Revenue Code Section 4975(c)(1)(E). The only benefit Mr. Swanson realized from the payments of dividends by Worldwide related solely to his status as beneficiary of IRA #1 which is not a prohibited transaction.
- It was only after Worldwide issued its stock to IRA #1 that Mr. Swanson held a beneficial interest in Worldwide’s stock. Therefore, the issuance of stock to IRA #1 did not, constitute a prohibited transaction.
- It was only after Worldwide issued its stock to IRA #1 that Mr. Swanson held a beneficial interest in Worldwide’s stock. Mr. Swanson’s only benefit would be as beneficiary of the IRA which is not a prohibited transaction.
The Tax Court reached similar conclusions with respect to IRA #2.
THE TAX COURT AGREED WITH SWANSON THAT THE IRS ARGUMENT THAT AN IRA CANNOT OWN A NEW ENTITY TO MAKE AN INVESTMENT IS A FRIVOLOUS POSITION THAT SHOULD BE SANCTIONED AND SUBJECT TO LITIGATION FEES
“We must apportion the award of fees sought by petitioners (Swanson) between the DISC (IRA) issue, for which respondent (IRS) was not substantially justified”
-Tax Court in Swanson V. Commissioner 106 T.C. 76 (1996).
What did we learn from the Swanson Tax Court case?
An IRA can own an Interest in a New Entity managed by the IRA holder
The Swanson case helped establish that an IRA holder is permitted to establish a new entity wholly owned by his or her IRA in order to make IRA investments. The Swanson case makes it clear that only after the IRA has acquired the stock of the newly established entity does the entity become a disqualified person.
An IRA Holder can manage the newly formed entity owned by the IRA
The Swanson case makes it clear that an IRA holder may serve as manager, director, or officer of the newly established entity owned by his or her IRA. The Tax Court held that Mr. Swanson was not a “disqualified person” as president and director of Worldwide until after the stock was issued to IRA #1. In other words, by having the IRA invested in an entity such as an LLC of which the IRA owner is the manager, the Swanson Case suggests that the IRA holder can serve as manager of the LLC and have “checkbook control” over his or her IRA funds.
The Tax Court in Swanson made it clear that it was only after Worldwide issued its stock to IRA #1 that Mr. Swanson held a beneficial interest in Worldwide’s stock. Therefore, the Tax Court is arguing that only once the IRA funds have been invested into the newly established entity does the analysis begin whether an IRA transaction is prohibited. Said another way, the Tax Court is contending that the use of an entity owned wholly by an IRA is not material as to whether a prohibited transaction occurred. The use of a wholly owned entity to make an investment is essentially no different if the IRA made the investment itself with respect to the prohibited transaction rules.
For more information about this case and others, please contact an IRA Expert @ 800.472.0646.