Tax Law Insights

A recent case reminds us that people need to be careful when dealing with their retirement plans, particularly if those accounts are used as investment vehicles to fund business activities relating to the plan participant or owner of an IRA or 410(k) plan account. Although for many people their IRA or 401(k) account may appear to be a ready source of capital for launching a second career or finally moving that business out of the garage, if investments involving these accounts are not carefully and thoughtfully structured, adverse income tax consequences and other losses can occur.

Most people are familiar with the significant income tax benefits in contributing to a qualified retirement plan such as a 401(k) plan, or individual retirement accounts (IRAs). Subject to some limitations, an individual may take income tax deductions for contributions to the qualified retirement plan or IRA, the income earned by a 401(k) plan or IRA is exempt from current income taxes, and the taxpayer has significant flexibility and control on the timing of the receipt of income from the 401(k) plan or IRA at retirement. These contributions are generally the cornerstone of most long-term savings plans.

Another advantage of the qualified retirement plan or IRA is that assets held in the qualified plan or IRA are exempt from the claims of creditors if the funds are used for retirement income. More specifically, if a participant in a retirement plan or the owner of an IRA files bankruptcy, the assets in the qualified retirement plan or the IRA, are generally not part of the bankruptcy estate and cannot be seized by the creditors of the bankrupt individual.

To achieve these income tax advantages and other protections there are very specific rules that must be met. Some of these rules govern the types of activities that can be carried out through a qualified retirement plan or an IRA. These rules are generally referred to as the "prohibited transaction rules" and these rules prohibit self-dealing between the plan participant and his/her qualified plan account (e.g. 401(k)), or the participant and her/her IRA account. For example, the lending of money between the IRA and the account holder, or using of the IRA assets for the benefit of the account holder, are both considered "prohibited transactions".

Violations of these prohibited transaction rules can result in severe penalties in the form of excise taxes, and these violations can also result in the loss of the income tax advantages discussed above. In other words, the 401(k) investment account will no longer as a "qualified retirement plan" and investment account for the IRA will no longer qualifies as an "IRA". In addition to the loss of the income tax advantages, the exemption from the claims of creditors for the qualified plan account or the IRA account, may also be lost.

For example, suppose Suzie Saver retires from her job as a successful engineer and decides to become a player in real estate business. Suzie Saver rolls over her $250,000 retirement plan account into an IRA so it is set aside for her retirement. Suzie borrows $500,000 from the bank and buys some distressed real estate that she hopes to flip for a quick profit. Unfortunately for Suzie, her real estate venture is a flop and Suzie is forced to file bankruptcy. Although many of Suzie assets can be seized and sold to pay her debts, her $250,000 IRA is likely exempt from these claims.

Compare this to the case of Tommy Taxpayer. Suppose Tommy Taxpayer retires from his job as a successful small business owner, and also decides to get into the real estate business. Tommy Taxpayer rolls over his $250,000 retirement plan account to an IRA so it is set aside for his retirement. Tommy borrows $250,000 from the bank and then uses his $250,000 IRA to form a limited liability company that partners with Tommy to buy some distressed real estate that Tommy hopes to flip for a quick profit. The LLC also pays Tommy a salary, guarantees Tommy's debt to the bank and engages in other activities for the benefit of Tommy. Unfortunately for Tommy his real estate venture is a flop and Tommy is forced to file bankruptcy. Many of Tommy assets can now be seized and sold to pay his debts and his $250,000 IRA may be subject to these creditor claims as well. Depending upon the specific structure of the investment and the nature of the relationship between Tommy, the LLC, and the IRA, a prohibited transaction may also have occurred. Thus, if a prohibited transaction occurs, not only is Tommy saddled with the tax liabilities that could arise from the prohibited transaction, but the former IRA account would lose its exemption and be subject to the claims of his creditors as well.

Contributions to a retirement plan such as a 401(k) plan or IRA offer significant income tax benefits and are the foundation of most successful savings strategies. As these savings grow, the accounts become attractive sources of capital for individuals. If investments involving these accounts are not carefully and thoughtfully structured, and the account holder does not strictly adhere to the rules related to prohibited transactions, adverse income tax consequences and other losses can occur.