IRA as Startup? IRS Says No

A federal court ruled a business owner violated prohibited transactions rules in creating a limited liability company (LLC) with assets from his individual retirement account (IRA).

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.

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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.

Chepeni(k)’s Thoughts: Employer Matching Contributions Not a Panacea

I learned one of my favorite words when I was living in Louisiana: lagniappe. It refers to a small gift a merchant gives a customer when they buy something. Loosely translated, it means “a little extra.”

The word lagniappe reminds me that, for years, we have been telling employees to save enough in their employer-sponsored retirement plans to receive the maximum match – that “little something extra” meant to thank them for their hard work and provide a few additional dollars for their retirement.

I realize now I have been teaching the wrong message.

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Here’s where I, and the industry, made our mistake: we touted the employer match as “free money,” and therefore, convinced employees that saving enough in their company retirement plan to receive the match was “good enough.” But it wasn’t. We failed to stress the importance of saving enough money for retirement.

The term “retirement readiness” usually refers to the ability to replace 75% to 85% of preretirement income. This figure doesn’t provide a “dream” retirement, but it’s enough to pay for food, shelter and clothing. To accommodate these basic needs, however, most employees need to start saving 10% to 15% of their income starting at age 21.

Yet many financial planners are telling retirement plan participants to save enough only to qualify for the company match. Big problem! Even personal finance guru Suze Orman has suggested other savings vehicles are better options than a company retirement plan if it doesn’t offer a match. Yikes!

According to the 2011 annual Plan Sponsor Council of America Survey, 95% of plans offered a match; the average in 2011 was 2.5% of pay. Typically, employers provided a match up to 6% of an employee's salary, according to 401k Help Center. Additionally, about 23% of employers offered a matching contribution of 50 cents per dollar—again up to a specified percentage of pay, usually 6%. These statistics clearly show that we have wronged the participant. Even if all employees saved 6% of their pay and received a 3% match, they still could not save enough to meet their basic minimum needs in retirement. Our industry's laser-focus on company matching contributions has fallen well short of helping participants achieve retirement readiness.  

What's more, we put an unfair burden on plan sponsors by insisting that a match was vital to the plan's success.  Employers have limited budgets for retirement plans, and they need to use them effectively. In recent years, we have discovered that plan features such as automatic enrollment and automatic contribution escalation are far more effective than company matching contributions to encourage participation and improve employee savings rates. And employers have made strides to embrace this trend. An Aon Hewitt survey of 210 mid- to large-size employers found 57% offered an automatic enrollment feature in their defined contribution plans in 2010. In 2011, Fidelity reported 51% of its 401(k) participants are now in plans that auto-enroll new hires, up from just 16% five years prior. And the numbers continue to improve. In fact, auto-enrollment and auto-escalation are the most impactful tools we have used to entice participants to adopt better savings habits.

Current matching formulas aren't the answer. If we wanted to do our participants justice, we would structure the match by stretching the benefit to a higher percentage of pay. For example, instead of 50 cents on 3%, make it 30 cents on 10%. This would help alleviate one of the problems we have created. According to Fidelity, the typical match could boost 401(k) plan participation by nine percentage points. This shows it has some effect, but not even close to what we need to solve our nation’s retirement crisis. We can and must do better.

Jason K. Chepenik, CFP®, AIF®, CkP  

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  

Securities offered through LPL Financial, Member FINRA/SIPC.  Investment advice offered through Independent Financial Partners (IFP), a registered investment adviser.  IFP and Chepenik Financial are separate entities from LPL Financial.

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