June 6, 2015

LLC Owned by Self-Directed IRA Cannot Pay Wages

Houston Tax Attorney Blog

Houston Tax Attorney

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The U.S. Court of Appeals for the Eleventh Circuit recently affirmed Ellis v. Commissioner, which held that the payment of wages for services to a self-directed IRA owner for his services rendered to an LLC owned by a self-directed IRA was a prohibited transaction. This case provides yet another example of how not to handle self-directed IRAs.

The facts and procedural history are as follows:

  • Mr. Ellis had his attorney form a Limited Liability Company or LLC to engage in the sale of used cars.
  • The LLC operating agreement listed Mr. Ellis’ self-directed IRA and a full-time employee of the LLC as the two members of the LLC.
  • The IRA acquired its 98% ownership interest by contributing $319,500 and the full-time employee purchased his 2% ownership interest for $20.
  • The LLC operating agreement named Mr. Ellis as the general manager and indicated that he was entitled to a guaranteed payment approved by the LLC members.
  • The LLC paid Mr. Ellis a salary of $9 thousand and $29 thousand for his services as general manager for the LLC’s first and second year of existence. The funds were drawn from the LLC checking account to pay Mr. Ellis.
  • Mr. Ellis reported this salary as wages on his Form 1040, U.S. Income Tax Return, for 2005 and 2006.
  • The IRS issued a notice of deficiency to Mr. Ellis for 2005 and 2006, asserting that he engaged in prohibited transactions by directing his IRA to acquire the LLC with an expectation that the LLC would employ him and receiving wages from the LLC.
  • The U.S. Tax Court agreed with the IRS, concluding that the payment of wages to him by the LLC in 2005 was a prohibited transaction.

On appeal, the appeals court agreed with the IRS and the U.S. Tax Court. The appeals court cited the general rule that an IRA loses its tax exempt status if the IRA engages in a prohibited transaction with a disqualified person. Mr. Ellis conceded that the LLC was a disqualified person, as Mr. Ellis owned the LLC via his IRA.

In evaluating whether the payment of wages was a prohibited transaction, the appeals court noted that the funds that were used to pay Mr. Ellis were almost exclusively from the contributions he made to the IRA. Thus, the appeals court concluded that Mr. Ellis transferred assets of the IRA to himself and that this indirect transfer was a prohibited transaction.

Mr. Ellis argued that there was no prohibited transaction because the funds were drawn from the LLC checking account and not the IRA’s checking account. The appeals court did not agree, noting that the rules prohibit the direct and indirect self-dealing with the plan assets or income.

Mr. Ellis also argued that there was no self-dealing for the salary as Section 4975(d)(10) excepts reasonable compensation for services from the self-dealing rules. The appeals court concluded that this language only excepts compensation for services rendered in the performance of plan duties–not for being the general manager of the LLC. Given the court’s reasoning, had the LLC operating agreement provided that Mr. Ellis was being paid a salary for managing the plan, this exception may have applied.

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