Tax Court Says Royalties Paid to Roth IRA Were Excess Contributions to IRA
The U.S. Tax Court recently issued another opinion involving a LLC owned by a self-directed IRA. The case is Block Developers, LLC v. Commissioner, T.C. Memo. 2017-142. The case invovles an IRA LLC that purchased a patent and then licensed the patent back to the prior owner, with the intent of the IRA LLC collecting the ensing royalites tax free. In explaining why the arrangement was not sufficient given the facts in the case, the case highlts how taxpayers with a similar arrnagment may be able to take action now to avoid the same type of IRS problem.
The Facts in the Block Developers, LLC Case
The Block Developers case involved a profitable S corp. The S corp. manufactured and distributed retaining wall blocks. Its owner held a patent for the blocks that were being sold.
The owner worked with an entrepreneurial estate planning to implement a plan to transfer the patent to an LLC that would be formed by Roth IRAs for the owners of the S corp. If successful, this would allow the S corp. to pay royalties for the use of the patent to the LLC and ultimately to the Roth IRAs. So the royalties would be tax free and the S corp. would be entitled to a deduction for the payments.
The Roth IRAs were only funded with $2,000 each. This leaves one wondering how the patent, which was apparently generated $1.2 million for the Roth IRAs over a seven year period, could afford to acquire such a valuable patent.
The answer was essentially a purchase agreement with a delayed payment. The LLC owned by the IRA only had to pay $1,000 up front and $249,000 at a future date for the patent. Once the LLC received $270,000 in royalty payments from the S corp., it was able to pay the remaining $249,000 to the S corp. to pay off the purchase agreement.
The IRS audited the LLC and concluded that the transfers to the Roth IRAs were excess contributions that triggered an excise tax. The excise tax is essentially 6% of the excess contribution each year until the excess contributions are removed. This excise tax can add up quickly as time goes by as it would for $1.2 million in excess contributions made over a seven year period.
The Dispute: Legitimate Business Purpose or Not?
The court considered whether the arrangement satisfied the substance over form doctrine. As stated by the court:
Substance-over-form is a court-constructed rule—it says that in tax cases a court doesn’t just follow the labels a taxpayer uses, but looks to see what in fact is going on. See Commissioner v. Court Holding Co., 324 U.S. 331, 333-34 (1945); Gregory v. Helvering, 293 U.S. 465, 469-70 (1935); Goldstein v. Commissioner, 364 F.2d 734, 740 (2d Cir. 1966), aff’g 44 T.C. 284 (1965).
In the context of transactions with businesses owned by Roth IRAs, the substance over form doctrine asks whether there was a legitimate business purpose for the transactions or if the prupose was just tax savings. The court concluded that there was no legitimate business purpose in this case.
It reached this conclusion based primarily on the fact that the business, meaning the S corp., did not change its business operations after selling the business. It continued to do all of the work to manufacture and distribute the blocks. The Roth IRA LLC did not take on any of these responsiblities. The Roth IRA LLC also did not bring on staff or seek to license the patent it held to other third parties.
The Takeaway: IRA LLCs Owning Patents Should Market Them to Others
This case adds to the growing body of cases that define how to structure self-directed IRA deals. It adds the concept that having the IRA LLC do something more with the property than using it to transact business with the prior owner is generally required. The case should serve as comfort for taxpayers who have IRA LLCs that invest in patents that are actively marketed to and/or licensed to third parties. Those whose IRA LLCs are not doing this, may need to take heed and impmlement this type of marketing and licensing program.