Payment of Compensation to IRA by company owned by IRA was a prohibited transaction

Over the past several years, a technique for financing new business ventures using funds from an IRA or qualified plan has gained increasing popularity. The IRS has cautioned against the pitfalls of using a plan or IRA in this fashion. A recent federal appellate court has found that the payment of compensation to an IRA owner by a company owned by the IRA is a prohibited transaction, resulting in the entire IRA balance becoming taxable to the owner.

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Mr. Ellis formed an LLC. His IRA invested $321,000 for a 98% interest and he personally invested $20 for a 2% interest. To compensate him for his services as general manager, the LLC paid Mr. Ellis a salary of $9,754 in 2005 and $29,263 in 2006. The wages were drawn from the LLC’s corporate checking account and were reported as income on his individual income tax returns.

The IRS found that Mr. Ellis engaged in prohibited transactions by

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(1) directing his IRA to acquire a membership interest in the LLC with the expectation that the company would employ him, and
(2) receiving wages from the LLC. 

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The Tax Court upheld the IRS. It held that because Mr. Ellis could direct his compensation from the LLC, that he engaged in the transfer of plan income or assets for his own benefit and dealt with the income or assets of his IRA for his own interest or account both of which are prohibited transactions. Such transactions are prohibited even if they are made in good faith or are beneficial to the plan.

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This case highlights the importance of obtaining advice from an experienced ERISA professional before engaging in any business transaction involving funds of a qualified plan or IRA.