Using an IRA like a bank is risky

The Tax Court recently ruled that an individual’s distribution from a simplified employee pension individual retirement account was taxable and subject to the 10% early-distribution penalty when the funds weren’t rolled over within 60 days (Thomas W. Alexander, et ux., v. Commissioner, TC Summary Opinion 2014-18, No. 1764-12S, Feb. 26, 2014).

Thomas Alexander was an electrical contractor working as a subcontractor on two commercial-real- estate projects. In 2009, the general contractor, True Craft Construction, ran into financial difficulties and failed to pay Mr. Alexander about $130,000 for his work on the projects.

One of the principals of True Craft proposed a deal that would give Mr. Alexander a promissory note for the $130,000 he was owed. In addition, he offered to assign to Mr. Alexander a piece of property that the principal owned as collateral for the debt. The collateral assignment came with a catch, though. The property had a past-due mortgage on it that was going to be foreclosed on by the bank. In order to prevent that from happening and keep his collateral intact, Mr. Alexander needed to pay the bank $36,000.

He had a SEP IRA with Charles Schwab & Co. Inc. and a relationship with a financial adviser there. His adviser suggested that he secure a personal loan from Schwab for the $36,000. However, because the foreclosure was imminent and the loan couldn’t be obtained in time, the adviser suggested that Mr. Alexander take a $36,000 distribution from his SEP IRA to stop the foreclosure. Can you guess where this is going?

PROCESSING DELAY

The adviser told Mr. Alexander that as long as he replaced the money within 60 days, there would be “no penalty with anybody.” Relying on this advice, Mr. Alexander, who was not yet 591/2, took a $36,000 early distribution from his SEP IRA and used the proceeds to bring the mortgage on his collateral up-to-date. Unfortunately — as is often the case — there was a delay in processing Mr. Alexander’s loan from Schwab. When he finally received the loan proceeds, he quickly mailed a personal check for $36,000 to his SEP IRA to complete his rollover. By the time the check was deposited into his SEP IRA, however, 66 days had passed since he had received the IRA distribution.

Mr. Alexander did not report the $36,000 as taxable income on his 2009 return because he believed that he had completed a timely tax-free rollover of the SEP IRA distribution. The Internal Revenue Service, on the other hand, determined that he owed taxes on the IRA distribution and sent him a notice of deficiency.

Although Mr. Alexander argued that he intended to do a rollover, the Tax Court said that a taxpayer’s intention does not determine the tax consequences of a transaction, and instead, what is actually done determines the treatment. Since the funds weren’t rolled over within 60 days, the court ruled that the SEP IRA distribution was taxable. Plus, the 10% early-distribution penalty applied because Mr. Alexander was under age 591/2 at the time he received his distribution.

Mr. Alexander’s lawyer argued that the distribution from the SEP IRA was a loan and thus, under IRC Section 72(p), was not taxable. This argument is wrong because Section 72(p) applies to loans from employer retirement plans, not to IRAs.

In fact, it probably worked in Mr. Alexander’s favor that the court didn’t view the distribution as a loan. Under IRC Section 4975(c)(1)(B), loans from IRAs to their owners are considered a prohibited transaction, and therefore any such “loan” Mr. Alexander received would have made his entire IRA subject to income tax and the 10% penalty.

The court noted that Mr. Alexander was free to apply to the IRS for a private-letter ruling for a 60-day extension. (If Mr. Alexander failed to get a 60-day extension from the IRS, his tax problems would get worse. The late rollover would be considered a $36,000 IRA contribution for 2009, thus creating an excess contribution subject to 6% penalties each year. If he were able to get a 60-day extension, then no taxes or 10% penalty would apply to the $36,000 SEP IRA distribution.

Whether such a waiver can be obtained in cases like this is debatable. Many 60-day private-letter rulings have been approved for custodian error. On the other hand, when IRA funds are used during the 60-day period, the IRS has generally held that the IRA owner assumes the risk if funds aren’t available, and thus, it will deny such requests.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.