The Tax Court determined in a recent case that, because an individual’s IRA owned the shares of his limited liability company, the payment of compensation to the individual for his services to the company was a prohibited transaction.

The prohibited transaction resulted in disqualification of the IRA and a deemed distribution of its assets.

In 2005, Terry Ellis organized a limited liability company (LLC), signing the operating agreement on behalf of the Terry Ellis IRA, an entity that did not yet exist. The IRA owned 98 percent of the membership units.

The LLC was formed to engage in the business of used car sales, with Ellis as the general manager. A month later, Ellis created the Terry Ellis IRA. He then transferred cash from his 401(k) account with a former employer to the IRA. The IRA transferred the funds to the LLC and received its membership units. The LLC elected to be treated as an association taxable as a corporation.

During 2005, the LLC paid Ellis $9,754 as compensation for his role as general manager and deducted that amount on its corporation tax return. Ellis’s 2005 return reported the $9,754 as taxable compensation. It also reported the distribution from the 401(k) account but did not report any portion of the distribution as taxable.

The IRS concluded that Ellis engaged in a prohibited transaction with his IRA either:

1. When he caused his IRA to engage in the sale and exchange of membership interests in the LLC; or
2. When he caused the LLC, an entity owned by his IRA, to pay him compensation.

The Tax Court concluded that the formation of the LLC did not involve any prohibited transaction. However, the compensation that the LLC paid to Ellis was a prohibited transaction.

The court agreed with Ellis that, at the time of its formation, the LLC was not a disqualified person with respect to the IRA because, at that point in time, the LLC had no owners or ownership interests. However, the court said that, by paying the compensation, Ellis engaged in a prohibited transaction.

Ellis argued that the payment of compensation was not a prohibited transaction because the amounts paid to him by the LLC did not consist of plan income or assets of his IRA. He saw the compensation as merely the income or assets of a company in which his IRA had invested.

Given the facts in this case, the court concluded that the LLC and the IRA were substantially the same entity.

As a result of the prohibited transaction, the full amount that Ellis transferred to the IRA from his old 401(k) account was deemed distributed to him on Jan. 1, 2005. That amount was therefore includible in his gross income.

The court also found that Ellis was subject to the 10 percent additional tax that applies to early distributions from qualified retirement accounts. Finally, the court found that Ellis was liable for the 20 percent accuracy-related penalty (Terry L. Ellis v. Commissioner, TC Memo 2013-245, Oct. 29, 2013).

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