The ability to successfully structure self-directed IRA and qualified plans into nontraditional and potentially lucrative investments always depends on understanding the Prohibited Transaction rules set forth in IRS Code Section 4975. In some cases these rules appear intentionally broad and cryptic. Frequently, we look to tax court decisions, private letter rulings, and the pondering of experts to guide us in the quest to find the best investment offering the most control over the outcome while still steering clear of Prohibited Transaction pitfalls.

The 2004 court case Joseph R. Rollins vs. The Tax Commissioner - 11/15/2004 offers self-directed investors some clarification with regards to the Prohibited Transactions and further clarification of the definition of "disqualified persons" with regards to one's retirement plan investments. Briefly stated, the Rollins decision was based on the following set of circumstances:

Rollins was the administrator for his own 401(k) plan. He also owned less than a controlling interest in three legal entities. Each of these entities borrowed money and executed a promissory note with Rollin's retirement plan at terms that would be considered fair market. Mr. Rollins acted as treasurer for these entities and was the signer on the promissory notes on behalf of the entities as well as directing the plan to fund the loans.

Definition of "Disqualified Persons"

A "disqualified person," in most cases, includes the IRA holder, lineal ascendants and descendants of the IRA holder, as well as any entity where the aggregate ownership share of disqualified persons constitutes a controlling interest. For example, if the son and daughter of an IRA holder owned 50% of CrazyPants LLC, the IRA could not do business with CrazyPants LLC, regardless of the fairness of the terms of the transaction. Using these rules, it seemed permissible for Mr. Rollins' plan to loan money to entities that were not "disqualified" as he did not own 50% of any of them.

Disqualified persons: while the definition covers employers, employee organizations such as collective bargaining units and other employer and family relationships, it is our experience that it is the IRA holder and his family members who are most often involved when deals are put together. The IRS has provided definitions of when transactions with these individuals will run afoul of the prohibited transaction rules. As a result, transactions are often designed with those definitions in mind in order to avoid a prohibited transaction issue. Mr. Rollins did exactly that in designing the plan loans. He acknowledged that he personally was disqualified but the transactions were with entities that were not. Yet the court determined that the loans gave him an indirect personal benefit and thus were prohibited transactions.

Disqualified Persons and The Rollins Decision

The Rollins Decisions caught some of us off guard because of the "controlling interest" definition we have carried around for so long. The resulting refinement of this definition has taught investors to look further into the structure of a transaction and examine: 1) Who is negotiating for each entity? 2) Who is responsible for carrying out the terms of the agreement/note? 3) Under what circumstances could the "use of" or "investment of" plan assets indirectly (or directly) benefit the interest of a disqualified person?

Judicial Observations:

Rollins, "the petitioner," owned from 9% to 33% interest in the three entities involved. Although he did not hold a controlling interest of "50% or greater," the judge made the following observations after ruling against the petitioner:




The petitioner was the single largest shareholder by a significant margin in all three entities. The comparison between his share and the shares of other shareholders was a focus of this decision.


The petitioner held the positions of president, secretary, and treasurer, as well as being the registered agent of all of the entities.


The treasurer, Rollins, was the signer on all the notes securing the indebtedness.


The notes were at higher than market value and there was no default. Mr. Rollins' Plan benefited from the security and the income of the investment.

Mr. Rollins had the burden of proving that he did not use the plan assets for his own benefit. The court determined that Mr. Rollins failed to carry this burden, noting specifically the sparse evidence presented.

Good Deal versus Bad Deal for the IRA/Qualified Plan

It is clear from this case that the substance of the transaction, "Was it a good or bad investment?" had no bearing on the ruling against Rollins. Simplistically defining "controlling interest" as a percentage owned by a disqualified person was not looking deep enough into the issue of whether or not there is self-dealing in the transaction. Disqualified persons involved in a transaction who are deemed to be receiving an indirect personal benefit, or "self-dealing," results in the transaction being a prohibited transaction.

Self-directed plan investors planning investments where disqualified persons or entities are involved, even in a less than controlling status, should realize that the IRS Tax commissioner can, and obviously will, look deeper than the broad percentage guidelines. He will look for, among other things, convincing evidence that there is NO personal benefit derived from the transaction, directly or indirectly, by those disqualified. Furthermore, investors must recognize that decisions with regard to prohibited transactions will not be decided solely on the merits of the investment itself. Prohibited transactions are just that - prohibited. As stated by the judge and worth noting by all of us when structuring investments for our IRAs or Qualified Plans: "Good intentions and a pure heart are no defense".

By: Catherine Wynne
www.NewDirectionIRA.com
Catherine Wynne is President of Entrust New Direction IRA, Inc, which provides account administration and recordkeeping services for Individual Retirement Arrangements and other plans to clients who want to control their own investment decisions. Entrust New Direction is committed to providing clients and their financial advisors with the best information and quality education. We believe that informed clients will be more likely to recognize and take advantage of investment opportunities available to their self-directed IRAs and other self-directed qualified plans. We provide information not only through our web site, but also through seminars and workshops throughout the West, as well as radio shows, books and CD-ROMs.

The recent national surge in home foreclosures coming on the heels of the collapse of the sub-prime lending industry and decline in home values likely means additional bad news for those former homeowners who feel like they just lost everything: additional income tax liability.

Income tax liability? From losing your home? Such is the nature of the United States Internal Revenue Code.

Given the foreclosure epidemic and the huge losses to which lenders of all sizes are now exposed, many lenders are willing to enter into a variety of work-out programs with their borrowers to avoid foreclosure. Avoiding foreclosure does not necessarily mean keeping the home, however.

The foreclosure process is time-consuming for the lenders and often subjects them to the additional time and expense of physically evicting the former home owner from the home after the foreclosure sale. From the borrower's perspective, a foreclosure is a huge blow to credit worthiness and will impact the borrower's ability to finance major purchases for years to come.

Considering many lenders' goals of reducing their losses on foreclosures, borrowers have met with success recently in negotiating "short sales" with their lenders. A short sale is the borrower's reconveyance of the home to the lender for less than the amount owed on the mortgage.

For example: Joe obtained a creative home loan and purchased a home at the height of home values and during the most liberal period in sub-prime lending.

Eventually, the appraised value of Joe's home began to drop and the "creative" part of his home loan kicked-in. Perhaps his interest rate adjusted or his interest-only payments ceased and he was required to commence paying both principal and interest.

In any event, Joe finds that he cannot afford to continue making the mortgage payments and, due to market circumstances, he now owes more on the mortgage than the home is worth. In other words, he is upside down in the home.

Joe defaults on the mortgage payments and is now subject to the foreclosure process.

Applied to the example above, the borrower might successfully negotiate a short sale with his lender. Many lenders are now accepting a reconveyance of the home and forgiving the remaining debt exceeding the value of the home.

In the example, Joe may have purchased the home for $300,000. He has made interest-only payments on the loan for a year, but due to the recent slump in the market, the home is now worth only $250,000. He still owes $300,000 on the mortgage. The lender, therefore, may accept a reconveyance of the home - in essence a $250,000 payment - against the $300,000 debt.

The sale is "short" because the value of the home does not cover the amount of the mortgage. The lender may forgive the additional $50,000 owed by the borrower in order to avoid the foreclosure process, or to avoid litigation expenses in pursuing the borrower for the deficiency balance, and essentially cut its losses.

For the borrower, he avoids foreclosure and its ramifications to his credit, as well as facing a likely judgment for the amount still owed on the debt.

The hidden drawback here, though, is that the tax code treats Joe's debt relief as income. By being relieved of the obligation to pay $50,000, the IRS considers that Joe has in effect put $50,000 in his pocket.

The debt relief is subject to ordinary income tax. Joe may not even know of his additional tax liability until he receives an envelope in the mail from the lender containing a 1099 form reporting the debt relief income to the IRS.

The same result may follow if Joe simply walks away from the home, allows foreclosure to proceed, and then the lender elects not to pursue Joe for collection of the deficiency balance on the loan.

The ripple effect of the sub-prime lending market over the past couple of years has yet to reach its full effect. Individual homeowners must be wary of all consequences of divesting themselves of the homes they purchased in that market.

While financial planning might be the last thing on a borrower's mind when he or she faces the harsh reality that the home will be lost in some way, the unforeseen consequences of a foreclosure or short sale can only be addressed through the sound advice of a tax professional, CPA, or, at the very least, the IRS website.

Of interest to us lawyers, however, is the approach the IRS will take to the likely spate of litigation that will proceed, alleging that these borrowers, now facing additional income tax liability through the loss of their homes, should not be responsible for the 1099 income tax burden, by virtue of alleged fraud or misrepresentation on the part of the sub-prime lenders.

As they say, "the Wheels of Justice grind slowly." We will all have to wait to see how this shakes out.

By: Aaron Lovaas
Aaron Lovaas is a lawyer practicing in the areas of business litigation, business formation and planning, and real estate matters through his law firm, Shimon & Lovaas, P.C., in Las Vegas, NV. aaron@shimon-lovaas.com website: http://www.shimon-lovaas.com.

Question: I am the primary beneficiary of a trust set up by my mother and my 2 daughters (ages 27 and 30) are also beneficiaries. The balance of the trust is to be distributed soon and my daughters want to disclaim any interest in it, so it will all go to me. My question is, what are the tax consequences of this arrangement? The total value of the trust is about $250,000. Thank you, L.

Answer: Dear L - You are right in thinking that there may be some adverse tax consequences if your daughters disclaim their share of the trust. Although it is not clear from your question, I am assuming that your daughters acquired a 1/3rd interest in your mother's trust upon your mother's death.

Generally speaking, when a person is designated as the beneficiary of an interest in property under a will or a living trust, the interest vests immediately upon the death of the transferor unless there is some other intervening condition that must be satisfied. The same is true for interests given to designated beneficiaries under retirement plans (including IRAs and 401(k) plans), annuity contracts, and life insurance policies.

There are times, however, when a designated beneficiary doesn't want the interest given to him or her, as is the case with your daughters. People in this situation often think that they can just refuse the interest and that's the end of the story. They feel that way because, in their minds, they haven't actually received anything and, therefore, they don't actually own it.

Unfortunately, the tax laws say otherwise. Once the interest vests in a designated beneficiary, the designated beneficiary is deemed to own it. From that moment on, any refusal or disclaimer of the interest by the designated beneficiary constitutes a gift of the present value of that interest for federal gift tax purposes. The gift is deemed to be made to the contingent beneficiary or beneficiaries designated under the governing instrument; i.e., the will, trust, etc.

If that's the case, then how would anyone ever refuse an inheritance without incurring a gift tax? The short answer is that, for many years, you couldn't. If there was any consolation in the way the tax laws were written, it rested in the fact that the resulting transfer could be offset by the annual gift tax exclusion. Any excess over the annual gift tax exclusion could be sheltered from an actual out-of-pocket tax payment by the unified credit against gift and estate taxes. Even so, it was still a pain because you had to file a gift tax return and you lost all or part of your unified credit against future gift and estate taxes.

In order to correct this problem, Congress amended the tax laws to provide for a qualified disclaimer as part of the Tax Reform Act of 1976. A "qualified disclaimer" allowed an individual to refuse an interest in property without being deemed to have made a gift of the interest. In that case, the individual was treated as though he or she had never received it - so there was no need to file a gift tax return, or to use a part of his or her unified credit, or even pay any gift taxes out-of-pocket.

Still, in order to take advantage of the qualified disclaimer provisions, you have to satisfy the following requirements:

(1) The disclaimer must be in writing.

(2) The disclaimer must be given to the personal representative of the decedent's estate or the trustee of the decedent's trust, or to any other person holding legal title to property to which the interest relates, no later than 9 months after the later of —

(A) the day on which the transfer creating the interest in such person is made, or

(B) the day on which such person attains age 21,

(3) The person making the disclaimer must not have accepted the interest or any of its benefits.

(4) And, as a result of such disclaimer, the interest must pass without any direction on the part of the person making the disclaimer, and passes either —

(A) to the spouse of the decedent, or

(B) to a person other than the person making the disclaimer.

So, Mrs. L, the good news is that your daughters can disclaim their interest in your mother's trust without the transfer constituting a gift to you. However, they will have to meet the requirements set forth above, including the requirement that the disclaimer be made within nine (9) months after the transfer was made to your daughters. I am assuming that is nine (9) months after your mother's death, but there may be other conditions in the trust instrument that actually delay the vesting of your daughters' interests. For this reason, I would suggest that you consult with an experienced estate planning attorney because these requirements are unforgiving. Once the nine (9) month period has expired, you're simply out of luck.

By: Michael Pancheri
Copyright 2006. The Living Trust Network, LLC.
Attorney Michael Pancheri is a practicing attorney and the founder and CEO of the Living Trust Network. You may contact him by email at info@livingtrustnetwork.com. You may also contact him at the Living Trust Network's web site. Its URL is http://www.livingtrustnetwork.com.

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In an earlier article, we discussed the annual gift tax exclusion and how it works. In summary, we said that you could give up to $12,000 in cash or property to any one person during 2006 and not have to pay a federal gift tax. In fact, you don't even have to file a gift tax return. This is not the result of a kind and benevolent federal government at work. Rather, it is simply an effort to avoid an administrative nightmare keeping track of nominal gifts for weddings, birthdays, holidays, etc. Can you image having to file a gift tax return every time you took a bottle of wine over to your neighbors' for dinner?

So, the annual gift tax exclusion exists purely for administrative reasons. But, what happens if you exceed that exclusion amount during 2006 or any other year? What if, for example, you give your son or daughter $20,000 as a down-payment on a house?

In that case, you are required to file a federal gift tax return (Form 709) for the year of the gift. The return is required by April 15th of the following year, just like your personal income tax return (Form 1040). For 2006, the gift tax return would have to be filed by April 15, 2007.

However, that does not mean that you will actually pay a gift tax, because the tax laws give you a credit that can be applied against any gift taxes incurred during your lifetime and any estate taxes incurred upon your death. Because the credit applies against both the gift tax and the estate tax, it's called a "unified credit."

For years 2002 through 2009, the gift tax unified credit is $345,800. That translates into a gift of $1,000,000 before any gift taxes are actually paid.

That being the case, why do you have to file a gift tax return when your gifts to any one person exceed the annual gift tax exclusion for that year? The answer is simply because the gift tax unified credit of $345,800 through 2009 is cumulative, and the only way the federal government can keep track of your taxable gifts and the amount of unified credit you have used is through the filing of gift tax returns.

In our example above, we assumed that you gave your son or daughter $20,000 as a down-payment on a house in 2006. In that case, you would have to file a gift tax return for 2006 and report the gift. However, the amount of the reportable gift is not $20,000, but only $8,000, since the first $12,000 is covered by the annual gift tax exclusion. Under the gift tax rate schedule, the gift tax on $8,000 is 18% or $1,440. Against this gift tax, you would apply $1,440 of your gift tax unified credit of $345,800, leaving no gift tax owing. The amount of gift tax unified credit available to offset any of your future gifts would be reduced to $344,360 ($345,800 - $1440).

The important point here is that you don't pay any gift taxes on the first $1,000,000 in gifts that you make during your lifetime. And, the $1,000,000 in gifts does not include any gifts covered by the annual gift tax exclusion. So, for all practical purposes, if you don't plan to give away more than $1,000,000 during your lifetime, then your decision to make gifts should not be influenced by federal gift taxes. The only downside, if any, is that you will have to file a federal gift tax return for each year in which your gifts to any one person exceed the annual gift tax exclusion for that year.

Copyright 2005. The Living Trust Network, LLC.

Attorney Michael Pancheri is a practicing attorney and the founder and CEO of the Living Trust Network. You may contact him by email at info@livingtrustnetwork.com. You may also contact him at the Living Trust Network's web site. Its URL is Living Trust Network