Consider this situation: A business owner thought an IRA was his money and he could use it to fund his start-up business. Instead, he had his entire IRA disqualified and he was forced by the appellate court to pay substantial penalties and a massive tax bill.
Normally, a withdrawal from an IRA would be taxed and then the money would be available to be used for anything. But instead of paying tax and a 10% early withdrawal penalty (if the IRA owner is under the age of 59 1/2), some clients use their self-directed IRA to invest in their business without incurring tax.
It sounds good on the surface, but as this case shows it can end in disaster if the transaction violates the IRAs strict self-dealing rules and triggers a prohibited transaction that disqualifies the IRA. Then the entire IRA is treated as if all the funds were distributed on January 1 of the year the prohibited transaction occurred, ending the IRA and creating a tax liability, plus possible penalties.
In a case decided back in 2013, the tax court ruled that the individual engaged in a prohibited transaction (self-dealing) when a business owned by his IRA paid him for being the general manager of that business. His IRA was disqualified and deemed distributed, resulting in the assessment of income taxes and the 10% early distribution penalty on the full amount. He was also hit with a penalty for underpayment of income taxes.
Be extra careful if thinking about funding your business with your IRA.
If you have any questions, please contact Tom Hofstad, CPA at firstname.lastname@example.org