Upholding an SDIRA in Bankruptcy | Frank Selden Law

Upholding an SDIRA in Bankruptcy

A 2014 bankruptcy case, In re Cherwenka, dealt with prohibited transaction claims against a self-directed IRA owner who used his IRA to invest in real estate. The bankruptcy trustee argued that the court should disqualify the IRA because Cherwenka engaged in prohibited transactions (PTs). If the court sided with the trustee, then the assets held in such a retirement account would not receive IRA protection from creditors and could be used to pay debtors involved in the bankruptcy. Most PT cases arise in Tax Court. However, the Bankruptcy Court’s jurisdiction does include rendering opinions on PT issues in bankruptcy cases.

Is Research a PT?

The creditor argued that Debtor performed work on the properties by researching and identifying the subject properties, selecting contractors, approving work, and overseeing payments from Pensco (the IRA custodian) for such work. Creditor asserted these acts constitute PTs under section 4975(c)(1)(C) as direct and indirect services between Pensco and Debtor, a disqualified person. The court found no evidence that Debtor engaged in any transactions with his IRA assets: “A transaction includes an exchange of goods or services. The evidentiary record does not include that Debtor received anything in exchange for his alleged services. Debtor’s testimony included that he received no money, discount, or other benefits for the identified activities he undertook with the Pensco IRA.”

The Court distinguished this case from In re Williams (Bankr E.D. Cal 2011), a similar case in which the self-directed IRA owner was managing properties owned by the IRA because in Williams, the IRA was paying the self-directed IRA owner for the services. The court stated that it was the payment from the IRA to the IRA owner in Williams that created the prohibited transaction and not the mere provision of managing the IRAs investment owned by the IRA.

Is Managing an LLC or trust a PT?

The SDIRAs I typically work with include an IRA investing into an LLC for which the IRA owner functions as the uncompensated manager. The court mentioned that all of the payments came directly from Pensco and that income received by the IRA went to the IRAs account at Pensco. Would the court come to the same conclusion for an IRA-LLC? It should, as uncompensated LLC management, by itself, is not a prohibited transaction.

In these types of cases, the burden of proof to demonstrate that prohibited transactions occurred rests with the creditor. A creditor with wide latitude to ask for documents in discovery. Such a creditor might be inclined to dig into financial records looking for prohibited transactions.

What Do Your IRA Records Show?Photo by Melinda Gimpel on Unsplash

Yes, SDIRA owners can sleep well at night, knowing that the court does not view researching, identifying investments, or approving work on the properties as prohibited transactions. The more important question I want SDIRA owners to ask themselves is... if you had to defend your IRA in either tax court or bankruptcy, what would your IRA financial records show? Do you have complete financial tracking, reconciled statements? Or do your records contain missing transactions a creditor could argue indicate nefarious activity even if none exists?

If you want help understanding the PT rules, or how to build a bulletproof financial record trail, call me. Better, and cheaper, to prevent mistakes than explain them.

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