Why You Shouldn't Mix Personal Funds with Retirement Funds to Invest

When it comes to real estate, there is a belief by some retirement investors that they can use personal and retirement funds in the same transaction without triggering the IRS prohibited transaction rules. However, a recent case would seem to suggest that using personal funds in the same transaction with their self-directed IRA is a no-go.

IN RE: KELLERMAN, Cite as 115 AFTR 2d 2015-1944 (531 B.R. 219), Code Sec(s) 408; 4975, (Bktcy Ct AR), (05/26/2015)

The Kellerman case involved a construction company owner and wife/LLC co-owners (the Kellermans) who were denied a claim for bankruptcy estate exemption for Mr. Kellerman’s self-directed IRA. The court concluded that Mr. Kellerman who along with wife, conceded that they, LLC and partnership formed by IRA and LLC were disqualified persons under IRC Section 4975(e)(2) and engaged in prohibited transactions by directing IRA to deliver property as non-cash contribution to IRA and LLC and to make cash contribution to partnership to develop property.

The Kellermans filed their voluntary Chapter 11 bankruptcy petition in the United States Bankruptcy Court. Prior to his bankruptcy case, Barry Kellerman created the IRA, which as of October 27, 2008, had a reported value of $252,112.67. The named administrator of the IRA is Entrust Mid South, LLC (“Entrust”). The IRA is self-directed by Barry Kellerman who made all of the decisions pertinent to the issues raised in the objections. At the commencement of their case, the debtors valued the IRA at $180,000.00 and claimed the entire fund as exempt under the Bankruptcy Act.

The trustee in the bankruptcy case against the Kellermans’ object to the the Kellermans’ claimed exemption in the IRA on the basis that it was no longer exempt from taxation under the Internal Revenue Code as of the commencement of the case and, accordingly, is not eligible for exemption. They allege that the IRA lost its exempt status in 2007 because Barry Kellerman directed the IRA to engage in prohibited transactions involving disqualified persons as defined by the Internal Revenue Code.

The alleged prohibited transactions involve the 2007 acquisition of approximately four acres of real property located near Maumelle, Arkansas. Panther Mountain Land Development, LLC (“Panther Mountain”) played a precipitating and integral role in the purchase. Barry Kellerman and his wife each own a 50 percent interest in Panther Mountain. To effect the acquisition and development of the four-acre property, the IRA and Panther Mountain formed a partnership whereby the IRA contributed property and Panther Mountain contributed property and cash.

The purchase of the four-acre tract also took place on August 8, 2007. Barry Kellerman made the decision to purchase the four acres. The purchase took place principally to complement and assist in the development of two nearby tracts of approximately 80 and 120 acres owned by Panther Mountain. While the four-acre tract could be independently developed, controlling it substantially assisted in the development of the other Panther Mountain properties. The IRA funded the entire purchase price.

Panther Mountain filed its own Chapter 11 bankruptcy on September 20, 2009, shortly after the Kellermans commenced their bankruptcy proceeding on June 3, 2009.

The Kellermans’ conceded that they are “disqualified persons” pursuant to IRC Section 4975(e)(2). Specifically, Barry Kellerman is the beneficiary of the IRA and a fiduciary under IRC Section 4975(e)(2)(A) because he exercises “discretionary authority” and “discretionary control” over the IRA as the owner. Dana Kellerman qualifies as a “member of the family” pursuant to subsection 4975(e)(2)(F) as the wife of Barry Kellerman. Panther Mountain constitutes a “disqualified person” under subsection 4975(e)(2)(G) because Barry Kellerman asserts a 50 percent membership interest. Likewise, the Entrust Partnership is a disqualified person pursuant to subsection 4975(e)(2)(G). Based on the Kellermans' concessions and the court's findings on disqualified persons, all that remains is a determination of whether a prohibited transaction occurred that terminated the tax-exempt status of the IRA.

The court concluded that in 2007, Barry Kellerman engaged the IRA in transactions including: (1) the purchase of the real property with IRA funds and subsequent conveyance of the real property to the IRA and Panther Mountain (the “non-cash contribution” under the Partnership Agreement), and (2) the cash contribution of $40,523.93 made by the IRA to the Entrust Partnership (the “cash contribution” under the Partnership Agreement). Collectively, individually, and with some redundancy, both the non-cash contribution and the cash contribution constitute “prohibited transactions” with disqualified persons pursuant to IRC Sections 4975(c)(1)(B), (D), and (E), which renders the IRA non-exempt.

What Can We Lean From The Case?

The case is a clear example that using retirement and personal funds in the same transaction can potentially trigger a self-dealing prohibited transaction under IRC 4975(c)(1)(D). By entering into a transaction with IRA funds that in some way directly or indirectly involves a disqualified person, in this case Panther Mountain, the IRA owner then is saddled with the burden of proving the transaction does not violate any of the self-dealing or conflict of interest prohibited transaction rules under IRC Section 4975, a burden that as this case shows could be difficult to satisfy.

As the court stated, “Further, and cumulatively, Barry Kellerman transferred or used “the income or assets of [the IRA]” for the benefit of each of the aforementioned disqualified persons and as a fiduciary dealt with “the income or assets of [the IRA] in his own interest or for his own account.” IRC Section 4975(c)(1)(D),(E). Barry Kellerman, as the owner and fiduciary of the IRA, (1) orchestrated the IRA's membership in the Entrust Partnership with Panther Mountain, (2) signed the Buy Direction Letter and the Sale Letter that facilitated the purchase of the four acres solely by the IRA but held with Panther Mountain as tenants in common, and (3) directed the payment of “Business Expense[s]” by the IRA to develop the four-acre tract. The real purpose for these transactions was to directly benefit Panther Mountain and the Kellermans in developing both the four acres and the contiguous properties owned by Panther Mountain. The Kellermans each own a 50 percent interest in Panther Mountain and stood to benefit substantially if the four-acre tract and the adjoining land were developed into a residential subdivision.

The Kellerman case is a great example why using retirement funds and personal assets in the same transaction is not advisable as it can potentially trigger the IRC Section 4975 prohibited transaction rules.