A IRA holding stock in Sub S Corp, Taxable?
I purchased years ago in my IRA, stock in a local bank which was operating as a C corporation. Over the years I received my dividend tax free and the stock increased nicely over that 20 year period. Recently the bank went to a Sub S corp, buying out many shareholders to get down to 100 sharehlder limit as required by law. I’m the only shareholder now that has the bank’s shares within the Sub S corp in my IRA. Here comes the problem.
The bank filed in my name a 990-T with the IRS showing my share of the bank’s profit and the tax on that amount. Without my knowledge, the bank then wrote a check out of my IRA to pay the tax. Then shortly after that the IRS sent me a penalty to pay as I did not make estimated payments on the tax. This all came as a surprise to me, the bank not mentioning their activity to me.
I went to the bank and sat down with the bank president. He claims that because the bank is now a SUB chapter S corp they can tax my IRA for my share of the bank’s profit. I did receive my dividends last year but can the bank tax my IRA this way? when I eventually take out those remaining dollars I will be paying tax on that again, double taxation. Certainly something is wrong here. And since when do I have to make estimated payments through my IRA and the tax owed on the banks overall reporting profit?
Can you help me find where in the IRS codes that the bank has the right to tax my IRA. My understanding is that the only time I have to pay taxes is when the money is distributed to me out of my IRA. I would appreciate and help and advice you can give meon this. Thanks,
Permalink Submitted by mk foss on Thu, 2009-11-26 00:26
You have learned the hard way that an IRA is not a good vehicle for owning a partnership or an S corporation.
IRAs are normally not taxed on their investments unless the investment is generating business income. Because an IRA is a tax exempt entity, it becomes taxable on business income – this is called Unrealted Business Income (UBI). Any income in excess of $1,000 is taxable using the tax rates attributable to trusts – those are the highest tax rates imposed on any entity. The custodian of the IRA (the same bank I assume) is supposed to file the return and pay the tax. There is a penalty the first year if you haven’t made estimated tax payments. Individuals (and trusts) do not owe a penalty when no return was required the prior year. Unfortunately IRS uses the corporate tax rules in assessing penalties on Unrelated Business Income Tax (UBIT) so you owe a penalty the first year you have UBI even if you haven’t in the past. It may be possible to reduce the penalty in some cases, but you can’t eliminate it.
You’re correct that the UBIT does lead to double taxation. The bank should have informed you of the UBIT rules when the S election was made, in my opinion. It could be they were unaware of the problem until the S corporation return was prepared. It’s difficult to make the problem go away because you cannot buy the shares from the IRA – that would be a prohibited transaction and could disqualify the IRA. The solutions I think are to have the bank shares sold within the IRA to invest in something else or to have the shares distributed to you and then come up with an equivalent amount of cash to roll to a new IRA or an existing IRA.
In any case, the S corporation income is allocated by days so you’ve already earned some UBI for 2009 and should be making estimated tax payments from the IRA. Unfortunately, what has happened is correct and can’t be undone at this point.
Permalink Submitted by Bruce Steiner on Thu, 2009-11-26 03:14
An IRA generally can’t own shares of an S corporation. But the American Jobs Creation Act of 2004 added Section 1361(c)(2)(A)(vi), whereby if a bank elects S, an IRA which owned shares when the law became effective (in 2004) can retain the shares. The practical effect is that the bank can elect S even though an IRA is a shareholder.
Under Section 1362(a)(2), a corporation needs the consent of all of its shareholders to elect S. So you must have consented to the S election.
Charitable organizations and retirement plans are generally tax-exempt. But there’s an exception for “unrelated business taxable income.” For the application of this to IRAs, see Sections 408(e)(1), 511(a) and 512. Your tax burden is not necessarily increased. If the bank didn’t elect S, it would have paid tax on all its income, even if it had an IRA or a charity as a shareholder.
If you didn’t want to keep the shares in your IRA, Section 4975(d)(16) offered an exception to the prohibited transaction rules whereby you could have purchased the shares from your IRA within 120 days from when the bank elected S.
Bruce Steiner, attorney
NYC
also admitted in NJ and FL