Terry Ellis v. Commissioner of IRS, 787 F.3d 1213

In 2005 Terry Ellis caused formation of CST Investments, LLC, an operating company, whose operating agreement listed his self-directed IRA (to be funded later) and Richard Brown as members; the IRA was to hold a 98% interest.
Ellis established an IRA in June–August 2005, rolled over funds from his 401(k), and directed the IRA (custodied by First Trust) to acquire essentially all of CST’s membership interest; the IRA’s year-end FMV was about $321,253.
Ellis was designated CST’s general manager with authority to act for the company; CST paid Ellis wages ($9,754 in 2005; $29,263 in 2006) drawn from CST’s corporate account and reported on the Ellises’ joint returns.
The IRS issued a notice of deficiency arguing Ellis engaged in prohibited transactions under 26 U.S.C. § 4975 by (1) causing the IRA to invest in CST expecting employment and (2) receiving wages from CST; the IRS treated the IRA as distributed under § 408(e)(2).
The Tax Court upheld the Commissioner’s determination that the 2005 wage payments were a prohibited transaction; this appeal concerns that ruling. The court affirmed, holding wage payments constituted an indirect transfer/use of IRA assets for Ellis’s personal benefit.

Issue	Ellis’s Argument	Commissioner’s Argument	Held
Whether CST’s payment of wages to Ellis in 2005 was a “prohibited transaction” under § 4975(c)	Ellis argued the wages came from CST’s corporate account (not IRA assets) and thus were not a prohibited transfer/use	Commissioner argued Ellis caused the IRA to fund CST and then directed CST to pay him, constituting an indirect transfer/use of IRA income/assets benefiting a disqualified person	Court held wages were a prohibited transaction: Ellis indirectly transferred/use of IRA assets for his own benefit in violation of § 4975(c)(1)(D) and (E)
Whether the Plan Asset Regulation or § 4975(d)(10) compensation exemption shields the wage payments	Ellis invoked 29 C.F.R. § 2510.3-101 (plan-asset rule for operating companies) and § 4975(d)(10) (reasonable compensation for plan services)	Commissioner argued § 2510.3-101 does not negate the broad prohibition on indirect self-dealing; § 4975(d)(10) applies only to compensation for plan duties, not compensation from a company	Court held neither defense applies: Plan Asset Reg. does not nullify § 4975’s ban on indirect self-dealing; § 4975(d)(10) inapplicable because wages were for company services, not IRA/plan duties

Blodgett v. Comm’r, 394 F.3d 1030 (8th Cir. 2005) (standard of review and tax-court deference principles)
Musco Sports Lighting v. Comm’r, 943 F.2d 906 (8th Cir. 1991) (precedent on review and tax issues)
Westoak Realty & Inv. Co., Inc. v. Comm’r, 999 F.2d 308 (8th Cir. 1993) (prohibited transactions prohibited even if made in good faith)
Comm’r v. Keystone Consol. Indus., Inc., 508 U.S. 152 (U.S. 1993) (broad reading of “indirect” in prohibited-transaction context)
Lowen v. Tower Asset Mgmt., Inc., 829 F.2d 1209 (2d Cir. 1987) (compensation exemption limited to plan-related services)
Peek v. Comm’r, 140 T.C. 216 (Tax Ct. 2013) (indirect transactions can constitute prohibited transactions)
Swanson v. Comm’r, 106 T.C. 76 (Tax Ct. 1996) (status of a corporation without issued interests for disqualified-person analysis)