DRAFT January 4, 2010

                       Issues to Consider with Self Directed IRAs

The 2006 tax legislation afford...
Note – recent bankruptcy court ruling that engaging in a
                            prohibited transaction also results i...
Note - "family member" is defined as a spouse, ancestor,
                       lineal descendent or spouse of a lineal de...
if the plan by itself can cause the entity to engage in a transaction, then the
transaction will be treated as if the plan...
10.      Brokerage commissions. PTE 86-128. Permits a fiduciary with
                         respect to an IRA to direct ...
7.     Direct or indirect transactions "using" IRA assets to benefit
                    anyone with whom the IRA owner ha...
C.       Prohibition on commingling except in common trust fund or common
                 investment fund
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Issues to Considerwith Self Directed IRAs


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Issues to Considerwith Self Directed IRAs

  1. 1. DRAFT January 4, 2010 Issues to Consider with Self Directed IRAs The 2006 tax legislation afforded new distribution options for plan participants and beneficiaries  of  qualified  retirement  plans.  Such  result  makes  it  desirable  to  do  a  rollover  to  an  IRA.  There  continues to be interest in self‐directed IRAs (that is, an IRA owner choosing his/her investment  options, beyond that of the IRA trustee’s or custodian’s investment options). However, there are  practical  and  legal  issues  that  the  IRA  owner  must  be  aware  of  before  making  self‐directed  investment  decisions.  This  panel  of  practitioners  and  government  officials  will  discuss  these  practical and legal issues.    Self‐directed  IRAs  can  be  further  divided  into  (1)  traditional  brokerage  IRAs,  where  the  owner  may  invest  principally  in  registered  investments,  and  (2)  non‐traditional  custody‐only  IRAs,  investing  principally  in  non‐registered  or  "alternative"  investments.    For  purposes  of  this  discussion,  we  focus  on  the  latter  as  a  fast‐growing  area  that  is  subject  to  a  great  deal  of  confusion.    I. Background / Framework A. Code section 408 sets out certain requirements for tax qualification 1. Certain activities that can result in loss of tax exemption under section 408 are commonly included under the broad umbrella of "prohibited transactions" (and we do so here), but they are more accurately characterized as qualification conditions (see below) 2. These "tax prohibitions" are solely under the jurisdiction of the IRS B. In general, rollover IRAs are not subject to Title I of ERISA C. IRAs are subject to the prohibited transaction rules of Code section 4975 1. The Department of Labor has jurisdiction over interpretation and issuance of exemptions 2. The IRS has jurisdiction over enforcement and imposition of the excise tax 3. The penalty for engaging in a prohibited transaction with your own IRA is tax disqualification of the entire IRA Query – can you reduce the risk by isolating a questionable investment in a separate IRA?
  2. 2. Note – recent bankruptcy court ruling that engaging in a prohibited transaction also results in loss of bankruptcy exemption1 4. The penalty imposed on anyone other than the IRA owner for engaging in a prohibited transaction with an IRA is a 15% initial excise tax on the "amount involved", plus an additional 100% under some circumstances if not timely "corrected" Note – "correction" and "amount involved" are determined pursuant to pre-ERISA regulations relating to foundations, and are not easily applied in some cases, particularly to "self-dealing" types of transactions II. Code section 4975 Prohibited Transactions A. Generally. Code section 4975(c)(1) prohibits any direct or indirect: 1. Sale or exchange, or leasing, or property between an IRA and any "disqualified person" with respect to the IRA. 2. Lending of money or other extension of credit between an IRA and any disqualified person. 3. Furnishing of goods, services or facilities between an IRA and any disqualified person. 4. Transfer of IRA assets to, or use of IRA assets by or for the benefit of, any disqualified person. 5. Act by a fiduciary that involves the fiduciary "dealing" with the assets of an IRA in his own interest or for his own account (self- dealing). Note – definition of "interest" can be quite broad 6. Receipt of any consideration by a fiduciary from any other party dealing with the IRA (kickbacks). Note – the Code contains no fiduciary "conflict of interest" analog to ERISA section 406(b)(2) (though this is not typically relevant in the case of a self-directed IRA). B. Disqualified person. As relevant to a self-directed rollover IRA, the term "disqualified person" generally includes: 1. Any fiduciary 2. Any service provider to the IRA (adviser, broker, accountant, etc.) 3. Any family member of a fiduciary or service provider 1 In re: Willis, No. 07-11010 (Bankr. D. Fla. Aug. 6, 2009). 2
  3. 3. Note - "family member" is defined as a spouse, ancestor, lineal descendent or spouse of a lineal descendant (but not a sibling) 4. Any corporation, partnership, trust or estate owned 50% or more by a fiduciary or a service provider Note – ownership by the IRA itself does not cause an entity to be a disqualified person C. Fiduciary. In the case of a self-directed IRA, the term "fiduciary" generally includes: 1. The IRA owner 2. A person hired by the IRA owner to exercise investment discretion over the account 3. A person providing non-discretionary investment advice to the IRA owner (a) on a "regular basis," (b) pursuant to an agreement or understanding (including course of dealing), (c) if the person receives any form of compensation (direct or indirect), (d) if the owner relies on the advice as a (not the) primary basis for making a decision, and (e) the advice is "personalized." Note – brokers and financial planners often argue (rightly or wrongly) that they are not fiduciaries to IRAs because their advice is not "personalized," particularly where the IRA is part of a larger portfolio. Note – many IRA service providers are unaware that providing non-discretionary advice and obtaining client consent does not relieve them of fiduciary responsibility. D. Plan assets. DOL regulations provide that when a benefit plan including an IRA makes an equity investment in an entity, the underlying assets of the entity are treated as plan assets (subject to the prohibited transaction rules) on a look-through basis unless an exception applies. The principal exceptions are: 1. Publicly offered securities. 2. De minimis holdings. Less than 25% equity ownership by benefit plan investors. 3. Operating companies. Investments in companies that develop or market goods and services other than the investment of capital, plus certain “hybrid” entities known as “venture capital operating companies” (VCOC) and “real estate operating companies” (REOC). E. Indirect transactions. DOL Interpretive Bulletin (IB) 75-2, 29 C.F.R. section 2509.75-2, provides that notwithstanding the fact that an entity does not hold plan assets, if an investment in an entity is made with the expectation or understanding that the entity will engage in a transaction that would be prohibited if made directly, then such indirect transaction will also be prohibited. Similarly, 3
  4. 4. if the plan by itself can cause the entity to engage in a transaction, then the transaction will be treated as if the plan were a party to the transaction. See discussion of Adv. Op. No. 2006-01A, below, for an example. Note – this rule is commonly overlooked. F. Exemptions. The prohibited transaction rules are subject to a number of statutory exemptions, and the Department of Labor has authority to issue administrative exemptions, which it does on a "class" basis (available to anyone meeting the conditions) and on an individual basis (available only to the named parties). "Key" exemptions of note to owners of self- directed IRAs include: 1. "Reasonable services." Code section 4975(d)(2). Permits the IRA to pay third-party service provider fees. Note – this exemption does not cover self-dealing. 2. Bank deposits. Code section 4975(d)(4). Permits a bank to place IRA assets in its own deposit accounts - commonly used to for sweep services in the self-directed context. 3. Benefits distributions. Code section 4975(d)(9). Eliminates any "technical" violation where IRA assets are distributed to the accountholder. Query – does this cover "in-kind" distributions or only cash? (Retirement home example.) 4. Reasonable compensation. Code section 4975(d)(10). This includes reimbursement of permissible out-of-pocket expenses. Note – this exemption does not cover self-dealing. 5. "Conflicted" investment advice. Code section 4975(d)(17). Permits a non-discretionary adviser or its affiliate to receive third- party compensation (e.g., commissions) under certain conditions. 6. Transactions with service providers. Code section 4975(d)(20). Permits the IRA owner to cause the IRA to enter into purchases and sales, loans, leases, etc. with service providers who are not acting as fiduciaries. 7. "Basic" securities transactions. Class PTE 75-1. Covers certain day-to-day securities activities involving broker-dealers. 8. "Proprietary" mutual funds. Class PTE 77-4. Permits a fiduciary to invest client assets in its affiliated mutual funds. 9. Interest-free loans. Class PTE 80-26. Permits the IRA owner or other disqualified person to lend money temporarily to the IRA for ordinary operating expenses and "incidental" purposes. The loan must be unsecured. 4
  5. 5. 10. Brokerage commissions. PTE 86-128. Permits a fiduciary with respect to an IRA to direct trades to itself or an affiliate and receive commissions. Commonly used in self-directed accounts held at brokerage firms. Note – DOL has taken the position that mutual fund "12b-1 fees" are not commissions for this purpose. 11. American Eagle coins. PTE 91-55. Provides a limited exemption from the prohibition on investing in metals and collectibles. 12. The "toaster exemption." PTE 93-1. Permits a financial institution to give small "gifts" to an IRA owner for opening an account (generally not to exceed $20 in value). 13. Bank services. PTE 93-33. Permits a bank to provide certain free or reduced-cost services (e.g., free checking, brokerage discounts, etc.) to an IRA owner or family member on account of maintaining an IRA. 14. Relationship brokerage. PTE 97-1. Provides similar relief for IRAs maintained with a brokerage firm. III. Common Self-Directed IRA Transaction Issues/Red Flags A. Transactions involving the IRA owner (loss of tax exemption). 1. Investing in employer's business or employer-sponsored fund. 2. Using IRA assets to start a business. • DOL Adv. Op. 2001-10A (fiduciary causing a plan to pay it fees) • IB 75-2 (investing in an non-plan assets entity with the expectation of a fee) • Application of IRS Michael Julianelle "ROBS" memo by analogy. 3. Receiving compensation from an IRA-owned business. 4. Coinvesting with disqualified persons. • DOL Adv. Op. 2001-10A (investing in limited partnership)2 5. Structuring distributions for estate planning purposes. • DOL Adv. Op. 2009-02A (distribution to trust paying fees to son) 6. Transactions involving family members of the owner. • DOL Adv. Op. 2006-09A (loan to son-in-law's business) 2 Compare with DOL coinvesting discussions in various insurance company exemptions, e.g., Equitable Life Assurance, 55 Fed. Reg. 33874, n.2 (1990). 5
  6. 6. 7. Direct or indirect transactions "using" IRA assets to benefit anyone with whom the IRA owner has a personal relationship. • DOL Adv. Op. 2006-01A (leasing of property to IRA owner's business) 8. "Householding" of IRA and non-IRA accounts. 9. "Checkbook LLC." 10. Personal use real estate (vacation/retirement home). B. Transactions involving IRA service providers (excise tax penalty). 1. Recommending a rollover into an IRA. • DOL Adv. Op. 2005-23A • Securities law implications (FINRA actions, class action suits) 2. Recommending a proprietary/affiliated investment. • DOL Adv. Op. 2005-10A (dollar-for-dollar fee offset) • Various exemptions available (see above) • Hedge funds 3. Receiving a fee for recommending an investment. • PTE 86-128 (securities sales commission paid by the IRA) • ROBS memo (promotional fee) 4. "Cross-collateralizing" brokerage accounts. • DOL Adv. Op. 2009-03A 4. Broker free credit. • PTE 2006-01 IV. Additional "Prohibitions" Relating to Tax Qualification under Code section 408 As noted above, the following "prohibitions" relate to tax qualification under Code section 408, and are conditions to maintaining the tax-exempt status of the IRA: A. Prohibition on holding custody of assets other than by a bank or other IRS-approved custodian – contrast with qualified plans which may have individual trustees Query – how far "down the line" does this requirement travel? (Bernie Madoff example) Query – does the "checkbook LLC" violate this requirement? B. Prohibition against investing in insurance contracts 6
  7. 7. C. Prohibition on commingling except in common trust fund or common investment fund 1. Common trust fund = IRC 584 common trust fund 2. Common investment fund = Rev. Rul. 81-100 group trust3 Query – what is "commingling"? D. Prohibition against borrowing (also a 4975 prohibited transaction) E. Prohibition against pledging account as security for a loan (also a 4975 prohibited transaction) Query – does this apply to a pledge "internal" to the IRA? Note – brokerage agreements commonly include pledges (see discussion of Adv. Op. 2009-03A, above) Note – few banks will lend to an IRA to acquire real estate without a personal pledge F. The following are not strictly "prohibited," but are red flags that can result in serious penalties or disqualification: 1. "Deemed" contributions in excess of the annual limit. • "Sweat equity" – problem of distinguishing between managing the IRA and managing an IRA asset • Bonus payment for opening new account 2. Under- or over-valuation of assets • Effect on RMDs • Potential prohibited transaction issues, see ROBS memo. 3 See, Treas. Reg. § 1.408-2(b)(5)(ii) defining "common investment fund." See also, IRS Notice 2004-50 (Jul. 23, 2004), Q&A 66, re: HSAs under Code section 223 (which appears to have the definitions reversed). 7