The Government Accountability Office (“GAO”) concluded over a year of research and investigation on self-directed IRA’s and 401(k)’s with a report to Congress called Retirement Security: Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets.
Self-directed IRA’s and 401(k)’s are accounts that may be invested into “unconventional” assets. The most common “self-directed” assets are real estate, LLC’s, start-ups, venture capital, private funds, and precious metals. The self-directed IRA industry has tripled over the past ten years and the demand and interest from retirement account holders continues to grow.
The GAO was tasked to research self-directed IRA’s by Senator Ron Wyden (D-OR) who serves as the ranking member of the Senate Finance Committee.
The GAO identified 27 custodians who handle self-directed IRA’s holding “unconventional” assets such as real estate, LLC’s, private company stock, and precious metals. Seventeen of these companies participated and responded to surveys and requests for information. These 17 companies reported holding 500,000 retirement accounts and $50 Billion in assets in unconventional investments.
I was interviewed by the GAO for this report and they also used my book, The Self-Directed IRA Handbook, while conducting research on the laws and taxes affecting self-directed IRA and 401(k) investors.
The GAO’s report concluded that IRS guidance is lacking in three specific areas:
- Prohibited Transactions: The GAO concluded that self-directed account holders who invest in unconventional assets are at greater risk of engaging in prohibited transactions and that the IRS should engage in additional outreach and education with regards to unconventional assets to ensure compliance. The prohibited transactions rules are found in IRC § 4975 and essentially restrict the account owner, and certain family members, from transacting personally with their own IRA. For example, it would be a prohibited transaction for an IRA owner to sell private stock they personally own to their own IRA. It is also a prohibited transaction to have use or benefit of your IRA’s assets. For example, if your IRA owned real estate, it would be a prohibited transaction to have personal use or occupancy of the property.
- UBTI (Unrelated Business Taxable Income): The GAO’s research and investigation concluded that many self-directed IRA and 401(k) investors are unaware of the unrelated business taxable income (“UBTI”) that can apply to some “unconventional” investments owned by an IRA. UBTI tax applies to IRA’s when they receive “business” income as opposed to “investment” income. IRA’s are designed to receive investment income such as rental income, interest income, dividend income, or capital gain income. However, if an IRA receives “business” income or “ordinary” income, that causes UBTI and the IRA ends up being responsible for tax on its income. In this instance, the IRA files a 990-T tax return and is responsible for tax on the income earned. Most self-directed IRA investments do not cause UBTI, but many self-directed investors unwittingly run into this tax. The GAO found in its report that there isn’t any guidance regarding UBTI in the IRS publications on IRA’s, Publications 590-A and 590-B. The GAO warned that without caution or specific guidance in these publications or through other efforts by the IRS, that self-directed account owners may unwittingly invest their account into assets that cause UBTI tax.
- Fair Market Valuations: The GAO’s report found that there is zero advice to custodians of IRA’s or to IRA owners regarding how to determine the fair market value (“FMV”) for unconventional assets held in a retirement account. Each year, the custodian of a self-directed IRA must report the FMV of the account to the IRS via form 5498. For publicly traded assets such as stocks or mutual funds, valuation is relatively simple as the valuations is the price of the stock or fund as of close of the market price on December 31 each year. For assets such as real estate or private company stock, such value is not as readily available and account holders and companies use varying methods for reporting FMV annually to the IRS. The GAO recommended that the IRS develop guidance or regulations on how unconventional assets should be valued and reported to the IRS. In their response to the report, the IRS stated that they will recommend that Treasury address fair market valuations in their upcoming retirement plan regulations for 2016-2017
The GAO report was an excellent analysis and summary of the common issues facing self-directed IRA and 401(k) owners investing in unconventional assets. As an attorney representing self-directed account holders for over ten years, I wholeheartedly agree with the three issues the GAO cited in their report and believe that further guidance from the IRS would increase awareness for not only account holders but also for their professional tax, legal, and financial advisers.
A prohibited transaction case from 2015 taught an important lesson for self-directed IRA investors. That lesson is that the substance of the actual transaction matters and that you cannot avoid a prohibited transaction by creating entities or other artificial structures that create no business purpose. Summa Holdings, Inc., et al, v. Commissioner, T.C. Memo 2015-119 (2015)
In Summa, two brothers invested a minimal amount of funds from their Roth IRAs into a new corporation called JCH. JCH then established and owned 100% of another new company called JCE. This new company, JCE, then in turn contracted with and received income from a company owned and majority controlled by the Roth IRA owners’ father. Clearly, any transaction between the brother’s Roth IRAs and their father would be a prohibited transaction. The prohibited transaction rules restrict your IRA from transacting with a disqualified person and the list of disqualified persons includes the father of and IRA or Roth IRA owner. IRC 4975 (e)(2)(F).
The Tax Court, in Summa, had to determine if the transactions between companies the Roth IRAs owned and companies in which the Roth IRA owner’s father owned and controlled were a prohibited transaction. The Tax Court relied on what is known as the “Substance Over Form Doctrine” to find a prohibited transactions for the Roth IRAs receipt of income. The Substance Over Form doctrine provides that the substance and not the form of a transaction determines its tax consequences. So, despite all of the companies, three in total, that separated the brother’s Roth IRAs from their father there is still a prohibited transaction as the overall substance of the Roth IRAs transactions was to unfairly shift income and assets to the tax-free Roth IRA accounts.
In fact, the Roth IRA owners stipulated with the IRS that the sole reason for their Roth IRAs investment into the companies and for the transactions was to accumulate income and assets tax-free. They conceded that there was no other business or investment purpose for the transactions. Consequently, the Tax Court rightly found a prohibited transaction and disqualified the Roth IRAs.
While careful planning and structuring is critical in your self-directed IRA transactions, no structure can overcome the lack of a legitimate investment or business interest for an IRAs investments. When investing your IRA into a deal, make sure your IRAs isn’t receiving any favorable treatment or benefit from a disqualified person (e.g. from the Roth IRA owner’s father). If your IRA is getting some favorable treatment or allocation of income or assets from a disqualified person, as was the case in Summa, you too could have a prohibited transaction.
A recent Bankruptcy Court decision dealt with prohibited transaction claims against a self directed IRA owner who was using their IRA to flip real estate for profit. The claims were brought by a bankruptcy trustee who argued that the protected IRA was no longer an IRA because it engaged in a number of prohibited transactions. If the trustee is successful in disqualifying the retirement account because of a prohibited transaction, then the funds and assets held in such retirement account are no longer protected from creditors and may be used to pay debtors involved in the bankruptcy. While most prohibited transaction cases arise in Tax Court, I’m seeing more cases on prohibited transactions in Bankruptcy Court as trustees are becoming more aggressive and as self directed IRAs are becoming more popular.
The case in question is known as In re Cherwenka, Case 13-57592-MGD (Bankr. N. D. GA 2014). The case included two important prohibited transaction analysis that are helpful to IRA owners.
Court Rules No Prohibited Transaction When Managing IRA Investment Properties Without Compensation
The first significant ruling from the Court was that there was no prohibited transaction when the IRA owner completed the following tasks related to the IRA owned property.
- Research and identified properties to buy
- Appointed and approved work on the properties
- Oversaw payments on the property for work from the self-directed IRA.
The Court reasoned that these actions do no constitute a “transaction” as defined in IRC § 4975 and as a result they cannot constitute a prohibited transaction. The Court further stated that, “…self-directed IRAs as qualified IRAs, necessarily implies that a disqualified person (the owner as fiduciary) will make investment decisions regarding the plan. The Court distinguished this case from In re Williams, 2011 WL 10653865 (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 caused the prohibited transaction and not the mere provision of managing the IRAs investment owned by the IRA.
Court Ruled That No Prohibited Transaction Occurred When IRA and Owner Invested Into Property Together
The second significant ruling from the Court was that there was no prohibited transaction when the IRA owner and the IRA co-invested into a property together. The property in question was owned 45% by the IRA and 55% by the IRA owner. The Court rejected the bankruptcy Trustee’s argument that such co-investment purchase resulted in a prohibited transaction and stated that the interests appeared to have been treated distinctly and that the HUD documents from the sale of the property show that the IRA and the IRA owner’s proceeds from the sale were treated separately and that they were apportioned properly. As a result, the Court concluded that no prohibited transaction occurred since there was no evidence of un-fair benefit between the IRA owner and his IRA. In its reasoning, the Court referenced DOL Opinion 2000-10A which addressed an IRA and the IRA owner co-investing into a partnership. In the Opinion the DOL states that, “a violation of section 4975 (c)(1)(D) or (E) will not occur merely because the fiduciary [IRA owner] drives some incidental benefit from the transaction involving IRA assets.” The Court referenced this opinion and stated that unless there is evidence of some un-fair benefit that no prohibited transaction occurred merely because of co-investment into the same property.
There are two key take-away’s for self-directed IRA investors from this case.
First, never take compensation or payment from the IRA for services rendered. It is clear that the Courts will find a prohibited transaction if you do and that you will no longer have an IRA.
Second, if you are buying property or others assets (e.g. LLC interests) between your IRA and yourself personally (or another disqualified person) those interests must be carefully calculated and treated such that there is no benefit going unfairly between the IRA and the disqualified person (e.g. IRA owner). In sum, get advice and plan carefully as there are many land-mines you could encounter when investing IRA funds with your own personal funds. Bottom line, it can be done but it can easily be done incorrectly.
The prohibited transaction rules are the most important rules to understand when you self-direct your retirement account. These rules restrict not what investments your retirement plan may acquire but whom your plan may transact with.
How It Happens
A prohibited transaction occurs when a retirement plan (e.g. self directed IRA or 401k) transacts with a disqualified person. IRC § 4975. A transaction is pretty easy to identify and is defined in the code as a sale, lease, exchange, payment, or other transfer of money from a retirement plan. If that transaction is with a disqualified person then the retirement plan has engaged in a prohibited transaction. The consequence of a prohibited transaction for an IRA is distribution of entire IRA while the consequence to a 401(k) or other employer based plan is a 15% excise tax on the amount involved and an additional 100% penalty if the transaction is not corrected. Regardless of the type of retirement account you are self-directing, the consequences are significant. IRC § 4975 (c)(3), IRC § 408 (e)(2)(A). IRC § 4975 (a),(b).
Often times, a disqualified person is generically referred to as a family member. While that definition can be accurate, it really can cause problems when applied as some family members are disqualified (e.g. spouse of plan owner) while others are not (e.g. brother of plan owner). Also, it can be really confusing to determine when a company is disqualified to a retirement plan or when partners are disqualified. Because of the confusion, I’ve created a disqualified person diagram to help sort out the details. If a party is in red, that means they are a disqualified person and that your retirement plan cannot transact with them. If the party is green, that means they are NOT disqualified and your retirement plan may transact with them.
Keep in mind that a self-dealing prohibited transaction can also arise if any disqualified party personally benefits from a retirement plans investments. In summary, you should avoid all transactions with disqualified persons and should seek legal counsel whenever a disqualified person is involved in any retirement plan investment.