Self-Directed IRAs, the DOL Fiduciary Rule, and Private Investment Denials

The so-called “DOL Fiduciary Rule” went into effect in June and has caused negative repercussions on self-directed retirement account investors who self-directed their IRA, 401(k), or pension into alternative investments. Many self-directed investors have been shut out from investing into private offerings – real estate funds, private placements, start-ups, private REITs, etc. – as investment sponsors or private companies raising funds fear that, by accepting the self-directed retirement account’s investment, they will be labeled a “fiduciary” and will need to adhere to fiduciary rules really meant for investment advisers.

What is a Fiduciary?

The Department of Labor (“DOL”) recently expanded the definition of who a “fiduciary” is to include any person or entity who renders “investment advice” for a fee or other compensation. The fee doesn’t need to be from the compensation itself, but just has to flow from the investment. Here’s the problem: If you run a private fund, start-up, or a real estate partnership, and you take investment dollars from a retirement account, then the DOL definition may include you as a fiduciary since your investment documents will likely contain information that would be considered “investment advice.” And, since you will indirectly receiving compensation as a part of management of the fund or start-up, then you are indirectly receiving a fee for providing investment advice and may consequently be deemed a fiduciary.

Fiduciary Rule Repercussions

Most investment sponsors dread being labelled a fiduciary as they are placed with very high legal standards including as the duty of prudence, the duty of loyalty, and they have to avoid self-dealing prohibited transactions that may arise if they are receiving any compensation that isn’t found to be “reasonable”. In short, application of the fiduciary rule makes them re-align the company’s or management’s interests to be in the best interest of the invested retirement account. While this sounds like a good deal for the retirement account investor – and it is – it puts the interests of management at odds with the retirement account, and creates significant liability to management if they accept retirement plan dollars when they are a fiduciary.

The fiduciary rule was primarily intended to apply to an adviser advising a client so that the investment adviser recommended investments in the best interest of the client, not just the highest paying commission for the adviser. Although that makes sense, the new definition is so broad that it also could apply to the company raising funds from a self-directed IRA or 401(k), and force those companies to reject investment dollars from self-directed IRAs and 401(k)s.

Exceptions

There are two exceptions to the Fiduciary Rule that will allow a self-directed retirement account to invest into a private investment offering: Independent Fiduciaries and Best Interest Contract Exemption.

Independent Fiduciary

If the self-directed retirement account investor has an independent fiduciary, then that fiduciary is responsible for their investment advice and the offering company won’t be deemed a fiduciary. An independent fiduciary would include a registered investment adviser or a broker-dealer. Consequently, if a self-directed IRA investor had an investment adviser who reviewed the investment, then the offering company would likely not be deemed a fiduciary for this investment. I’ve seen numerous companies starting to require this for all retirement account investments. For those clients who already use an investment adviser, this is easier to comply with. But, most self-directed investors do not use an adviser, and as a result would need to spend money to engage one for the purposes of reviewing the investment just so they could qualify to invest.

Best Interest Contract Exemption (BICE)

The second exemption is the best interest contract exemption, otherwise known as “BICE.” BICE provides that a person is exempt from the fiduciary rule, but has lengthy requirements that really won’t work for an investment sponsor or someone raising private capital from an IRA. Based on the requirements, it will really only work for advisers or insurance companies offering financial products.

What to Do Moving Forward?

Many private investment offerings are not restricting self-directed accounts yet. They are either agreeing that they are fiduciaries and are taking that into account their company’s operations or they are taking the legal position that the fiduciary rule doesn’t apply to them, which may be correct as the law is new and still unclear. However, if you end up being restricted from investing your self-directed IRA or 401(k) into a private investment because the offering company is worried about the fiduciary rule, you may choose to rely on the Independent Fiduciary exemption and could engage an investment adviser – if you don’t already have one – to review this investment and serve as the fiduciary for the investment.

Self-Directed IRA Valuations: Why Does My Self-Directed IRA Custodian Ask for a Valuation Update Every Year?

If you have a self-directed IRA with non-publicly traded assets like real estate, private stock, or an LLC interest, you’ve definitely been asked for an annual fair market valuation for the assets in your account. Why does your IRA custodian ask for this every year? Because they have to.

An IRA must report its fair market value to the IRS annually. Fair market value is reported to the IRS by your IRA custodian via IRS Form 5498. For standard IRAs holding stocks or mutual funds, those account values are automatically determined as they simply take the stock or fund price as of the close of the market on December 31st each year, and they use these amounts to set the year-end account fair market value. For self-directed accounts, such fair market values are not readily available and it becomes the IRA account owner’s responsibility to obtain their self-directed investment values so that their custodian can properly report the account’s fair market value. The value of an account is important for a few reasons. First, the IRS requires it to be updated annually. Second, it is used to set required minimum distributions (“RMDs”) for those account holders over the age of 70 ½ with traditional IRAs. Lastly, the account value is used when converting an entire account, or a particular investment or portion of the account, from a traditional IRA to a Roth IRA.

WHAT IS FAIR MARKET VALUE

Fair market value of an investment has been broadly defined by the Court as:

“The price at which property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.” U.S. v. Cartwright, 411 US 546 (1973).

Now here’s the hard part: Even though the IRS requires IRAs to update their fair market value on an annual basis, the Government Accountability Office noted in their recent report that:

“Current IRS guidance includes NO [emphasis added] guidance or advice to custodians or IRA owners regarding how to determine the FMV [fair market value]”. United States Government Accountability Office, GAO-17-02, Retirement Security Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets. (Dec. 2016).

The absence of guidance, however, has not relieved IRA owners or their custodians from obtaining and reporting this information. While there is no specific fair market valuation guidance for IRAs, there are commonly accepted methods of reporting value used by professionals and companies within the self-directed IRA industry. Most of these methods have been adopted from law and regulations governing employer retirement plans or estates.

METHODS TO BE USED BY ASSET TYPE

The table below outlines preferred valuation methods that are commonly used in the industry for the most common self-directed IRA assets. As you will note, when the valuation is needed for a taxable event, such as a distribution or Roth conversion, greater detail and supporting information will be required as the valuation will result in tax being due.*

AssetNon-Taxable (Annual FMV)Taxable (RMD, distribution or conversion)
Real EstateComparative Market Analysis (CMA) from a real estate professional is preferred. Some IRA custodians accept property tax assessor values or Zillow reports in non-taxable situations.Real estate appraisal is preferred. Some IRA custodians accept a broker’s price opinion.
Promissory NoteValue of a note can be reported by calculating the principal due plus any accrued and unpaid interest. This is the valuation method used for calculating the value of a note for estate tax purposes.Same as non-taxable, principal amount due plus accrued and un-paid interest. For notes in default, a third-party opinion as to value is typically required in order for the note to be written-down below face value.
Precious MetalsFor bullion, use the spot value of the metal in question times the ounces owned. Spot value is widely reported on a daily basis on financial sites.

For acceptable coins, use market data for the coin in question via the Grey Sheets available at www.bullionvalues.com.

Same as non-taxable.
LLC, LP, or Private Company InterestObtain a third party-opinion of value of the LLC interest. The opinion should rely on IRS Revenue Ruling 59-60. For asset holding companies, the valuation should focus on the value of the assets. For operating companies, the valuation should focus on earnings.Similar requirement, but the detail of the opinion should be more significant. For example, for an asset holding company where the IRAs interest is determined by the assets of the LLC. A CMA would be acceptable for calculating that assets value in the company in an annual valuation. However, an appraisal of the real estate to calculate in that asset would be required in a taxable situation.

Since the valuation reporting policies of custodians vary, IRA owners should make sure that they understand their IRA custodian’s policies for valuations for the assets in question.

Our firm routinely assists clients with obtaining third-party opinions of value and can assist IRA owners who need to produce a report or third party opinion as to an LLC or other investment interest held by an IRA.

* Please note that there are clearly differences of opinions on these matters, and since there is no specific legal guidance for IRA valuations, please keep in mind that the table above is based on my own industry experience and opinions. Seek a licensed professional in all instances for your specific situation.

GAO Report on Self-Directed IRAs Concludes IRS Lacking in Three Key Areas

image4280The 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:

  1. 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.
  1. 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.
  1. 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.

3 Year-End IRA Tips

vgsgn1482893180It’s the end of the year and many IRA investors are stressing about what they need to do by December 31, 2016. Here’s what you need to know for your IRA as it relates to year-end.

1. 2016 Contribution Deadline. First, the good news. You don’t have to make your 2016 contributions by year-end. You have until April 18, 2017 to make your traditional IRA, Roth IRA, or SEP IRA contributions for 2016. Check out the “IRS Year-End Reminders for IRAs” here for more details.

2. Roth Conversions. If you are planning to convert traditional IRA dollars to Roth for 2016, then you must make that conversion by December 31, 2016. If you convert in 2016 (by 12/31/16), then the amount you convert will get reported on your 2016 tax return. For those that have a down year or that simply want to start down the path of moving funds from traditional (tax-deferred funds) to Roth (tax-free), you’ve got to jump on this now. Your IRA custodian will typically have a Roth Conversion form that you complete and return to them. If you are converting cash, then the process is pretty simple as the value of the conversion is the cash amount. If you have a self-directed asset such as real estate or an LLC interest, you will need an appraisal or valuation of that asset in order to convert it to Roth. And lastly, if you’re on the fence about doing a Roth conversion because you’re worried about how much it will cause you in taxes, the IRS allows you to un-do the Roth conversion later in 2017, your funds go back to traditional funds, and you don’t have to pay the tax. This is one of the few things the IRS let’s you un-wind. Check out my prior article on Roth re-characterizations here.

3. The Over 70 1/2 Club. For those over 70 1/2 with traditional IRAs, you are required to take required minimum distributions (“RMD”) from your account each year. The deadline for 2016 RMDs is December 31, 2016. There is a 50% excise tax penalty for failure to take RMDs. In other words, if you don’t distribute the money to yourself from your IRA in time, the IRS will just take half of it to penalize you. Those with Roth IRAs need not worry as Roth IRAs are exempt from RMD. I’ve explained the facts and fiction on RMDs in a prior article you can find here.

So, if you’ve got a Roth conversion or RMD to take for 2016, you better get your “IRA” in gear. If you’re wondering about IRA contributions, don’t worry, you’ve got until April 18, 2017 to make them.

Self Directed IRAs, Prohibited Transactions, and the IRS Statute of Limitations: Thiessen v. Commissioner

SDIRA Prohibited TransactionIn the recent case of Thiessen v. Commissioner, 146 T.C. No. 7 (2016)the Tax Court considered how long the IRS has to allege a prohibited transaction against an IRA. In general, the IRS must allege a prohibited transaction against your IRA within three years after the return is filed. IRC 6501(a). However, that time-period may be extended another three years for a total of six years pursuant to IRC 6501(e)(1) when the taxpayer fails to report an amount that is in excess of 25% of the gross income stated in the return. For prohibited transaction rule violations, a failure to report occurs when you don’t disclose the prohibited transaction to the IRS or when you fail to claim the distribution that occurs from a prohibited transaction on your personal tax return. A prohibited transaction could be disclosed to the IRS though attachments to the return or other correspondence but the Tax Court first looks to see what was reported to the IRS on the IRA owner’s personal 1040 tax return for the years in question. In other words, if you don’t volunteer clear information of a prohibited transaction to the IRS then the limitation period can be extended up to a total of six years so long as the prohibited transaction would result in an gross income in excess of 25% of the taxpayer’s personal return. Note: IRS Form 5329 is used to declare a prohibited transaction on your personal return.

There are a few very important takeaways from the Tax Court’s ruling in Thiessen and from the IRS Internal Revenue Manual on Prohibited Transactions.

STATUTE OF LIMITATION TIPS

PRACTICAL THREE YEAR PERIOD

 

According to the IRS Agent Manual, Internal Revenue Manual, 4.72.11.6, IRS agents are instructed and trained to only review for prohibited transactions within a three-year window. In order to pursue a prohibited transaction past three years, an agent must receive approval from IRS Area Counsel. So, for practical purposes, the IRS is examining prohibited transactions within a three-year window.
FAILURE TO DISCLOSE SIX YEAR PERIOD

 

As had occurred in Thiessen, if any IRA owner fails to disclose a prohibited transaction to the IRS, the IRS may pursue a prohibited transaction for up to six years. This six-year clock runs six years after you filed your return in question. So, if you filed a 2010 personal return on April 15, 2011, and if the return did not include disclosure of a prohibited transaction, the IRS could pursue a prohibited transaction up until April 15, 2017. Keep in mind, this failure to report though must be a prohibited transaction that exceeds 25% of the gross income of the taxpayer for the year in question.

A final word to note is that the IRS may pursue prohibited transactions past six years and into an indefinite time-period when the prohibited transaction was fraudulent or a willful attempt to evade tax. IRC 6501(c)(1),(2),(3). I’m not aware of cases in this situation, nevertheless, don’t expect to be in safe waters if you fraudulently entered into a prohibited transaction as the statute of limitations never runs in those situations.