Should a SDIRA Be Used to Obtain a Portugal Golden Visa?

The Portugal Golden Visa is a unique EU residency-by-investment solution that offers a pathway to Portuguese citizenship without the need to relocate and live in Portugal. The Golden Visa permits Americans, including family members the opportunity to live and work in Portugal. It also offers Americans an opportunity to travel visa-free throughout the Schengen area. In order to secure a Golden Visa, the American must make a 500,000 Euro investment into a qualifying investment fund. A significant number of Americans are considering utilizing a self-directed IRA or (“SDIRA”) to invest into a qualified investment fund. This article discusses the risks of utilizing a SDIRA to obtain a Golden Visa.

An Overview of SDIRA

Since 1974, the Internal Revenue Service (“IRS”) has permitted individuals to totally “self-direct” investments made within their IRAs. Self-directed IRAs are also authorized by federal law and are held by a trustee or custodian that permits investments in a broader range of assets than is permitted by traditional IRAs. See Levine v. Entrust Grp, Inc, 2012 WL 6087399 (N.D. Dec. 6, 2012).  Although a SDIRA allows individuals to invest in numerous illiquid assets, investments in some assets are prohibited. These include, but may not be limited to, collectibles, including artwork, stamps, jewelry, antiques, and rugs. Investments in life insurance are also prohibited. In addition, an individual cannot use an IRA to invest in real estate that he or she will personally use. See IRC Section 408.

A key term governing SDIRAs is “prohibited transactions.” If a self-directed IRA engages in a “prohibited transaction,” the “self-directed” IRA will lose its tax exempt status. Because of the importance of the “prohibited transaction” concept, individuals need to identify a prohibited transaction. Internal Revenue Code Section 408(a) provides the technical statutory definition of a “prohibited transaction” with respect to self-directed IRAs. For this purpose, a “prohibited transaction” is determined under the rules of Section 4975 of the Internal Revenue Code. The sanction for a prohibited transaction is the disqualification of the tax exempt status of the IRA account. In the event of a prohibited transaction, for income tax recognition purposes, the IRS will treat all the assets of the IRA as being distributed to its owner as of the first day of the year in which the transaction occurs. In many cases, the IRS will assess an additional 10 percent tax for premature distribution. In addition, the IRS could assess a number of additional significant penalties.

In order for a prohibited transaction to occur, there must be a transaction involving a “disqualified person” with respect to the “plan.” A “disqualified person” includes: 1) a fiduciary; 2) a person providing services to the plan; 3) an employer any of whose employees are covered by the plan; 4) an owner, direct or indirect of 50 percent or more of: i) the combined voting power of all classes of stock entitled to vote or the total value of the shares of all classes of a corporation; ii) the beneficial interest of a trust or unincorporated enterprise which is an employer or an employee organization; 5) a member of the family including spouse, ancestor, lineal descendant and any spouse of a lineal descent; 6) a corporation, partnership, or trust or estate of which is 50 percent or more of the combined voting power of all classes entitled to vote of the total value of the shares of all classes of stock of such corporation; 7) the beneficial interest of such trust or estate or owned directly or indirectly or held by persons; 8) an officer, director, a 10 percent or more shareholder or a highly compensated employee. See IRC Section 4975(e).

A “prohibited transaction” with respect to a self-directed IRA includes:

1. sale or exchange, or leasing, or any property between a plan and a disqualified person;
2. lending of money or other extension of credit between a plan and a disqualified person;
3. furnishing of goods, services, or facilities between a plan and a disqualified person;
4. transfer to, or use by or for the benefit of, a disqualified person the income or assets of a plan.
5. act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own interests or his own account; or
6. receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

The Internal Revenue Code defines the term “fiduciary,” in part, to include any person who exercises any discretionary authority or discretionary control respecting management of such a plan, or exercises any authority or control regarding management or disposition of its assets. Where none of these relationships described in the Internal Revenue Code are found to exist, an entity would not be a disqualified person with respect to a plan.

A prohibited transaction is not limited to transactions with disqualified persons. A prohibited transaction can also take place self-dealing. Self-dealing happens when an IRA owner uses a SDIRA to obtain a personal benefit. Common examples of personal benefits are: 1) an owner of a SDIRA borrowing money from a SDIRA, 2) an owner of a SDIRA buying SDIRA property; 3) an owner of a SDIRA performing work on behalf of the SDIRA; and 4) a SDIRA owner paying personal expenses from an SDIRA account.

The broad scope of the prohibited transaction rules indicate that transactions between an IRA and a party related to the IRA’s owner should be evaluated in advance. When evaluating self-directed IRA transactions, the Department of Labor (the “Department”) is a good source of interpretive guidance regarding the prohibited transaction rules. Although IRAs are generally regulated by the Internal Revenue Code, the Department has been given the authority to issue rulings regarding what constitutes a prohibited transaction. The Department has a well established position that the investment by a plan in a company does not preclude the company from engaging in a transaction with a disqualified person with respect to the plan. Based on this authority, a co-investment by an IRA and parties related to the IRA is not per se prohibited. However, as demonstrated by the below opinion, not all co-investment structures will be upheld.

ERISA Opinion No. 2006-01A

This opinion involved an S Corporation that was 68 percent owned by a married couple (the “Berrys”) as community property and 32 percent owned by a third party named George. Mr. Berry proposed to create a limited liability company (“LLC”) that would purchase land, buy a warehouse and lease the real property to the S Corporation. The investors in the LLC would be Mr. Berry’s IRA (49 percent), Robert Payne’s IRA (31 percent) and George (20 percent). The party requesting the letter stated that the S Corporation was a disqualified person under Internal Revenue Code Section 4975(e)(2).

The Department cited Labor Regulation Section 2509.75-2(c) and ERISA Opinion No. 75-103 for the proposition that “a prohibited transaction occurs when a plan invested in a corporation will engage in a transaction with a party in interest (or disqualified person).” Based on that authority, the Department reasoned that since Berry’s IRA invested in the LLC with the understanding that the LLC would lease its assets to the S Corporation (a disqualified person), the lease would be a prohibited transaction and Berry, as a fiduciary, would be in violation of the prohibited transaction rules.

Because Mr. Berry exercises authority or control over its assets and management of his IRA, the Department determined that Mr. Berry was a fiduciary to his own IRA, and as such, a disqualified person with respect to his IRA. The Department determined that a lease of property between the LLC and an S Corporation would be a prohibited transaction under Internal Revenue Code Section 4975. As indicated in the Opinion, the Department perceived a problem in the decision to establish the LLC as both a vehicle for IRA investment and as a lessor of real property to the S Corporation. Mr. Berry was the IRA owner and also the majority owner of the S Corporation. Thus, the investment by Berry’s IRA in the LLC was itself a prohibited transaction.

ERISA Opinion No. 2000-10A

The transaction at issue involved a family partnership (the “Partnership”), a general partnership that was an investment club (known as Madoff Investment Securities ) established by Bernie Madoff. Leonard Adler (“Adler”) and some of his relatives invested directly and indirectly in the Partnership. This was done through another general partnership. Adler planned to open a self-directed IRA for $500,000. At the time he planned to direct the investment and the Partnership would become a limited partnership. According to the plan, Adler would become the only general partner in the Partnership and he would own 6.52 percent of the total partnership interests. However, Adler would not have any investment management functions. Rather, a registered investment advisor, Madoff Investment Securities, would be retained to select investments for the Partnership’s assets. None of the funds contributed by the IRA would be used to liquidate or redeem any of the other partners’ interests in the Partnership. In exchange for its investment, the IRA would own approximately 40 percent of the partnership interests.

According to the opinion issued by the Department, the IRA’s purchase of an interest in the Partnership would not be a prohibited transaction. The Department acknowledged that the IRA was a “plan” and that Adler was a fiduciary. While Adler was a disqualified person because of his roles as both the IRA fiduciary and the general partner of the Partnership, the investment transaction was to be between the Partnership and the IRA. Furthermore, Adler’s ownership interest, both direct and indirectly, (6.52 percent directly plus 40 percent via the IRA) did not constitute a majority interest. Thus, in this particular case, the Partnership itself was not a disqualified person. The Department stated that the parties claimed that Adler did not (and would not) receive any compensation from the Partnership and had not (and will not) receive any compensation due to the IRA’s investment in the Partnership. Consequently, In the Department’s view, this particular transaction was not prohibited. However, the Department reserved the right to reclassify future transactions between the parties if a conflict of interest between the IRA and the fiduciary arose in the future. What can be taken away from the Department’s opinion is the prohibited transaction rules are not violated merely because a fiduciary derives some incidental benefit from a transaction involving IRA assets.

Stocks and Self-Directed IRA

Individuals often want to place stocks in a self-directed IRA to defer the tax consequences. Individuals may consider utilizing financing transactions involving a self-directed IRA to acquire stocks.

For example, in Peek v. Commissioner 140 TC 12, the Peeks founded FP Corp and directed their new IRAs to use rollover cash to purchase 100 percent of FP Corporation’s newly issued stock. The Peeks used FP Corporation to acquire the assets of AFS Corporation. They personally guaranteed the loans to FP Corporation that arose out of the asset acquisition. The Internal Revenue Service or (IRS’s) position was that the personal guarantees of the FP Corporate notes were prohibited transactions under Section 4975(c) as a direct or indirect lending of money or other extension of credit between a plan, i.e., the IRA, and disqualified persons, i.e., the Peeks. The Peeks countered that the personal guarantees were not prohibited transactions because they did not involve the IRA, whereas a prohibited transaction involved the plan.

The United States Tax Court held that the loan guarantees were prohibited transactions. The court cited the Supreme Court’s observation in Keystone Consolidated Industries, Inc, 508 U.S. 152 (1993) that when Congress used the phrase ‘any direct or indirect’ in Section 4975(c)(1), it employed ‘broad language’ and showed an obvious intent to ‘prohibit something more than would be valid without it; if the provision prohibited only loan or loan guaranty between disqualified person and plan itself, then prohibition could easily and abusively avoided simply by having an IRA create shell subsidiary to whom the disqualified person could then loan funds, which was an obvious evasion that Congress intended to prevent by using the word indirect.

Exclusive Benefit Rule

Anyone utilizing an SDIRA for investment purposes must understand the exclusive benefit rule. The exclusive benefit rule states that an IRA arrangement must be set up and maintained solely for the benefit of the account holder and its beneficiaries. However, the IRA beneficiary cannot take a personal or financial advantage from an IRA transaction. A violation of the exclusive benefit rule triggers a prohibited transaction and results in the entire IRA being distributed to the account holder on January 1st of the year the improper transaction had taken place.

The exclusive benefit rule brings us to the first major consideration for SDIRA owners that use IRA funds to obtain a Portugal Golden Visa. The use of SDIRA funds will ultimately result in the SDIRA owner obtaining a personal benefit in the form of EU residency or citizenship as the result of the investment. Although there are no cases, IRS or Department of Labor rulings addressing the question if obtaining EU residency or citizenship as the result of a SDIRA in a Golden Visa program violates the exclusive benefit rule or is a prohibited transaction, given the SDIRA owner obtains a benefit as the result of the SDIRA investment, there is a significant possibility that possibility that a SDIRA investment in a Portugal Golden Visa could result in the termination of the SDIRA tax exempt status. It can also trigger a number of penalties.

The Investment in a Qualified Investment Fund Can Trigger the Punitive PFIC Tax Regime

Under Portugal’s immigration laws, the individual seeking to immigrate to Portugal must directly invest in the qualified investment fund. This typically means the SDIRA establishes an entity in Portugal such as a Bosque Portuguese Lda in his or her own name. The SDIRA owner will typically use a U.S. checkbook LLC to fund the Bosque Portuguese Lda which will invest in the qualified fund. This type of structure is not only concerning from a disqualified transaction point of view, but unknown to most SDIRA owners in many if not all cases, the Portuguese qualified investment fund is taxed under the Passive Foreign Investment Company (“PFIC”) tax regime. Under the so-called PFIC “default method,” gains and “excess distributions” are taxed at the highest marginal income tax rate of the year (currently 37 percent) and the Internal Revenue Code often assesses an interest charge on gains and dividends. The PFIC tax regime is often considered one of the punitive provisions in the Internal Revenue Code. Since an SDIRA investor is directly holding the qualified investment fund through a Portuguese entity instead of holding the qualified investment fund through a tax-exempt IRA, the IRS could attempt to assess a PFIC tax on the SDIRA owner directly. In addition, by holding the qualified investment fund directly through a Portuguese company, the SDIRA may have a number of international informational filing requirements with the IRS such as the annual filing of Form 8938, FinCen 114, and possibly Form 5471. The penalties associated with failing to timely international information returns with the IRS are very steep.

Conclusion

The foregoing discussion is intended to provide a basic understanding of the basic understanding of the Portugal Golden Visa program and hazards of utilizing an SDIRA to obtain a Golden Visa. Anyone considering obtaining a Portugal Golden Visa or utilizing a SDIRA to obtain a Golden Visa could easily have his or her entire SDIRA investment lost through excess taxes and penalties. As a result, any considering obtaining a Golden Visa should consult with a qualified international tax attorney before attempting to obtain the Golden Visa. Individuals that have started the Golden Visa process should also consult with a qualified international tax attorney to determine if options are available to mitigate U.S. tax and potential penalties associated with the investment.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is a frequent author and speaker on international tax topics.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.