Something Old, Something New … Self-Directed IRA Planning in the 21st Century

Since 1974, the IRS has permitted individuals to totally “self-direct” investments made within their Individual Retirement Plans (“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). Self-directed IRAs allow individuals and small companies to invest in asset classes that are often deemed illiquid. These include but are not limited to tax lien certificates, real estate, livestock, and private companies. Hence, self-directed IRAs allow individuals who prefer to leverage their personal expertise in their investment to do so.

Although a self-directed IRA 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.

Overview of the Applicable Prohibited Transaction Rules

A key term governing self-directed IRAs 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 an additional 20 percent tax under Internal Revenue Code Section 6662. (The Internal Revenue Code imposes an additional tax of 20 percent on the portion of an underpayment attributed to: 1) negligence of federal tax law and 2) a substantial understatement of income tax.

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.

The broad scope of the prohibited transaction rules indicates 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 invests in a corporation that 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 indirect (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 that the prohibited transaction rules are not violated merely because a fiduciary derives some incidental benefit from a transaction involving IRA assets.

Self-Directed IRAs and Checkbook Control

A number of self-directed IRAs utilize a concept known as checkbook control. This involves the use of an LLC to give an IRA holder so-called checkbook control over the IRS’s account assets. In such situations, a self-directed IRA purchases a majority interest in the outstanding units of an LLC for which the self-directed IRA account holder serves as a general manager and has authority to act on behalf of the LLC. Checkbook control may seem like a great operating idea for the holders of a self-directed IRA because it provides them with access to IRA funds. Self-directed IRA account holders use checkbook control to gain direct and rapid control over the IRA’s investments. Checkbook control bypasses typical custodian approval, which may offer greater flexibility in selecting investments. However, the use of checkbook control by any self-directed IRA holder can be risky. If a self-directed IRA account holder personally receives money or assets from the LLC as a result of checkbook control, receipt of any money or assets from the IRA will likely be treated as a prohibited transaction.

How to Correct a Prohibited Transaction

The Internal Revenue Code or its regulations do not provide instructions. Thus, if a self-directed IRA account holder has committed a prohibited transaction, there is no “curing” process recognized by the Internal Revenue Service (“IRS”). The applicable provisions of the Internal Revenue Code, the IRA is disqualified retroactively as of the beginning of the year in which the violation has occurred. This would result in the entire account balance becoming a taxable distribution. However, it may be possible to mitigate the tax consequences of a prohibited transaction by “undoing” the prohibited transaction as soon as possible. For self-directed IRA account holders, correcting the violation will not necessarily prevent the disqualification of the IRA. However, correcting the prohibited transaction may reduce the penalties associated with the transaction.

The exact “curing” process to correct a prohibited transaction depends on the type of violation. Below are a couple of examples of prohibited transactions and the steps that can be taken by the self-directed IRA account holder to correct the transaction.

If an IRA account holder transferred property held by the IRA to himself, the asset should immediately be returned to the IRA. Any profits or gains realized as a result of the transaction should also immediately be returned to the IRA.

If an IRA account holder made an improper loan to a disqualified person. The loan proceeds should be immediately returned to the IRA.

If an IRA asset is used for personal use such as the impermissible use of real estate held by the IRA, the personal use of the real estate must stop immediately and the fair market rental value of the real estate must be paid to the IRA.

How to Properly Transfer Property from a Self-Directed IRA

Investors often utilize self-directed IRAs to acquire real estate or invest in companies (such as corporations). Eventually, property held by the self-directed IRA will need to be transferred to the IRA account holder. To move an asset out of a self-directed IRA, the account holder can either transfer the asset directly to another self-directed IRA custodian in a tax-free exchange. The most common methods of tax-free exchange involve a trustee-to-trustee transfer and a direct rollover. In cases in which a self-directed IRA account holder seeks to make a distribution from the IRA, the following Steps should be followed by self-directed IRA account holders when transferring property (whether it be real estate or a business) to account holders.

1. Obtain an Appraisal of the Property or Asset Transferred from the IRA

Any property or assets held by a self-directed IRA that will be transferred out of the IRA must be appraised. The IRA cannot provide an appraisal. An appraisal of assets transferred from a self-directed IRA can only be provided by a qualified independent appraiser. If the IRA is transferring a business, the appraisal should satisfy Internal Revenue Manual 2.3.1. This rule discusses factors a valuator must obtain and analyze when valuing a business. According to the Internal Revenue Manual 2.3.1, a valuator should consider the following:

1. The nature of the business and the history of the enterprise from its inception. See IRM 2.3.1.1.

2. The economic outlook in general and the condition and outlook of the specific industry in particular. See IRM 2.3.1.2.

3. The book value of the stock or the interest and financial condition of the business. See IRM 2.3.1.2

4. The earning capacity of the company. See IRM 2.3.1.3.

5. The dividend-paying capacity. See IRM 2.3.1.4.

6. Whether or not the enterprise has goodwill or other intangible value. See IRM 2.3.1.5.

7. Sales of the stock or interest and the size of the block of stock to be valued. See IRM 2.3.1.6.

8. The market price of stocks or interests of corporations or entities engaged in the same or similar line of business having their stocks or interests actively traded in a free and open market, either on an exchange or over-the-counter. See IRM 2.3.1.7

9. Other information deemed to be relevant. See IRM 2.31.8.

2. Submit the Appraisal to the Custodian of the IRA

Once an appraisal is obtained, the appraisal should be provided to the self-directed IRA custodian.

3. Request Non-Cash Withdrawal

The custodian of the IRA should be advised that the IRA account holder is seeking a non-cash withdrawal of property from the IRA.

4. Transfer of Title

If real property is transferred from the self-directed IRA, the transfer of ownership of the real property from the self-directed IRA to the IRA account holder should be recorded with the proper county recorder’s office.

5. Form 1099

After the property is transferred from the IRA to the IRA account holder, the IRA should issue the account holder a Form 1099 to reflect the value of the property transferred for tax purposes.

Conclusion

An investor may utilize his or her IRA to hold a number of investments. However, the prohibited transaction rules must be an important consideration in evaluating any transaction to be undertaken by an IRA that involves a party related to the IRA owner (Such as a person of ascending or descending lineage, including his or her spouse). Depending upon the circumstances and the relationships among the parties, a co-investment by an IRA and parties related to the IRA may not run afoul of the prohibited transaction rules. In evaluating any self-directed IRA, an investor should consult with counsel who has a detailed understanding of the prohibited transaction rules as defined in ERISA and the Internal Revenue Code.

The tax attorneys at Diosdi & Liu, LLP represent clients in a wide variety of domestic and international tax planning and tax controversy cases.

Anthony Diosdi is a partner and attorney at Diosdi & Liu, LLP, located in San Francisco, California. Diosdi & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.