By Anthony Diosdi
A self-directed retirement plan is a type of structure that allows the holder to transfer tax free funds from a retirement account to acquire real estate. There are a number of rules however that must be followed in order to make such a transaction work. Let’s first start with a basic retirement account. Retirement accounts (such as IRAs and 401K plans) can be created by contribution subject to annual dollar limits or by rollover from a qualified plan. The owner usually cannot take out distributions prior to age 59 ½ without penalty.
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 foreign investments, 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 “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. 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).
If a prohibited transaction is entered into is not correct, the IRS may assess a 100 percent penalty.
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 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 invests 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.
Loans and loan guarantees involving the acquisition of stocks should never be utilized.
Purchasing Real Estate with the Self-Directed IRA
Individuals often utilize self-directed IRAs to acquire real estate. A self-directed IRA can be utilized to acquire real estate. However, there are a number of rules that must be followed. Once a self-directed IRA has been established and the self-dealing rules are understood, the next step is to transfer money from the IRA to a custodian to purchase specific investment property. (The beneficiary of a self-directed IRA cannot live in or utilize the real property acquired by the self-directed IRA). This is typically done through a real estate letter of direction. When purchasing real estate property through a self-directed plan, there are four rules that must be understood.
1. Deed: it is imperative that the purchase is properly titled. This requires an understanding of the state law where the real property is located. Understanding state law regarding titling property held by a self-directed plan can be confusing. For example, Florida has a specific statute that dictates exactly how real estate held by a self-directed plan must be titled. In our practice, we have noticed real property held by self-directed plans titled as “IRA or Retirement Plan Custodian, Inc FBO #16879845.” This does not comply with Florida state law and could have disastrous consequences. Florida Statute Section 689.072 requires that real estate held by self-directed plans to be titled as either, “IRA or Retirement Plan Custodian Inc., as custodian or trustee for the benefit of (name of individual retirement account owner or beneficiary) individual retirement account.”
2. Acquiring Property: when purchasing real property for a self-directed investment plan, the funds required must come directly from the retirement plan.
3. Accounting: any expenses or income associated with the self-directed plan must be originated or remitted to the self-directed plan.
4. Execution of Document: any documents regarding the self-directed account’s real estate must be signed by the custodian of the plan who acts on behalf of the plan.
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 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.
Anthony Diosdi is a tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
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.