By Anthony Diosdi
The growth of 401(k) plans and other defined contribution plans (as opposed to traditional defined pension plans) has generated additional opportunities for employees and retirees to use IRAs. To postpone taxation of the account balance in such a plan, the individual must rollover some or all of the account balance to an IRA or other qualified plan. This has resulted in the growth of “self-directed” IRAs. Since 1974, the IRS has permitted individuals to totally “self-directed” investments made within their IRAs. Self-directed IRAs are held by a trustee or custodian. They permit investment in a broader range of investments than is permitted by traditional IRAs.
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 and jewelry, antiques, and rugs. 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 under the special term under the special rules 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.
One of the most frequent questions we are asked is can stock options be placed in a self-directed IRA, and if not, would the establishment of a LLC holding company cure the defect for the purposes of the “prohibited transaction” rules. We will address these questions in this article. But, before we answer these questions, we will discuss the “prohibited transaction” rules in detail. By the time, we discuss whether or not an owner of a self-directed IRA can hold stock options in the plan or through LLC in the plan, the answer should surprise nobody.
Overview of the Applicable Prohibited Transaction Rules
Internal Revenue Code Section 408(a) provides the technical statutory definition of a “prohibited transaction” with respect to self-directed IRAs. The prohibited transaction rule included in Section 408 of the Internal Revenue Code provides that an IRA loses its status as an IRA if the owner of the account, or the beneficiary of the account, engages in a prohibited transaction with an account. A prohibited transaction committed by an owner or beneficiary essentially “disqualifies” an IRA, and the account is no longer exempt from income tax. The income tax regulations under Internal Revenue Code Section 408 draw a distinction between a prohibited transaction committed by the owner (or beneficiary) of the account and any other person. For this purpose, a ‘prohibited transaction’ is determined under the rules of Internal Revenue Code Section 4975. As noted above, the sanction for a prohibited transaction by the owner or beneficiary of an IRA is disqualification of the account. That is, the IRA is treated as if all of its assets were distributed to its owner as of the first day of the year during which the transaction occurs and the IRA ceased to exist as of that day. The sanctions for a prohibited transaction by another person (defined in Section 4975 as a “disqualified person”) are the excise taxes imposed by Section 4975. The excise taxes are imposed in two tiers. First, there is a tax of 15 percent of the amount involved (generally, the transaction value). Second, if the transaction is not “corrected” (generally, undoing the transaction) there is a tax of 100 percent of the amount involved.
In order for a prohibited transaction to occur, there must be a transaction involving a “disqualified person” with respect to a “plan.” For example, a sale or exchange of assets is among the types of transactions prohibited between the plan and a disqualified person. The Internal Revenue Code defines the term “plan” to include an IRA. The Internal Revenue Code defines “disqualified person,” to include, in part:
1) A fiduciary;
2) A person providing services to the plan;
3) An employer of 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 capital interest or profits interest of a partnership; iii) a 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 descendant;
6) A corporation, partnership, or trust or estate of which is 50 percent or more of the combined voting power of all classes of stock 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 which is owned directly or indirectly by a disqualified person(s);
8) An officer, director, or ten 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, of 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 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 the relationships described in the Internal Revenue Code are found to exist, an entity would not be a disqualified person with respect to a plan.
As noted, the Internal Revenue Code prohibits any direct or indirect sale, or exchange or leasing of any property between a plan and a disqualified person. The Internal Revenue Code also prohibits any direct transfer to, or use by or for the benefit of, a disqualified person the income or assets of a plan in his or her own interest or for his or her own account. The relevant regulations characterize such transactions as involving the use of authority by fiduciaries to cause plans to enter into transactions when those fiduciaries have interests which may affect the exercise of their best judgment as fiduciaries, i.e., a conflict of interest.
For example, a Bankruptcy Court in “In re Williams, 2011 WL 10653865 (Bankr. E.D.Cal.2011)” determined a prohibited transaction under Internal Revenue Code Section 4947 disqualified a “self-directed” IRA where the IRA made payments to the beneficiary for services rendered. The Williams case involved a self-directed IRA that owned real property. Significantly, the Williams court determined that payment by the “self-directed” IRA to the beneficiary for work and services was a prohibited transaction under Internal Revenue Code Section 4975(c)(1)(C). In another case, an individual, who had caused his self-directed IRA to invest a substantial majority of its value in his used car business with the understanding that he would receive compensation for his services as the business’s general manager, engaged in a prohibited transaction with respect to his IRA when he directed his business to pay him a salary.
Department of Labor Guidance Regarding IRAs and Prohibited Transactions
The Department of Labor (the “Department”) is the source of interpretive guidance regarding the prohibited transaction rules. Although IRAs are generally regulated under the tax rules of 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 in a recently issued ERISA Opinion, not all structures pass muster.
ERISA Opinion No. 2006-01A
This letter 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, 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%), Robert Payne’s IRA (31%) and George (20%). The party requesting the letter represented that S Corporation was a disqualified person under 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 “a prohibited transaction occurs when a plan invests in a corporation as part of an arrangement or understanding under which it is expected that the 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.
Mr. Berry may have believed that the prohibited transaction issues would be satisfactorily addressed by structuring the LLC as a real estate operating company (a “REOC”). Under the authority regarding “plan assets” (Labor Regulation Section 2510.3-101), a REOC is a particular type of business entity that is structured so as to not be deemed to hold the assets of a plan investor such as an IRA. If a REOC is properly established, ordinarily a transaction between a REOC and a disqualified person would not be a prohibited transaction because the transaction would not involve the use of plan assets.
Because Mr. Berry “exercises authority or control over its assets and management,” 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 concluded that a lease of property between the LLC and an S Corporation would be a prohibited transaction under Internal Revenue Code Section 4975 as to Berry’s IRA. 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 an S Corporation, the entity that would lease the real property from the REOC. Consequently, in the Department’s view, the investment by Berry’s IRA in the LLC was itself a prohibited transaction.
If properly structured, it is permissible for an IRA to invest along with related parties. ERISA Opinion 2000-10A addressed such a co-investment structure and comparison between the two rulings is instructive. The approach taken in ERISA Opinion 2000-10A yielded an acceptable co-investment opportunity without running afoul of the prohibited transaction rules. In sum, an individual who had an existing interest in an investment partnership wanted his self-directed IRA to co-invest with the partnership.
ERISA Opinion No. 2000-10A
The issue was whether allowing the owner of an IRA to direct the IRA to invest in a limited partnership in which the IRA owner and his relatives are partners would give rise to a prohibited transaction.
The transaction at issue involved a family partnership (the “Partnership”), a general partnership that was an investment club established by Bernie Madoff. Leonard Adler (“Adler”) and some of his relatives were invested in the partnership, both directly and indirectly through another general partnership. Adler planned to open a self-directed IRA for $500,000. At the time he planned to direct the investment, the Partnership would become a limited partnership. Adler would become the only general partner in the Partnership and would own 6.52 percent of the total partnership interests. He 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’ interest in the Partnership. In exchange for its investment, the IRA would own approximately 40 percent of the partnership interests.
The Department’s opinion was that 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. Adler was a disqualified person because of his roles as both the IRA fiduciary and the general partner of the Partnership which held the “plan assets” of the IRA. The investment transaction would be between the Partnership itself and was not a disqualified person. The parties had represented that Adler did not (and will 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 and the Department’s views were expressly based on those representations. The Department observed that, if a conflict of interest between the IRA and the fiduciary arose in the future, there would be the potential for a prohibited transaction violation. The prohibited transactions rules, however, are not violated merely because the fiduciary derives some incidental benefits from a transaction involving IRA assets.
Utilizing an LLC to Hold Stock Options
When determining whether or not an LLC can be used to hold stock options in a self-directed IRA, we must take into consideration Section 4975 of the Internal Revenue Code. The purpose of Section 4975, in large part, is to prevent taxpayers involved in a qualified retirement plan (including self-directed IRAs) from using the plan to engage in transactions for their own account. Under these standards, an owner of an IRA cannot place stock options (vested or unvested) directly into a self-directed IRA. Utilizing an LLC to hold the shares will not likely change the outcome.
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 (“Service’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.
Utilizing an LLC to hold stock options through a self-directed IRA structure is analogous to Peek v. Commissioner discussed above. Thus, the owner of a self-directed IRA cannot hold stock options in a self-directed IRA.
A self-directed IRA is a wonderful tool. The account owner is permitted to invest in numerous illiquid assets. However, a self-directed IRA cannot be used to hold stock options and establishing an LLC will not somehow magically clean such a transaction. Anyone considering utilizing a self-directed IRA should consult with a tax attorney well versed in this area. We have advised many individuals regarding the complex self-directed IRA rules.
Anthony Diosdi is a partner at Diosdi Ching & Liu, LLP. He represents clients in all aspects of tax disputes at the federal, state, and local levels. He has more than 20 years of experience, first as a tax accountant with PricewaterhouseCoopers and then in private practice.
Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or email@example.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.