IRA owners who self-direct their IRA’s investments serve in a fiduciary capacity to their IRA and are subject to a variety of restrictions, one of which is that they must not personally benefit from the IRA’s assets (“plan assets”) outside of the IRA. Consequently, IRA owners must understand how the prohibited transaction provisions under the Internal Revenue Code prevent an IRA owner from personally benefiting when dealing with plan assets. Further, an IRA owner must also know when the assets and activities of an IRA-owned business entity itself must be treated as “plan assets” when considering the prohibited transaction provisions under the applicable IRS regulation (i.e., the “Plan Asset Regulation”). We discuss below the different types of prohibited transactions and when the Plan Asset Regulation must be considered.
Prohibited Transactions
IRC Section 4975 imposes a 15% excise tax on the “amount involved” in a prohibited transaction which increases to 100% if not corrected. The excise tax applies to any “disqualified person” who participates in the prohibited transaction. For purposes of each prohibited transaction, the owner of the IRA is considered to be a disqualified person. If an IRA owner engages in a prohibited transaction that is not corrected, the IRA may be disqualified by the IRS—where the entire balance of the IRA will be deemed a non qualified distribution. If the IRA is disqualified, the IRA owner would not be subject to the excise tax.
Unless a statutory or individual exemption applies, the following prohibited transactions will be subject to the excise tax, or may otherwise cause the IRA to be disqualified:
Property Transactions–Any direct or indirect sale or exchange, or leasing, of any property between the IRA and a disqualified person is a prohibited transaction.
Credit Transactions–Any direct or indirect lending of money or other extension of credit between the IRA and a disqualified person is a prohibited transaction. This particular prohibited transaction can be easily missed. For example, where an IRA owner pledges the securities held in his non-IRA account (to a broker) as security for trades/transactions that his IRA account engages in, this will constitute a prohibited extension of credit to the IRA (See Advisory Opinion 2009-03A).
Goods, Services or Facilities–Any direct or indirect furnishing of goods, services, or facilities between the IRA and a disqualified person is a prohibited transaction.
Income or Assets of the IRA–Any direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the IRA is a prohibited transaction.
Self-Dealing–Any direct or indirect act by a disqualified person who is a fiduciary where he/she deals with the income or assets of the IRA in his/her own interest or for his/her own account is a prohibited transaction. For example, the IRA invests in a business owned by the IRA owner allowing the owner to benefit directly from IRA’s investment (i.e., where the IRA owner is paid for services provided to the business owned by his/her IRA).
Receipt of Consideration–Any direct or indirect receipt of any consideration for his/her own personal account by any disqualified person who is a fiduciary from any party dealing with the IRA in connection with a transaction involving the income or assets of the IRA is also a prohibited transaction.
While there are a number of exemptions to the prohibited transactions described above, most are not applicable in the IRA context because of the nature of the IRA and its relationship to the owner. When considering a potential investment opportunity for an IRA, it is important to determine whether the IRA owner will benefit personally from the IRA’s investment. For example, if the IRA purchases real estate and the owner of the IRA receives a sales commission from the sale of property to theIRA, the IRA owner’s receipt of a sales commission is likely a prohibited transaction. If the IRA investment is benefiting the IRA owner personally (versus benefiting the IRA directly), it will likely be considered a prohibited transaction. Any investments by the IRA must benefit the IRA directly, not its owner (i.e., the IRA’s only purpose for investing funds must be to directly increase the value of the IRA itself).
Application of the Plan Asset Regulation
When an IRA invests in a business entity the IRA owner should be aware of the Plan Asset Regulation, as it may require the IRA owner to “look-through” the IRA’s investment in the business entity and treat the assets of that entity as assets of the IRA (the “Look-Through Provision”) when applying the prohibited transaction provisions of ERISA. If the Look-Through Provision applies to the IRA’s investment in the business entity, the entity’s assets are considered to be assets of the IRA. As a result, any activities of the business entity that directly benefit the IRA owner personally (instead of the IRA) may be deemed a prohibited transaction that is subject to the excise tax, or may cause the IRA to be disqualified.
Treasury Regulation Section 2510.3-101 is referred to as the “Plan Asset Regulation” –it defines what is to be considered “plan assets” (i.e., assets of the IRA) when an IRA invests in another business entity (e.g., corporations, limited liability companies, general partnerships, limited partnerships, etc.). Generally, if an IRA invests in a business entity, the IRA’s assets only include its investment and not the underlying assets of the entity. However, there are certain circumstances under the Plan Asset Regulation that require the underlying assets of the business entity itself to be considered the assets of the IRA (i.e., the Look-Through Provision). If the Look-Through Provision applies to the IRA investment in an entity, the operational activity of the entity itself will be considered the “activity” of the IRA for purposes of the prohibited transactions listed above. For example, if the Look-Through Provision applies to a corporation owned by an IRA, the owner of the IRA must determine if any activities of the corporation are benefiting the owner directly (e.g., the entity extends a loan to the owner) versus the IRA—if the entity is engaged in any activity that benefits the owner directly, that transaction or activity will likely be considered a prohibited transaction.
The Look-Through Provision applies to an IRA’s investment in an entity when the IRA owns (or in combination with other IRAs and tax-qualified employee benefit plans owns) 25% or more of any class of equity interests in an entity. For example, if the IRA owns 25% or more of the membership interests of a limited liability company, the assets of the LLC are deemed to be assets of the IRA and the prohibited transaction provisions apply to the LLC’s activities. However, the Plan Asset Regulation will not impose the Look-Through Provision in the following circumstances:
the entity is a publicly traded company;
the investment is in a mutual fund that is registered under the Investment Company Act of 1940;
the entity is an operating company (i.e., the entity is not merely a holding company);
the entity is a real estate operating company; or
the entity is a venture capital operating company.
Conclusion
IRA owners must constantly be aware of how they interact with their IRA, avoiding any instances of personally benefiting from their IRA’s activities and investments. IRA owners must also avoid personally benefiting from any transactions and/or activities of business entities that are owned by their IRA when the Plan Asset Regulation applies.
If you have any questions about these proposed rules, contact one of our attorneys.
© Boutwell Fay LLP 2019, All Rights Reserved.This handout is for information purposes only, and may constitute attorney advertising. It should not be construed as legal advice and does not create an attorney-client relationship. If you have questions or would like our advice with respect to any of this information, please contact us.The information contained in this article is effective as of February 28, 2019.