Amounts held under individual retirement accounts (“IRAs”) can be a substantial source of retirement income. The growth of 401(k) plans and other defined contribution plans (as opposed to traditional defined benefit pension plans) has generated additional opportunities for employees and retirees to use IRAs. A defined contribution plan may offer a lump sum form of distribution exclusively, and some employers have adopted this design. To postpone taxation of the account balance in such a plan, the retiree (or other terminating employee) must rollover some or all of the account balance to an IRA or other qualified plan. Even if the employer’s plan permitted an employee to maintain an account under the plan post-termination, the employee might prefer the investment options that a self-directed IRA could offer. For all of these reasons, the amounts held in IRAs have become quite substantial. This underscores the importance for IRA owners and beneficiaries to be aware of the restrictions placed on them by the rules regarding prohibited transactions, as that term is used in ERISA and the Internal Revenue Code (the “Code”).
Overview of the Applicable Prohibited Transaction Rules
The prohibited transaction rule included in Section 408 of the 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 the 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 regulations under 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” (a “PT”) is determined under the rules of Section 4975 of the Code. As noted above, the sanction for a PT 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 date. For a traditional IRA, this would impose income tax on the account and perhaps the additional 10% tax for premature distribution. For a Roth IRA, the account would permanently lose its exempt status and perhaps incur early distribution penalties. The sanctions for a PT 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% 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% of the amount involved.
In order for a PT 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 a plan and a disqualified person. The Code defines the term “plan” to include an IRA. The Code defines “disqualified person,” to include, in part:
- A fiduciary;
- A relative of a fiduciary;
- A partnership of which (or in which) 50 percent or more of the capital interest or profits interest of such partnership is owned, directly or indirectly, or held by a fiduciary or a relative of a fiduciary; and
- A corporation of which (or in which) 50 percent or more of the vote or value of the corporation’s stock is owned directly or indirectly, or held by a fiduciary or a relative of a fiduciary.
The Code defines the term “fiduciary,” in part, to include any person who exercises any discretionary authority or discretionary control respecting management of such plan, or exercises any authority or control regarding management or disposition of its assets. Where none of the relationships described in the Code are found to exist, an entity would not be a disqualified person with respect to a plan.
As noted, the Code prohibits any direct or indirect sale, or exchange or leasing, of any property between a plan and a disqualified person. The Code also prohibits any direct or indirect transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan. Moreover, a fiduciary is prohibited from dealing with 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.
The broad scope of the PT rules indicates that any transaction between an IRA and a party related to the IRA’s owner should be evaluated in advance. The severity of the sanction, essentially a death sentence for the IRA, suggests that owners must also be careful regarding any IRA investment which may involve entities that are otherwise related to the owner in some manner. For example, a co-investment by an IRA with parties related to the IRA is an area where care is in order.
Department of Labor Guidance Regarding IRAs and PTs
The Department of Labor (the “Department”) is the source of interpretive guidance regarding the PT rules. Although IRAs are generally regulated under the tax rules of the Code (as outlined above), the Department has been given the authority to issue rulings regarding what constitutes a PT. The Department has a wellestablished 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
A lesson to be gleaned from this opinion is that a prearranged transaction which is contingent upon the investment of an IRA may be a PT. This opinion letter involved an S Corporation that was 68% owned by a married couple (the “Berrys”) as community property and 32% 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). (This representation apparently was based on the fact that the Berrys were the majority owners of S Corporation.)
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 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 PT rules. (Although it was not mentioned in the Opinion, the clear implication is that the Berry IRA would be disqualified as a result of such PT.)
Mr. Berry may have believed that the PT 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 PT 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 S Corporation would be a prohibited transaction under 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 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 PT.
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 PT 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. The pool of assets that would be available in the co-invested entity would be large enough to secure the services of a particular investment adviser.
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 PT.
The transaction at issue involved a family partnership (the “Partnership”), a general partnership that was an investment club. 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% 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 of its investment, the IRA would own approximately 40% 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. (This “plan asset” issue is addressed further below.) The investment transaction would be between the Partnership and the IRA. Adler’s ownership of the Partnership (6.52% directly plus 40% via the IRA) did not constitute a majority interest and therefore the Partnership itself 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 PT violation. The PT rules, however, are not violated merely because the fiduciary derives some incidental benefit from a transaction involving IRA assets.
The Department noted that, by virtue of the contemplated investment by the IRA in the Partnership, there will be “significant investment” in the Partnership by the IRA. Under the Department’s plan asset rules, investment is “significant” if 25% or more of an entity’s interests are held by one or more IRAs or other benefit plan investors. Accordingly, the Partnership will be deemed to hold the assets of the IRA. As a result, any person who exercises discretionary authority or control with respect to assets of the Partnership will be a fiduciary of the IRA and subject to the restrictions of the PT rules. The Department was essentially confirming to Adler that the PT rules would remain relevant to the IRA’s investment in the Partnership on an continuing basis.
The PT 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. 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 PT rules. Co-investment opportunities may present challenges beyond the PT rules. An IRA owner considering a coinvestment opportunity should also be aware that certain investment restrictions may be imposed by the IRA custodian. For example, many IRA custodians will not agree to hold real estate directly under an IRA. Other common restrictions relate to illiquid assets, which would include many limited partnership interests. In evaluating any co-investment opportunity for an IRA, it would be wise to consult with counsel, as well as the IRA custodian, to determine a legally and practically viable approach.