I. Due Diligence:
Many people are unaware that it is perfectly legal for Retirement Plans (e.g. Individual Retirement Plans – IRAs) to purchase non-traditional investments, such as real estate, commercial paper, private companies and promissory notes among others.
The only reason that investors remain unaware of this fact is that most IRA Custodians (by policy but not by law) allow only investments that produce commission for them; generally trades in public stocks and funds.
A brokerage firm subsisting on commissions doesn’t sustain itself if they allow real estate or other longer term private investments. As such, they either refuse to tell their clients of the possibilities of non-traditional investments, or they don’t know about it at all.
Most of our clients elect to use a private Limited Liability Company (LLC) wholly owned by the IRA and managed usually by the client (IRA owner). For most of our clients, the investments are straightforward and we always counsel them on the prohibited transactions Code and other relevant regulations.
The IRS Code does not explain what a plan may invest in; it only outlines what a plan may not invest in. Consequently, our attorneys have put a lot of time into thoroughly understanding the Internal Revenue Codes and Regulations affecting your facilitation of client retirement plans into non-traditional investments.
On February 20, 2004 I met with a representative of the Dept. of Labor, Office of Exemption Determinations, in Washington D.C. Our procedures and understanding of relevant Code sections and IRS/Dept. of Labor regulations were verified as accurate by a Pension Law Specialist with 28 years total service in both the Internal Revenue Service (IRS) and the Department of Labor (DOL).
Our procedures have also been verified by a legal opinion from a Certified Public Accountant who also is licensed as an independent attorney holding a Master of Laws in Taxation (LL.M).
We at IRAAA are confident that our basic structure (e.g. an LLC owned 100% by an IRA which is managed by the IRA owner) meets relevant laws and regulations.
In addition, there are often more complicated situations that arise where the law may be unclear. In these situations we have researched law and regulations, researched published opinions and exemptions and submitted written requests for General information that will obtain a written reply from the appropriate government Agency or Agencies.
Finally, where a client’s specific situation is not clearly addressed in the law, we recommend that we obtain a written Letter ruling or Exemption as required by the appropriate Agency. Our clients can be confident that we have undertaken due diligence to verify its processes, procedures and recommendations. In this Memorandum, the relevant Internal Revenue Code sections or other citations are placed as end notes for easier reading and ultimate verification.
II. Congressional Laws, Agencies and their Relationship:
The substantial legal authority supporting our basic products – discussed in greater detail below – is derived from separate independent sources of legal authority. In an effort to be concise, we do not explicitly address certain general areas of tax treatment.
For example, tax-free rollovers, have been in common practice for in excess of a decade. Where the terms of the trustee-to-trustee transfer are satisfied and the Custodian of the new IRA is an IRS approved Custodian, the tax free nature of the transfer will generally be respected. In addition, the capital contribution to a newly formed LLC is also tax free.
The Internal Revenue Service (IRS) is the Agency that carries out the Internal Revenue Code (IRC), Title 26 of the United States Code. The Agency also creates regulations as a means of carrying out or interpreting various Code sections. These are called the “Code of Federal Regulations” or “CFRs.”
Finally, the Agency issues Letter Rulings, Advisory Opinions and other publications that allow taxpayers a more detailed version of the applicability of Regulations and Code Sections. The IRS has carefully outlined in both Code and regulation what a retirement plan may not do. Thus, the IRS has jurisdiction over whether a particular transaction violates the IRC.
However, under Presidential Reorganization Plan No. 4 of 1978, effective December 31, 1978, the authority of the Secretary of the Treasury (IRS) to issue interpretations regarding section 4975 of the Code (prohibited transactions) has been transferred to the Secretary of Labor (DOL) and the Secretary of the Treasury is bound by the interpretations of the Secretary of Labor pursuant to such authority.
The transactions set forth herein warrant detailed discussion. This memorandum will address the following issues related to our products:
(1) Introduction, (2) Prohibited Transactions, (3) Exemptions, (4) Plan Asset Rule,
(5) Unrelated Business Taxable Income, (6) Conclusion.
Individual Retirement Accounts or “IRAs,” are entitled to own various assets subject to certain restrictions. This broad investment selection was made clear in Field Service Advisory 200128011 (April 6, 2001) wherein the Internal Revenue Service (IRS) considered the ability of an IRA owner to invest in a Foreign Sales Corporation (FSC). The quote from the text is in bold:
There is no specific Code provision or regulation prohibiting an IRA from owning the stock of a FSC. The type of investment that may be held in an IRA is limited only with respect to insurance contracts, under section 408(a)(3), and with respect to certain collectibles, under section 408(m)(1).
This is consistent with IRS Private Letter Ruling 8241079 dated February 25, 1982, concluding in favor of a retirement plan investing in an unregistered bond. Finally, investment of IRA funds into a business entity is permitted by interpretive bulletins issued in 1975 and the publication of final regulations following these bulletins that was codified on November 13, 1986. While it is conclusive that an IRA can own an LLC interest or a promissory note, this is only the first step of the legal analysis.
The Internal Revenue Code provides a concise statement of law from which to begin our analysis of some additional matters to be considered in order to conclude in favor of the continued tax-deferred environment of the IRA:
[An] individual retirement account is exempt from taxation . . .unless such account has ceased to be an individual retirement account by reason of paragraph (2) or (3). Notwithstanding the preceding sentence, any such account is subject to the taxes imposed by Section 511 (relating to imposition of tax on unrelated business taxable income of charitable, etc., organizations).
By this section, the IRA is lawfully tax exempt with certain exceptions. The references to IRC § 408(e)(2) and (3) are to, respectively, Prohibited Transactions and Improper Borrowing. Section 511 is otherwise known as Unrelated Business Income Tax (“UBIT”). While the other restrictions set forth in this correspondence cause a deemed distribution (and therefore, taxable income) from the IRA, UBIT subjects only certain income to taxation. Because it is probably the most misunderstood and overly dramatized Code section, the Prohibited Transactions code provides an excellent starting point from which to commence the analysis.
2. Prohibited Transactions
IRC § 4975(c)(1) states that a “prohibited transaction” includes any “direct or indirect”:
· sale or exchange, or leasing, of any property between a plan and a disqualified person;
· lending of money or other extension of credit between a plan and a disqualified person;
· furnishing of goods, services, or facilities between a plan and a disqualified person;
· transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
· act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
· 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.
Thus, as long as IRA LLC Strategy does not involve a “disqualified person,” no “prohibited transaction” can be triggered. This term generally includes fiduciaries, employers, employees, family members and entities in which equity interests in excess of fifty (50%) percent are owned by the IRA owner (or family members). These are detailed below:
· Fiduciary and Disqualified Persons:
The IRA, through the participation of the Registered Trust Company or Self-Directed IRA Custodian, will usually be the sole member of the LLC. The IRA owner will be appointed as the Manager of the LLC by all members, including the IRA (signed by the Custodian). Then, through a specially designed operating agreement, the manager is given authority to choose investments on behalf of the IRA. Any person who exercises authority or control respecting the management or disposition of the underlying assets, and any person who provides investment advice with respect to such assets for a fee (direct or indirect), is a fiduciary of the investing plan. Thus, after initial formation and capitalization of the LLC, the IRA Owner will be a “disqualified person” with respect to the plan or the assets of the plan. However, the issue then becomes whether the IRA owner is a disqualified person prior to formation or capitalization of the LLC.
Prior to the formation and capitalization, the LLC is not in existence. The LLC has no members or membership interests. The LLC has no equity interests outstanding. Before its legal formation, the LLC does not fit within the definition of a “disqualified person” under the Code. Thus, the initial capital contribution to the LLC by the IRA and otherwise disqualified persons, is not a prohibited transaction. This specific issue was addressed in Swanson v. Commissioner, 106 T.C. 76 (1996). The Tax Court, in holding for the Taxpayer, states the following:
We find that it was unreasonable for [the IRS] to maintain that a prohibited transaction occurred when Worldwide’s stock was acquired by IRA #1. The stock acquired in that transaction was newly issued — prior to that point in time, Worldwide had no shares or shareholders. A corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e)(2)(G). It was only after Worldwide issued its stock to IRA #1 that petitioner held a beneficial interest in Worldwide’s stock, thereby causing Worldwide to become a disqualified person under section 4975(e)(2)(G). . . Therefore, [the IRS’] litigation position with respect to this issue was unreasonable as a matter of both law and fact.
The choice of entity (LLC) does not affect this holding. Rather, it is the fact of the newly issued equity interest in the newly formed entity. The IRS is cognizant of the hazards of litigation presented by pursuing this course as a mode of challenge. In holding the IRS’s position “unreasonable,” the Tax Court required the Defendant (the IRS) to pay the taxpayer costs and attorney fees. In conclusion, the direction of funds as an initial capitalization from the new IRA to the LLC does not constitute a disqualified person.
This conclusion was also acknowledged by the IRS in Field Service Advisory (FSA) 200128011 (April 6, 2001). In that FSA, the Service states:
In light of Swanson, we conclude that a prohibited transaction did not occur under section 4975(c)(1)(A) in the original issuance of the stock of FSC A to the IRAs in this case. Similarly, we conclude that payment of dividends by FSC A to the IRAs in this case is not a prohibited transaction under section 4975(c)(1)(D). We further conclude, considering Swanson, that we should not maintain that the ownership of FSC A stock by the IRAs, together with the payment of dividends by FSC A to the IRAs, constitutes a prohibited transaction under section 4975(c)(1)(E).
Even conceding that the LLC Manager and IRA owner is a fiduciary after the formation of the LLC, the basic IRA LLC Strategy does not envision any transaction between the Manager of the LLC and the plan. Therefore, while the disqualified person would be present, the necessary transaction would not. This can change, however, when the manager chooses to take a fee or employ himself in the investment. These must be dealt with on a case by case basis as facts change.
Upon implementation of the IRA LLC Strategy, the IRA involves neither an employer nor employee. The Swanson case, in footnote 14, arrives at the same conclusion.
14/ Furthermore, we find that at the time of the stock issuance, Worldwide was not, within the meaning of sec. 4975(e)(2)(C), an “employer”, any of whose employees were beneficiaries of IRA #1. Although sec. 4975 does not define the term “employer”, we find guidance in sec. 3(5) of the Employee Retirement Income Security Act of 1974 (ERISA), Pub. L. 93-406, 88 Stat. 829, 834. In pertinent part, ERISA sec. 3(5) provides that, for plans such as an IRA, an “’employer’ means any person acting directly as an employer, or indirectly in the interest of an employer, in relation to an employee benefit plan * * *.” Because Worldwide did not maintain, sponsor, or directly contribute to IRA #1, we find that Worldwide was not acting as an “employer” in relation to an employee plan, and was not, therefore, a disqualified person under sec. 4975(e)(2)(C). As there is no evidence that Worldwide was an “employee organization,” any of whose members were participants in IRA #1, we also find that Worldwide was not a disqualified person under sec. 4975(e)(2)(D).
· Family Member
Disqualified Person includes a “member of the family” as that term is defined in IRC 4975(e)(6). The family of an individual, or fiduciary, “shall include his spouse, ancestor, lineal descendant, and any spouse of a lineal descendant.” Id. Note that the definition does not include brothers, sisters, aunts, uncles or other non-lineal descendants. Again, the interaction between the plan and ANY disqualified person must be reviewed on a case by case basis. IRAAA always works with its clients to determine exactly what the client intends as an investment and whether any prohibited transaction might result.
· Equity Interest in an Entity.
Section 4975(e)(2) encompasses equity interests in an entity in excess of fifty (50%) percent. Thus, any entity already owned by the IRA owner or fiduciary in which the IRA/LLC might invest must be scrutinized to ensure that a prohibited transaction in sales, services or loans will not occur between the two entities.
As mentioned in the introduction, since 1978 the Secretary of the Department of Labor has had the authority to issue interpretations regarding prohibited transactions and the IRS is bound by those interpretations. Since receiving this authority, the Department of Labor has issued hundreds of exemptions.
The Employee Retirement Income Security Act of 1974 (ERISA) prohibits certain classes of transactions between employee benefit plans and certain persons defined as “parties in interest”. The law does, however, contain a number of statutory exemptions from the prohibited transaction rules.
In addition, ERISA gives the Department of Labor authority to grant administrative exemptions from the prohibited transaction provisions if the Department first finds that the exemption is:
· administratively feasible;
· in the interest of the plan and of its participants and beneficiaries; and
· protective of the rights of participants and
· beneficiaries of the plan.
Most of the transactions prohibited by ERISA are likewise prohibited under the Internal Revenue Code. The Code also contains exemptive authority similar to that found under ERISA.
The Department of Labor has gained 20 years of experience with the processing of large numbers of applications for exemptions from ERISA’s prohibited transaction provisions. Through that experience with a wide variety of transactions, a number of transactions have emerged which have similar characteristics.
The ERISA law contains several specific exemptions whereby plans may engage in transactions otherwise prohibited by law. In order to use these statutory exemptions, parties must meet the conditions of the applicable exemption.
ERISA generally provides statutory exemptions for, among other things, loans to participants, the provision of services necessary for the operation of a plan for no more than reasonable compensation, loans to employee stock ownership plans, and deposits in certain financial institutions regulated by other State or federal agencies.
Under ERISA, the Department may grant administrative exemptions to an individual or a class of individuals allowing them to engage in a variety of transactions involving employee benefit plans.
Class exemptions are administrative “blanket” exemptions which permit persons to engage in similar transactions with plans in accordance with the conditions of the class exemption without asking for an individual exemption. For example, class exemptions have been granted covering:
* Transfers of individual life insurance contracts between plans and their participants (PTE’s 92-5 and 92-6)
* Sales of customer notes to plans by their sponsoring employers (PTE 85-68)
* Interest-free loans made to plans by their sponsoring employers (PTE 80-26)
Individual exemption requests must be drafted by certain standards and contain specific information to be considered. The attorneys at Legal Strategies, PC can draft exemption requests for those clients who propose an otherwise prohibited transaction, but the transaction meets the criteria for exemption. Where two or more individual exemptions are granted by the Dept. of Labor, a similar fact pattern can achieve an exemption in an expedited fashion. The time line for a formal opinion depends upon the workload of the Department, but they have indicated to IRAAA that it can take as long as six months, or as little as just a few weeks.
4. Plan Asset Rule:
Investment of IRA funds into a business entity is clearly permitted. However, the assets of the LLC are assets of the IRA where the plan owns 100% of the LLC. This is significant because where the LLC assets are considered “plan assets” any transaction between the LLC and a disqualified person is potentially subject to the prohibited transactions Code. This could arise in transactions such as loans between the IRA/LLC and the plan owner, employee or management payments to the plan owner or a lineal descendant, etc. However, the assets of an LLC are not necessary considered “plan assets.” Under the plan asset rule:
…when a plan invests in a non-publicly traded entity, the assets of the plan include BOTH the equity interest and an undivided interest in each of the underlying assets of the entity, unless:
(1) The entity is an operating company, or
(2) Equity participation in the entity by benefit plan investors is not
Under the Code, when a plan owns less than 25% of an entity, equity participation is not “significant” so the assets of the entity are not assets of the plan. The issue then, is whether entity assets are considered “assets of the plan” when 25% to less than 100% of the entity is owned by the plan. This is what we refer to as the “gray area” and can only be definitively answered based upon the facts of each case.
Because the law is not completely clear, IRAAA makes the safe assumption that when a plan owns 25%-99% of an entity the IRA involvement may be considered “significant.” Therefore, we acknowledge that when a plan owns 25% to 99% of an LLC, the assets of the LLC should be considered assets of the IRA for a prohibited transaction analysis, unless the LLC is considered an “operating company.”
Thus, the question becomes, “Is the entity an “operating company,” under 29 CFR 2510.3-101?
Most of our clients who have IRAs owning 25% to 99% of a private company might like to interact with the company such that it might appear to be a prohibited transaction. This includes personal guarantees on loans to the LLC, loans made by a disqualified person to or from the LLC, or other personal benefit from the transaction. This seems possible only if:
· The company fits the definition of “operating company.” and
· The loan guarantee is made to the company loaning to the LLC, not to the plan or plan assets.
In other words, if a personal guarantee of a mortgage on property purchased by an LLC (partially owned by an IRA 25-99%) is required, we would want to be certain that our clients fit within the definition of an “operating company.” Further, we ensure that no other prohibited transactions are taking place in the set up or operation of the entity and its investments. This is what IRAAA provides to its clients in continuing legal support throughout the process. We request that our clients ask questions and provide details of their investment intentions in writing (e.g. E-mail) so that there is no misunderstanding.
5. Unrelated Business Income Tax:
As previously provided above, IRC § 408(e)(1) states:
[An] individual retirement account is exempt from taxation . . .unless such account has ceased to be an individual retirement account by reason of paragraph (2) or (3). Notwithstanding the preceding sentence, any such account is subject to the taxes imposed by Section 511 (relating to imposition of tax on unrelated business taxable income of charitable, etc., organizations). [Italics added].
To the extent that there is unrelated business taxable income (UBIT) earned by the IRA, it will be currently reportable and taxable by the plan participant. For example, the interest earned by a promissory note is expressly excluded from the definition of UBIT.
There shall be excluded [from the definition of unrelated business taxable income] all dividends, interest, payments with respect to securities loans (as defined in section 512(a)(5)), amounts received or accrued as consideration for entering into agreements to make loans, and annuities, and all deductions directly connected with such income.
There are certain factual patterns in which UBIT might apply. We advise our clients on a case by case basis whether the UBIT might apply to the particular investment.
IRAAA is a leader in the area of self-directed pension plans. We can and do help our clients to accelerate their tax free or tax deferred pension plan growth by knowing and understanding the complex laws and regulations affecting pension possibilities. This Memorandum is designed not to teach the reader how to make non-traditional investments, the legal minefield is far too immense to attempt this without years of study. Rather, by this we hope to instill confidence in our clients and associates by explaining the underlying platform of IRAAA products, as supported by DOL and IRS Codes and regulations.
The LL.M. Program in Taxation is designed for those interested in studying complex course work in taxation and tax-related issues. Admission to the LL.M. degree program requires an LL.B. or J.D. degree from a law school approved by the American Bar Association and the Association of American Law Schools. Law degrees from schools in foreign countries do not meet these minimum requirements. To earn the LL.M. degree in taxation, students need to satisfactorily complete 24 credit hours of study in residence. The following courses are required for the LL.M. degree in taxation if they were not previously taken in law school: Estate and Gift Tax Planning, Federal Income Taxation, Partnership Taxation, and Corporate Taxation. No credit is given for any course earning a grade of 75 or below.
Codified in 26 USC § 408(d)(3). (Also known as IRC Section 408).
26 USC § 721.
Governed by IRC Section 408.
IRS FSA 200128011.
See ERISA IB 75-2 and its codification: 29 CFR 2509.75-2.
Defined in IRC 4975(e)(2).
26 USC § 4975(e)(3)(A).
26 USC § 4975(e)(2).
Id. at 25.
29 CFR 2509.75-2
29 CFR 2510.3-101 (h) (3) See Also 29 CFR 2510.3-101(a)(2).
Department of Labor Opinion Letter 90-23. See Also H.R. Rep 93-1280 , 93rd Cong., 2d Session, 308 (1974) and 26 USC § 4975(c)(1)(B).
29 CFR 2509.75-2(a).
29 CFR 2510.3-101(a)(2).
29 CFR 2510.3-101(f).
Id. An “operating company” is defined as an entity that is primarily engaged, directly or through a majority owned subsidiary in the production or sale of a product or service other than the investment of capital (Including venture capital companies and real estate operating companies). A real estate operating company is defined by 29 CFR 2510.3-101(e). An entity is a “real estate operating company” if:
1. On the initial valuation date, at least 50% of its assets are invested in real estate which is managed or developed and with respect to which such entity has the right to substantially participate directly in the management or development activities.
2. During the 12 month period beginning with the initial valuation date, such entity in the ordinary course of its business is engaged directly in real estate management or development activities.
IRC § 512(b)(1).
See also, Treasury Regulation 1.512(b)-1(a)(1).