Trustees of individual retirement accounts (IRAs) have increasingly seen participants turning to nontraditional or alternative investments in their accounts. These investments include not only real estate but also mortgages and closely held entities such as limited partnerships (LPs) or hedge funds. In many cases, the IRA trustee can acquire these assets only upon the participant's direction. This arrangement, known as a self-directed IRA, leaves the trustee operating as a custodian with no discretion to manage the account's assets.1
While an IRA may not own life insurance contracts or collectibles (with some exemptions), nothing in the Internal Revenue Code makes holding alternative investments impermissible per se.2 Still, acquiring or selling an alternative investment poses three major risks to a self-directed IRA trustee:
Increased potential for a prohibited transaction3 — Generally speaking, a prohibited transaction is a form of self-dealing. Engaging in a prohibited transaction results in loss of the IRA's tax-exempt status and a deemed distribution of the account's assets.4 The IRA participant will immediately recognize tax on any deferred income.
Difficulty in complying with tax reporting and administrative duties — This second risk is equally challenging: All IRA trustees have mandatory tax reporting and administrative duties.5 For example, the IRA trustee must report an accurate fair market value (FMV) of the IRA's assets to the participant and the Internal Revenue Service. By their very nature, alternative investments frequently do not have a readily available market value. The IRA trustee still must obtain an estimated FMV from a reliable source.
Exposure to personal liability — Perhaps the least understood risk is when a self-directed IRA trustee deviates from its nondiscretionary role. If a self-directed IRA trustee voluntarily deems itself a fiduciary of an employee benefit plan, this assumed duty may expose the trustee to personal liability for imprudent management of the account's investments.
These risks arise in two different scenarios: when participants want to move an existing alternative investment from one trustee to another, or when they direct the current trustee to purchase or sell an asset. Banks or other qualified trustees of a self-directed IRA are under no obligation to accept alternative investments. They do so to accommodate their clients.
THE RIGHT PATH
Handling alternative investments in a self-directed IRA requires the trustee to address the tax and administrative considerations before accepting the account and to maintain a nondiscretionary role when managing it. To do this means establishing a clear understanding between the IRA participant and the trustee. The participant must assume responsibility for certain risks inherent to alternative investments and acknowledge the IRA trustee's nondiscretionary capacity in administering the account.
More specifically, the IRA trustee must (1) recognize the underlying tax constraints; (2) acknowledge the required tax reporting and administrative duties; (3) determine its standard of conduct; and (4) ensure that the IRA participant understands and agrees to bear the risks associated with the alternative investment. Let's drill down to see what these elements really entail.
Recognize the underlying tax constraints — An IRA trustee must understand that several tax issues impact the holding of alternative investments. Violation of the corresponding IRC provisions will defeat the IRA's goal of tax deferral.
(a) Prohibited transactions — The IRC defines the circumstances when a prohibited transaction arises and the individuals or entities to whom the rules apply. Relevant, prohibited transactions fall into two categories: mechanical and broad-based transactions.
A mechanical prohibited transaction involves some type of direct or indirect transfer, sale, exchange, lease or furnishing of services between the IRA and an individual or entity.6 A broad-based transaction does not require a transfer from the IRA. Rather, it involves a person or entity receiving a personal benefit from using the IRA's assets or income.7
Common to both categories is the requirement of a disqualified person, as defined by the IRC.8 A mechanical prohibited transaction normally has two disqualified persons. The first, most often the participant, directs that a second to whom he is related or whom he controls, receive something following the direction.
A broad-based prohibited transaction focuses on a disqualified person's use of the IRA's assets or income. The presence of one disqualified person (usually the participant) is enough to create a prohibited transaction.9
The IRA participant is a disqualified person not only in an individual capacity, but also as a fiduciary when it exercises its investment discretion.10
(b) Unrelated business taxable income (UBTI) — If an IRA conducts a trade or business, the UBTI provisions come into play.11 A trade or business is normally a for-profit activity that generates taxable income. To maintain a trade or business in a tax-exempt entity such as an IRA, would provide an unfair advantage over for-profit businesses.
An IRA also creates UBTI if it holds “debt-financed property.” A mortgage used to pay for income-producing real estate is debt-financed property and can generate UBTI.
As an IRA creates UBTI, the trustee must pay the tax from the account and file Form 990-T with the IRS.
(c) Excess contributions resulting from the participant's providing personal services — An IRA is a separate entity, and the trustee must ensure that the participant recognizes this status. For example, the IRA purchases a vacant lot and builds a rental property on the land. The participant contributes labor (personal services) by pushing a wheelbarrow and planting trees on the premises. The value of these activities may constitute an excess contribution, which triggers a penalty under the IRC.12 If the IRA profits from the personal services, the participant may owe income and self-employment taxes.13 The furnishing of personal services may even fall under the prohibited transaction rules and create UBTI.14
(d) Abusive transactions — The IRS has indicated that certain transactions between an outside corporation controlled by the participant and an entity owned by a Roth IRA may be abusive.15 The transactions involve the entity held in the Roth IRA acquiring property or receiving contributions of property or services that are not fairly valued. These attempts to shift value to the tax-exempt Roth IRA could result in an excess contribution penalty and recognition of income. The IRS has stated that this strategy amounts to a “listed transaction,” which is a tax avoidance scheme.
Acknowledge the IRA trustee's required tax reporting and administrative duties — Although a self-directed IRA trustee does not have discretion over investments, it assumes several mandatory obligations, including reporting information to the IRS and satisfying administrative requirements inherent to IRAs.
(a) Valuation issues — The IRA trustee must report an accurate FMV of all IRA assets annually, including alternative investments. The IRA trustee cannot evade this responsibility by asking the participant to provide the value or by seeking a waiver of the duty.16 When a readily available market value does not exist for an entity, the IRS has stated that IRA trustees must apply the guidelines in Revenue Ruling 59-60.17
(b) Liquidity — Alternative investments are generally illiquid. This lack of liquidity can create a variety of problems. If the IRA must pay a required minimum distribution (RMD), the account needs sufficient cash to do so or the IRA trustee might have to make an in-kind distribution of the alternative investment. Divorce also can spark liquidity concerns should the IRA trustee have to divide the alternative investment. IRA trustees need liquid assets to pay operating expenses associated with the alternative investment for such needs as property insurance, costs of repair and maintenance. The IRA participant cannot pay these expenses personally as they potentially would constitute excess contributions.
(c) Environmental considerations — A self-directed IRA trustee must consider environmental issues before accepting an asset. Discovery of environmental hazards while the IRA trustee has legal title may result in personal liability for the trustee. The IRA trustee can mitigate this risk by having the participant complete an environmental questionnaire or require further assessment of the property prior to acceptance. The account agreement or other documents should provide that the IRA will bear the expense of any assessment.
(d) Tax reporting considerations — Among the self-directed IRA trustee's most important duties is tax reporting. This job goes beyond filing Form 5498, showing any contributions, the IRA's FMV and whether an RMD is due. The IRA trustee also must report, and the IRA must pay, any UBTI. Should the IRA participant violate the prohibited transaction rules, the IRA trustee must report a total distribution of the account to the IRS on Form 1099-R.
(e) IRA trustee's fees — While establishing a reasonable fee is more of business decision than an administrative matter, the self-directed IRA trustee should receive appropriate compensation. The additional risks with alternative investments strongly suggest that a self-directed IRA trustee charge more than for a normal custody account holding marketable securities. If the participant intends to pay the fee from the account, liquidity again becomes an issue.
Determine the IRA trustee's standard of conduct for a self-directed IRA—
Federal tax considerations — A popular belief is that an IRA is the equivalent of an employee benefit plan.18 Consequently, self-directed IRA trustees must automatically apply the fiduciary duty rules created by the Employee Retirement Income Security Act (ERISA). Under these rules, a fiduciary19 of an employee benefit plan shall not allow a transaction to proceed if it “knows or should know that such transaction” constitutes one of the enumerated prohibited transactions.20
While ERISA created the IRA as part of the IRC, ERISA's legislative history does not view a self-directed IRA trustee as subject to the “know/should know” standard applicable to fiduciaries of employee benefit plans. The IRA trustee does not cause the account to engage in a prohibited transaction unless it has some personal interest in the transaction.21 The drafters of ERISA separated the functions of a fiduciary of an employee benefit plan from those of a nondiscretionary IRA trustee.22
Under the IRC, the focus of the prohibited transactions rules is on the participant. With discretionary authority over investments, the participant must determine whether the transaction is prohibited. The “tax standard,” however, implicitly places three responsibilities on the self-directed IRA trustee: to disclose the scope of the prohibited transaction rules to the participant; to document that the participant understands the consequences of a prohibited transaction; and to obtain the participant”s representation that any transaction involving the alternative investment will not result in a prohibited transaction.
Of course, inquiry into the IRA trustee's duty to determine if a potential prohibited transaction exists does not end with federal law. Absent relevant language in the IRA agreement, state law might create this duty of care. Jurisdictions with directed trust statutes may effectively require an IRA trustee to monitor for prohibited transactions.23
Case law provides insight into a self-directed IRA trustee's duties to the participant of a self-directed IRA. In Metz v. Independent Trust Corporation,24 the participant's IRA trust agreement left the trustee with no discretion to manage or evaluate the participant's investments. The participant then directed a loan to his handpicked investment advisor, a disqualified person.25
Documents signed by the participant stated that the investment advisor was not a disqualified person and the transaction was not prohibited. The participant also held the trustee harmless for following his direction. After the investment advisor absconded with the loan proceeds, the participant sued the trustee for breach of trust for authorizing a prohibited transaction.
The participant asserted that despite his statements to the contrary, the trustee knew he was engaging in a prohibited transaction. He claimed that the ERISA standard (requiring that the trustee “know/should have known” that the transaction was prohibited) and state law invalidated his representations, making the trustee personally liable. The courts did not agree. In affirming the district court's ruling, the appellate court found that the ERISA fiduciary standard did not apply to a self-directed IRA trustee.26 Moreover, the court found, the trustee's execution of the participant's direction did not violate state law.
The absence of any discretion regarding investments protected the bank and was the linchpin of the court's decision.27 The self-directed IRA trustee has no duty to disclose when a transaction is prohibited or to stop it if the participant represents that it does not constitute a prohibited transaction.
Given this background, what is the standard for an IRA trustee when it comes to reviewing potential alternative investments for a prohibited transaction and other tax concerns? The answer turns on the terms of the IRA agreement, any other account documentation and the trustee's subsequent conduct.
Prohibited transactions and other tax concerns — If the participant has exclusive control over the IRA's investments, the trustee has no duty to determine if the transaction is prohibited. However, to reduce its risk, the trustee must inform the participant of its responsibility to make this determination and secure multiple layers of documentation cementing the participant's understanding.28
A nondiscretionary IRA trustee who deviates from this standard and views itself as the equivalent of an ERISA fiduciary, increases personal risk. If the participant engages in a transaction that the IRA trustee knew or should have known was prohibited, personal liability under state law may result.29 The voluntary assumption of duty offers the participant remedies for negligence and breach of trust.30
Voluntarily monitoring for prohibited transactions may portend even more onerous consequences for the self-directed IRA trustee. Performing this duty may require the IRA trustee to perform other duties and place others associated with an ERISA fiduciary, including but not limited to, evaluating the investment's performance and advising the participant of its suitability for the account.31 Failure to satisfy any of these duties opens the door for allegations of negligence and breach of trust.
The trustee of a self-directed IRA needs to disclose additional tax concerns. The disclosures should cover potential penalties for providing personal services and investment strategies that the IRS considers abusive. Finally, any disclosure should highlight investments that may trigger UBTI, including debt-financed assets.
An IRA trustee may decide for policy reasons that it must exercise fiduciary powers (act like a traditional trustee under state law) to safeguard the account. Alternatively, it may decide simply to hold the assets as a custodian and agree that someone authorized to serve under the IRC should act as trustee with fiduciary powers.32 In any event, the agreement should expressly reflect the limits of the IRA trustee's authority.
Administrative duties — Unlike its passive role regarding investments, the IRA trustee must demonstrate active oversight in administering the self-directed IRA to fulfill its standard of conduct. The key point is maintaining the IRA's separate identity. This standard means the IRA trustee must pay all bills from the IRA, deposit all receipts to the account and maintain sufficient cash to pay its obligations, including any RMDs.
Finally, the IRA trustee must not only file reports, but also independently determine the value of any distribution or investment.
Ensure that the self-directed IRA participant understands and agrees to bear the risks associated with the alternative investment — The core elements the IRA trustee must document involve disclosures to the participant and confirmation that he:
understands the scope of the tax rules applicable to IRAs, including but not limited to prohibited transactions;
acknowledges the tax consequences of engaging in a prohibited transaction;
agrees that the trustee has no duty to determine that an alternative investment complies with the prohibited transactions rules;
certifies that the investment will not create a prohibited transaction and that subsequent use of the asset will comply with the prohibited transactions rules;
agrees that the IRA trustee must fulfill certain duties to administer the account properly, including but not limited to obtaining an alternative investment's FMV in accordance with regulatory guidelines; and
agrees to respect the IRA as a separate entity and not provide any personal services to the account.
The IRA trustee must structure the account's operating documents to maintain its nondiscretionary role to preclude any duty to evaluate, monitor or render advice regarding investments. Crafting the operating documents in this manner and adhering to their nondiscretionary language will avoid creation of a contractual or independent duty of care.33 Relying on this rationale, judicial authority relieved an IRA trustee of liability for failing to notify participants when a borrower defaulted on mortgage payments34 and verifying whether a third party had recorded mortgages following the participant's direction to invest with this entity.35
Satisfying this step entails three layers of documentation. The IRA agreement and disclosure statement are the first layer. The second layer includes a specific disclosure to the participant that the IRA trustee has no duty to determine in advance that a transaction will pass the prohibited transactions rules. However, if it subsequently learns that the participant engaged in a transaction that potentially was prohibited, it has the right to investigate, and if necessary, report the violation to the IRS.
The third, and most important layer is the participant's written direction to hold, purchase or sell a specific alternative investment. Obviously, the participant direction should expressly state that: the IRA trustee is not acting as a fiduciary by evaluating or providing any advice on the merits of the transaction; the transaction is not prohibited under the IRC; future use of the investment will not be prohibited; and the IRA trustee may rely on these representations in executing the transaction and will bear no liability for doing so.
An alternative to creating internal documentation is reliance on external sources. The IRA trustee can ask the participant to obtain an advisory opinion from the Department of Labor. This department has jurisdiction to rule on whether a prospective transaction violates the prohibited transaction rules. IRC Section 4975(c)(2) provides administrative exemptions for a prohibited transaction. An exemption would allow what otherwise would be a prohibited transaction.
PROCEED WITH CAUTION
Dealing with alternative investments in self-directed IRAs is challenging but manageable. Recognizing the proper allocation of risk and addressing it through layered documentation should significantly reduce risk to the IRA trustee.
Sticking to the nondiscretionary posture created by the plan's documentation will further protect the IRA trustee from liability. Should it voluntarily decide to escalate its status to a discretionary role, it will become the functional equivalent of an ERISA fiduciary. The trustee will then have duties to know or to investigate whether the participant is engaging in a prohibited transaction and to monitor investment performance.
— The author thanks two former Wachovia Bank colleagues, Linda Dillow and Chris Gammon, for their insight into self-directed IRAs.
- The Internal Revenue Code created individual retirement arrangements (IRAs) as trusts under Section 408(a) or as custodial accounts that are deemed trusts under Section 408(h). The tax consequences are the same in each instance. An IRA trust is a creature of federal law and requires additional language in the trust agreement or the operation of state law to vest the IRA sponsor with powers traditionally associated with a trustee.
- IRC Sections 408(a)(3) and 408(m).
- IRC Section 4975. For a comprehensive discussion of IRAs, prohibited transactions and other tax rules on investments, see chapter 8 of Natalie Choate's Life & Death Planning for Retirement Benefits, 6th ed., Ataxplan Publications, Boston, 2006.
- IRC Section 408(e)(2).
- Treasury Regulations Section 1.408-5.
- IRC Section 4975(c)(1), subparagraphs A through D; Department of Labor Advisory Opinion (DOL 2006-01A) illustrates an “indirect mechanical prohibited transaction;” the IRA participant created an entity in which the IRA was a minority shareholder and he was not a manager; the entity at the direction of a disqualified person then leased property to an entity controlled by the IRA participant.
- IRC Section 4975(c)(1), subparagraphs D and E.
- Disqualified persons under IRC Section 4975 include the IRA owner, the owner/participant's spouse, ancestors, lineal descendants and spouses, an entity in which any of the named persons collectively own more than 50 percent of the beneficial interest, an officer, director or highly compensated employee of a controlled entity, a fiduciary (the participant in a self-directed IRA) or service provider; a separate provision of the IRC, Section 408(e)(2)(A), makes the participant and the named beneficiary disqualified persons.
- Rollins v. Commissioner, T.C. Memo. 2004-260 (2004) is a good example; the taxpayer, a fiduciary of his qualified retirement plan, arranged for several corporations in which he owned a minority interest, to obtain loans from his plan. The taxpayer signed the notes on the corporations' behalf; the decision found that the taxpayer failed to prove that he had not used the plan's asset for personal benefit, a violation under Section 4975(c)(1)(D).
- Gerald M. Harris, T.C. Memo. 1994-22 (IRA participant is a disqualified person); IRC Section 4975(e)(3) (definition of fiduciary) and Treas. Regs. Section 54.4975-9 (definition of “fiduciary”).
- IRC Sections 511-514.
- IRC Section 4973.
- Natalie Choate, “Estate Planning for Retirement Benefits: Recent Developments,” Sophisticated Estate Planning Techniques (ALI-ABA Study Materials SL023, September 2005), at pp. 8-9.
- Revenue Notice 2004-8, 2004-1 Internal Revenue Service Cumulative Bulletin 333.
- IRS Interpretative Letter EP:R:9 (Feb. 24, 1993).
- 1959-1 IRS Cumulative Bulletin 237.
- Many financial institutions “have determined that [IRAs] most resemble Employee Retirement Income Security Accounts.” See Judith A. Dorian, “IRAs: More than Meets the Eye,” Trusts & Estates, June 2002, at p. 33.
- A fiduciary under the Employee Retirement Income Security Act (ERISA) rules for employee benefit plans has discretion over the plan's assets or administration. The definition looks to function rather than formal title to establish fiduciary status. See 29 United States Code 1002(21)(A).
- 29 U.S.C. 1106; ERISA created two sets of prohibited transactions rules: one under the labor code (title 29) and the other under the tax code (title 26). The categories of prohibited transactions are virtually identical under the labor and tax codes.
- Conference Report 93-1280, at p. 295, IRS Cumulative Bulletin 1974-3, at p. 456 (“The labor provisions … make certain specific transactions “prohibited transactions” which plan fiduciaries are not to engage in. The tax provisions include only the prohibited transactions rules and apply only to disqualified persons, not fiduciaries, unless the fiduciary is otherwise a disqualified person and the transaction involved him or the fiduciary benefited from the transaction”). An IRA administrator can become a fiduciary under the IRC if it has discretionary authority to manage or administer the IRA. IRC Section 4975(e)(3).
- See 29 U.S.C. 1103(b)(3(B) (custodial IRAs excluded from fiduciary responsibilities under ERISA); 29 Code of Federal Regulations Section 2510.3-2(d) (employee pension benefit plans do not include IRAs); Title I of ERISA contains the rules that apply traditional concepts of trust law and brings employee benefit plans within its realm. Title II of ERISA established IRAs but did not include the same fiduciary duty rules in IRC Section (408) creating an IRA. However, simplified employee pension (SEP) plans and savings incentive match plans (SIMPLE IRAs) may be subject to the ERISA fiduciary rules. See Choate, supra note 3, at chapter 10.13.
- Virginia Code Annotated, Section 26.5.2C; see Rollins v. Branch Banking and Trust Co. of Va., 46 Va. Cir. 147 (2004) (directed trustee retains common law duty to warn).
- Metz v. Independent Trust Corporation, 994 F.2d 395 (7th Cir. 1993).
- A prohibited transaction requires at least one disqualified person. See note 17, supra, for the categories of disqualified persons.
- Metz specifically cited 29 U.S.C. 1103(b)(3)(B), which excluded a custodial IRA from ERISA's fiduciary duty rules and extended its protection to an IRA agreement for self-directed (nondiscretionary) trustees. The court applied a functional rather than literal test to preclude a nondiscretionary trustee from being subject to ERISA's fiduciary rules.
- Another case absolving a self-directed IRA trustee for failure to warn of a prohibited transaction is Scionti v. First Trust Corp., 1999 U.S. Dist. Lexis 23253 (S.D. Tex. 2001). The court also ruled that the participant could not base a private cause of action on IRC Section 4975.
- If the IRA agreement or other document gives the administrator discretion over investments, then it becomes the functional equivalent of an ERISA fiduciary whose duty includes determining if a transaction is prohibited.
- As the fiduciary duty rules under ERISA do not apply to IRAs (with the possible exception of SEP and SIMPLE IRAs), the participant cannot use them to prosecute a private cause of action. See generally Garratt v. Walker, 121 F.3d 565 (10th Cir. 1997).
- See Jorgensen v. State National Bank & Trust Co., 255 Neb. 241 (1998) (IRA custodian rendered advice leading to IRS disqualification of participant's account and participant sued, among other grounds, for negligence; bank did not dispute allegation, but unsuccessfully asserted statute of limitations defense.)
- See DiFelice v. US Airways, Inc., 397 F.Supp.2d 758, 772 (E.D. Va. 2005) (a fiduciary shall employ proper methods to investigate, evaluate and structure the investment; act in a manner as would others who have a capacity and familiarity with such matters; and exercise independent judgment when making investment decisions).
- IRC Section 408(a)(2) allows someone other than a bank to serve as IRA trustee provided the IRS is satisfied that the proposed trustee can administer the account consistently with the requirements of IRC Section 408.
- See Abbott v. Chemical Trust, 2001 U.S. Dist. Lexis 6214 (D. Kan. 2001); on a potentially contrary note, Florida enacted a statute effective July 1, 2006, for a passive IRA trustee holding real estate as “custodial property;” the trustee in dealing with this property shall follow a standard of care substantially similar to the standard for an ERISA fiduciary. See Florida Statute Section 689.072(6).
- Brown v. California Pension Administrators and Consultants, 45 Cal. App. 4th 333 (Cal. App. 2d Dist. 1996).
- Paszamant v. Retirement Accounts, Inc., 776 So.2d 1049 (4th DCA 2001).